Taking Profits on one ... giving up on another

Just a quick note to post some changes in my portfolio -- after watching MEMC Electronic Materials grow into one of my larger holdings on the back of near-300% gains, I decided to give in to some of my misgivings about the company's valuation and take profits on about 40% of my holdings.

I'm still holding the balance of my WFR shares, and I do think that it's certainly possible that they will continue to climb -- but there is significantly more risk in the equation now that we're dealing with a trailing PE of 31.

The polysilicon shortage that helped to fuel WFR's rise, on the back of strong pricing, a huge ramping of demand from solar cell manufacturers, and continued strong demand from semiconductor companies, is now getting quite long in the tooth. It was part of my initial buy thesis in this stock when I bought it a little over two years ago. That means that MEMC and their competitors have had plenty of time to see the demand curve rising and put into place plans for dramatic increases in production -- which nearly all producers have done, with some increased production already online.

I'm not enough of an expert on this industry to know whether or not the "big four" polysilicon suppliers will overplay their hand and oversupply the market as their new supply continues to come online over the next year -- so given the boom and bust history of this sector, I'm hedging my bets, taking enough profit off the table to be comfortable holding the balance and watching the supply/demand dance play out. I sold 40% of my WFR position at $60.02, and will continue to hold the rest pending future developments.

And my other recent move, which was long overdue, was to clear the decks of my holdings in Cryo-Cell (CCEL.OB). I was impressed with this cord-blood banking operation when I first picked up shares back in November of 2005, and thought that they were on the cusp of a few good things: potential relisting on a major exchange, transition to a consistently profitable operation thanks to their ongoing relatively high-margin income from storage fees, and possibly increased public interest in their product as stem cell "miracles" come to light.

Well, how's 0 for 3? I should have listened to Yehuda Fruchter and sold my shares a while back when it began to be clear that management was either "competency challenged" or not aligned with common shareholders.

Instead of transitioning to a high-margin, solid growth company with good steady income from storage fees, Cryo-Cell has gone through a few different high risk product "near launches" that seem to have not gone well, notably for Plureon placental stem cells, an innovation that appears to still be in search of a market. They've also invested heavily in marketing, and in upgrading and/or fixing their facilities, which they had said before were already state of the art, and now appear to be trying to develop yet another higher margin (and higher risk) maternal stem cell product of some kind. Ballooning costs led to a bitter challenge for board seats that's still underway, but I don't see this ending well ... at least not in the near term ... so I'm clearing out my shares at about a 40% loss.

Thankfully this remained a relatively small investment for me (and a shrinking one, of course), but I'll take it as a lesson that what seem to be great business plans from microcap operators can quickly turn if management doesn't think the same way you do. I've had similar results so far from my other "microcap with a promising business plan," MMC Energy, but I'm willing to be a bit more patient with that one.

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Indirect Investing

One of the themes that has come up with several companies I'm thinking about or have recently bought is the notion of the "indirect investment", by which I mean the purchase of a company in order to get access to the earnings (or growth,or whatever) of a subsidiary or related company -- either at a discount, or because the subsidiary isn't separately traded, or just for diversification in getting two significant businesses in one package.

Cypress Semiconductor (CY) fits this idea nicely, and I own a few LEAP options in the shares and remain tempted to buy the common stock -- it's a downtrodden semiconductor company which the market doesn't like at all. They haven't had particularly nice margins of late, or anything else to make the Street stand up and cheer, and short sellers are holding about 10% of the float.

Most importantly in my opinion, though, many years ago they bought a tiny company that had technology and designs for manufacturing solar cells, and built manufacturing capacity for that company. They've since IPO'd part of that solar company, called SunPower Corporation, but they still own about 70%. And today, though Cypress is the parent, Both companies trade at similar market caps, with SunPower's enterprise value of about $2.5 billion and Cypress at about $2.6 billion.

