One Guy's Investments: Will New Capacity Drown MEMC Electronic Materials? (WFR, STP)

Companies in the semiconductor and solar cell industries have been fighting an at times severe shortage of polysilicon and silicon wafers as they try to ramp up capacity -- and that shortage has done wonderful things for the resurgent MEMC Electronic Materials (WFR), a company I've held for about a year and a half. There has been lots of press coverage of this shortage over the past year, including a recent AP article on the ceiling this is putting on solar cell growth.

WFR is an integrated producer of silicon wafers for both the solar power and semiconductor industries, with their own polysilicon supplies and an excellent roster of customers in both industries. As I've written about before, in January they announced plans to dramatically expand their production to help meet increased demand ... and more recently, they made a deal with Suntech Power (STP) to help finance that expansion.

MEMC Electronic Materials has also made a pretty good recovery from some financial problems about two years ago, and they've now finally issued all of their outstanding SEC filings and are now current, with a solid balance sheet and, as far as I can tell, no lingering dark clouds over management. So they're in a great spot, right?

Well, the honeymoon couldn't last forever -- WFR is one of the bigger players in this industry, and the largest in the US, but it's a distant fourth in world market share.

And the big guns -- SUMCO and Shin-Etsu, who together hold more than 60% of the world market, are expanding, too (SUMCO announced their expansion in May, Shin Etsu announced theirs yesterday). Each company is investing roughly a billion dollars in its investment plans.

And even if demand for wafers continues to grow dramatically over the next few years, which I expect, there's certainly a solid chance that these expansion plans of three of the four biggest manufacturers will create overcapacity and/or a price war for their largely commoditized products. Even though WFR and their competitors know that this boom/bust cycle is bad news for all the companies involved, no one can risk losing market share if the market does continue to grow as quickly as it is now.

The analyst from Macquarie has a quote in the Reuter's article, and this quote makes me a little nervous about whether the fight between the big guys will end up squashing the not-quite-as-big WFR:

"We're in for a consistent sense of oversupply of roughly 20 percent until 2011, unless chip makers really expand production capacity. But Shin-Etsu has little choice but to expand, given competition from SUMCO."

I don't know this analyst's record, and I don't know if he's right -- but that's certainly a possibility if indeed the chip makers fail to make the expansions that we expect, and to drive demand for raw materials for those chips. And if we do see any pullback in solar power investment with a decline in fossil fuel prices (which I don't expect long term, but should consider just in case) ... then a wafer glut is certainly a possibility a year or two out as new capacity comes online. And I'm also making the assumption that over the next few years we'll continue to see silicon photovoltaics hold market share over the newer thin-film panels that use a lot less silicon, if that assumption proves wrong silicon demand will be impacted there as well.

I have a few options:

I can sit and wait and see if demand continues to keep up with supply over the next couple of years, and risk the excellent gains I have in WFR right now.
I can sell part of my holdings to book a profit, and perhaps move that money to Suntech Power (which I think is the most appealing solar play) or one of the semi manufacturers to hedge my bets, since they would benefit significantly from an overall drop in wafer prices.
Or I can try to time the peak of WFR pricing and sell all of my WFR holdings six to nine months before that peak.

That last one's pretty much a joke, since I have no way to make that prediction -- and no reason to believe any analyst would be correct in timing that peak precisely. I already missed a peak of about $48 that would have given me a 200% gain in less than a year, so there's not much chance I'm likely to catch the next price peak.

I'm going to be patient for the moment -- Shin Etsu's new production will come online in about a year, and SUMCO's in eighteen months, and WFR's expansion is likely to be more gradual over the next few years ... so while it's possible investor panic about this will set in early, I don't expect to see it immediately. And it's entirely possible that demand will more than keep up with supply.

But I will be ready to sell a portion of my WFR holdings if valuation continues to creep up (today's forward PE in the high teens isn't as nice as the sub-10 PE I saw when I made my initial purchase) and it continues to look like these dramatic expansion plans might be overestimating the market's capacity in the out years. I'll let you know if and when I make that decision.

Labels: WFR