So that means, if you buy Cypress you're getting $1.75 billion of SunPower, which means you get the semiconductor business for substantially less than a billion dollars. Now, whether or not the semiconductor business is worth more than that is another question -- but even though it's not growing as fast as solar, there is certainly a market. The Semiconductor Industry Association (they're unbiased, right?) reported 9.2% growth year over year in January, so if Cypress was a proxy for semis as a whole you might be tempted. They do work in many different segments of the semiconductor marketplace, so perhaps there's an argument to be made there.

This may be too widely understood an "indirect investment" to make any money from, especially since Cypress has resisted "unlocking the value" of their SunPower subsidiary by selling it or spinning it off ... Cypress is probably already trading primarily on the value of their SunPower holdings.

In solar power, there's another way that I've held on to a somewhat indirect investment, too -- my shares of MEMC Electronic Materials (WFR) were initially bought because they were cheap, the share price didn't reflect the great position they held in the semiconductor wafer business because of their integrated supply chain and good supply of polysilicon in a tight market. But one of the reasons I've held the shares after a huge advance,and in the face of an uncertain balance between burgeoning silicon supply and hopefully booming demand, is their growing exposure to solar power -- including warrants to purchase five percent of Suntech Power (STP) that they received in exchange for a long-term silicon supply agreement. That doesn't yet move the needle at WFR, but it could very well do so in the future -- or at least cushion any blow from a slowdown in semiconductor demand, should it come.

Moving away from silicon, Naspers (NPSN) is another investment along these lines -- I bought shares recently, and while I like the cash generation of their core media (South African newspaper and pay tv) assets, what I really like is the growth potential of their partially owned division, Chinese IM leader (with the QQ product) and portal company Tencent, and their acquisition spree in emerging markets media and internet companies.

The impact on the market cap is big here, too, since Tencent is roughly a $6 billion company and Naspers owns about 36% ... and NPSN itself has a market cap of about $7 billion, so roughly a third of Naspers' market cap is attributable to their not very profitable (in earnings terms) Tencent holdings, which significantly depresses the company's PE ratio and makes them seem a bit more expensive than they really are.

Tight relationships among corporations can give us opportunities to do this kind of investing in nearly any industry -- Ship Finance Limited, a company I've owned in the past, gets an indirect ride on the profits of former parent Frontline. They own Frontline's ships and get a steady lease rate for them, which they churn out as a high, steady dividend yield ... but if the tanker business takes another turn up they'll get a bonus from a profit sharing agreement whereby they get a portion of all profits over a set level on their tankers. Which is probably why the shares are just about at all time highs while the more leveraged Frontline languishes on the currently tepid prognosis for tanker rates.

This kind of investing is not unusual, of course -- a lot of what professional investors do is try to find hidden values in the companies they're interested in, and many arbitrageurs spend their days figuring out which companies are likely to move to unlock those values in a particular time frame.

Other examples abound -- buying Roche a few years back to get a cheaper bid on the future of Genentech comes to my mind as one example ... and in a related way, biotech and other IP-heavy industries also give us the opportunity to invest in companies because of royalties they receive from successful or promising products.

Using the Genentech example again, this might mean buying PDL Biopharma (PDLI) because of the humanized antibody royalties they get from several of Genentech's big products, including Avastin and Lucentis (though PDLI also has its own issues, including a looming fight with a big investor about their spending habits).

Whatever your focus, it sometimes pays to look a little deeper into the companies that interest you -- maybe the companies that don't appear to be publicly traded are really available for investment as subsidiaries of others, or maybe the shares that look a little too pricey are hiding an unusual gem.

full disclosure: I own shares in Naspers, MEMC Electronic Materials, and PDL Biopharma, and call options on Cypress Semiconductor. I have no position in the other companies mentioned.

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Wafer Fat for MEMC (WFR)

A great quarter from MEMC Electronic Materials (WFR) was released last night ... and much more importantly, the company issued very optimistic guidance not only for this coming year but for the next 3-5 years. Eric Savitz, who first introduced me to this company a couple years ago, has a good summary of their earnings news here.

Though I remain somewhat nervous about the stock at these high prices (new almost-ten-year high today), I find it very difficult to consider selling any shares with the business plan management has laid out, and their excellent performance so far during their multi-year turnaround.

MEMC Electronic Materials sells polysilicon and silicon wafers to the semiconductor and solar energy industries -- and, as I've written about before, they've enjoyed almost perfect timing as sales and demand from the solar cell makers have picked up just as semiconductor demand overall has maybe dipped a little (though that really goes segment to segment, there are still plenty of strong semi manufacturers that are going full speed on production even as others work through an inventory glut).

The nervousness for investors lies in the fact that polysilicon production by all of the major manufacturers is going to increase significantly in the years ahead.

WFR management, through its projections that they will earn "over $3 this year" (a 20% bump over street estimates) and $5-7 a share in 2010-2012, is essentially saying that the increased production by both them and their major competitors will be absorbed by the market, and that margins won't suffer (in fact, they expect margins to improve). Some, including Citigroup, are intimating that this is just a ploy to boost the stock price, but I have no idea -- the price was already quite high, and valuation decent, yesterday.

With increasing analyst estimates rolling in, the forward PE should now be something like 15 or 16 -- which is a lot higher than it was when I bought shares a couple years ago as the turnaround started to bear fruit, but also a lot lower than most companies that are growing earnings at a 50% clip.

So although the company seems quite expensive to me, since my shares are now up more than 200%, as an outsider looking in I'd still have to consider it to be pretty fairly priced ... or even a bargain, if you believe the company's assessment of their future prospects.

And with margins continuing to grow during what has been a rough price war for AMD and Intel (two of the major silicon wafer customers) and a widely reported inventory problem in the semi space, I'm inclined to continue to give management the benefit of the doubt. They talk to their customers every day, and they're the ones signing these lucrative deals with solar companies and seeing evidence of a rebound in core semi wafer demand in 2007 (as I wrote back in October, they now have contracted for ten years of sales that equal well over half of their current sales rate just to the solar companies, which must give them a certain level of confidence).

It makes me nervous to hold a company that has appreciated this far, and in every other case where I've had a 200% gainer I've taken some profits on a portion of my position -- but with WFR, the earnings and growth potential have more than kept pace with the stock price while the multiple expansion has been relatively modest (and deserved, given their discount valuation before the turnaround began), and I don't want to walk away from the kind of projections they're making. This has certainly always been a cyclical business, but with the increasing number of products using semiconductor chips, and the steeply ramping demand for solar energy worldwide, I think the boom and bust cycle for semi demand may moderate and have less influence on WFR's results than in the past.

So, with somewhat nervous hands, I continue to hold.

disclosure: I do own WFR with no plans to buy or sell in the near future, and in the semi space I hold LEAP options on Cypress Semiconductor.

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MEMC Makes Another Deal (WFR)

It has been a very busy year for MEMC Electronic Materials (WFR) -- though the shares have come down pretty dramatically from their highs in the late winter of $48 or so, every indication is that their sales and earnings are continuing their torrid growth.

The concern has been, from me as well as many others, that there is the potential for a near-future glut in silicon wafers as WFR and all of the major manufacturers prepare to ramp up (or in a couple cases, have ramped up) capacity to meet high demand from both the semiconductor and solar industries.

I still have that concern, but every time WFR makes a deal like the one announced today, I feel a little more secure. In preparation for making big investments in increasing their production capacity for solar-ready silicon wafers (to go along with what has been the core of their business, the production of wafers for the semiconductor industry), they've been pre-selling that capacity -- today it was announced that they have a new deal with Gintech, a Taiwanese solar cell manufacturer, to supply silicon at "pre-determined" prices for 10 years beginning in about a year.

This deal, expected to be worth between $2.5 and 3 billion, comes on the heels of two other similar deals -- one with Motech for about $1.6 billion (that fell apart), and one with Suntech Power that could be worth up to $6 billion.

I'll guess that a midpoint number for each of these deals is a fair assumption to start with, which means a total deal value of $8 billion over ten years. That averages out to $800 million a year, which compares to about $1.2 billion in sales for MEMC last year, so these deals are very significant in giving MEMC a chance to dramatically ramp up their sales volume.

And of course, they're not dropping their core business, which has been the supply of silicon wafers to the semiconductor industry -- though with some recent softness in semis, I think investors are probably pretty happy to see them further diversifying into another potentially large market.

I'm also happy to see that, as with the other deals they've signed, this one includes a "kicker" that allows WFR to make some real money if solar power takes off in the dramatic way that some people expect. With each of these deals, WFR has received in exchange not only a prepayment or a sweetheart loan to help pay for their capacity expansion, but also a warrant of some kind to purchase a significant amount of the solar company in question -- ranging from 5 to 10%.

That allows them to ride along with any solar power boom, and protects them to some degree from preselling their silicon too cheap, since if silicon prices for solar are much higher in five or ten years than expected it's likely to be because demand has grown much faster than expected ... which would mean that Suntech and Gintech might be worth a heck of a lot of money.

I wrote a couple weeks ago that I was nervous about the huge increase in silicon wafer supply that's coming on the market -- and I still am. But as the deal volume has climbed -- to the point that they now have contracted for ten years of sales that equal upwards of 60% of their TTM sales -- I've grown less nervous. A glut is certainly still possible, and if I see enough evidence of it impacting WFR in the near future I still may sell, but a solid floor of future sales like this is nothing to sneeze at.

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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.

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Making Money from a Cleaner California?

Probably everyone saw or heard the news about California passing new emissions rules a week ago -- there was an interesting editorial on it in the Salt Lake Tribune recently, and the Washington Post ran a more detailed article when the bill passed. The Financial Times ran a story on the political debate, and the possible business impact on our most populous state.

So what does this mean for investors? Is there money to be made on the tails of this initiative to clean up California's air over the next 20 years and push toward reaching the standards of the Kyoto Protocol?

California already gets most of its energy from relatively clean sources (if you ignore transportation), compared to many states. You can see from this CA Energy Dept. summary how the citizens of the left coast get their energy -- coal is pretty low, renewable sources fairly high.

But they're committing to reducing emissions over the next 20 years even as their population may be expected to grow significantly ... so what companies might benefit from that?

I think there are a few categories that might be worth looking at:

1. Natural Gas. The biggest impact on the electricity market in California is that the state will essentially no longer accept power from the current coal-generated plants. This accounts for about 20% of in-state generation and an unspecificied but probably significant part of their imported electricity (as the Utah story referenced above would indicate, the plants that rely on cheap Rocky Mountain coal and sell electricity interstate will be cut out of the CA market).

To me, that means natural gas will be in higher demand in California because it is the only efficient, relatively clean power source that's likely to be able to take up much of the slack as coal plants go offline. Who benefits? You've got the big natural gas producers like Chesapeake (CHK) or XTO (XTO), the drillers like Nabors (NBR), which has some gas exposure, or Grey Wolf (GW), which is focused entirely on gas.

You might also look to the pipeline companies, since most of California's natural gas is going to have to come in via pipeline from the key producing areas in the Southwest and the Gulf. Here's a map of the pipelines that currently serve the state, you can see that they've got excellent distribution from the big basins already ... but volume should grow, which is how pipelines make money. I'd guess El Paso's (EP) western pipelines are probably among the biggest beneficiaries, but I haven't looked at it in detail.

2. Coal Scrubbers. Alternatively, instead of boosting natural gas usage for electricity generation, you might see an aggressive push for cleaning up coal plants. That says to me that the engineering and construction companies that build and retrofit power plants, and the manufacturers of emissions scrubbers for coal plants, might get some additional business. That could be a lot of folks, but URS (URS) is probably more focused on coal scrubbers than the other big E&C guys, though most of the coal scrubbing I've heard of is focused on removing sulfur dioxide, not carbon dioxide which is the bigger issue here.

It might even be possible to see some of the coal technology companies climb, too, if coal gasification or newer clean coal technologies might get a boost from this renewed focus on emissions -- that could perhaps be folks like Sasol (SSL) with their coal liquefication system, or Headwaters (HW) with their various coal technologies, for example, though I can't claim to know much about that business.

3. Power plants that already run on natural gas. This could conceivably allow for some significant rate hikes in California, if the demand for energy continues to grow but the suppliers shrink. That tells me that the folks who are already online with environmentally friendly or natural gas-powered power sources will have a competitive advantage (as much as the market remains competitive, at least).

PG&E is the big provider here, but I'm not so interested in getting involved with a huge company like that with a checkered history and significant regulatory risk. I've looked a bit lately at a tiny company that might benefit down the road, MMC Energy (MMCN.OB) is a small OTC stock that recently went public (and is moving soon to the ASE to attract more institutional buyers). MMCN is building a holding company for the small power plants that have been divested by larger (and sometimes bankrupt) utilities in high-growth areas ... and they're planning to refurbish and expand those plants with new natural gas turbines to serve peak overload periods at peak rates.

They came to my attention because they recently bought two natural gas power plants in San Diego (Chula Vista and Escondido) that were offline (they're also buying a decommissioned plant in Bakersfield, and have a letter of intent to buy a Utah plant that's under construction) [September 13 update: MMC Energy yesterday terminated their letter of intent to buy the Utah plant], and got them online for summer peak season, with plans to expand at least one of them. This is certainly a risky company, and it's largely unknown so far (though it has been touted heavily by Energy and Capital, a service I know nothing about ... which makes me nervous). I've read the company's filings (if you're interested, please read at least the 10-QSB) and didn't see any red flags, but it's going to continue raising lots more money to buy and upgrade or restore plants so I'd say there's a good chance of significant dilution in the near term.

4. Renewable Energy Companies. This is the sector that immediately comes to mind for most folks when we talk about reducing emissions, though CA will be hard pressed to replace their coal-fired electricity with solar or wind power within the next 20 years. They are, however, trying very hard to subsidize the growth of renewable energy ... as are other states to lesser degrees, and as are several other countries (notably China and Germany).

This is good news for lots of companies, but there aren't many profitable, reasonably priced renewable energy companies ... even though prices are much more reasonable now than they were last winter in the peak of our oil and natural gas panic.

The wind energy bets are few and far between -- you could throw your money at GE, which makes most of the turbines, but wind energy isn't going to move their needle. Or you could look to the composite-materials companies like Hexcel (HXL) or Zoltek (ZOLT) that make or engineer the materials required for efficient windmills.

Solar energy is a much more wide-open business, and with state and local governments also pushing for more rooftop solar cells in new housing production and subsidizing solar implementation elsewhere, demand for photovoltaics should continue apace, with or without California's new emissions rules. You can look at MEMC Electronic Materials (WFR), which I own, as the supplier of the silicon wafers that go into solar panels, or you can look at the manufacturers like Suntech Power (STP -- my favorite among these with their Chinese connection), Evergreen Solar (ESLR) or SunPower (SPWR -- or look at CY to possibly buy control of SPWR on the cheap).

Will California's plan really fly, or will this plan move to other states? It's way too soon to tell, but the California auto emissions rules certainly had a massive impact on the rest of the country and on auto manufactureres worldwide, and as one of the largest economies in the world you have to accept that state decisions really matter (CA is somewhere between the fifth and 10th largest economy in the world, right up there with Italy and France if treated as an independent nation -- just how big depends on who you ask).

I don't know whether they can pull off an emissions trading scheme with just one state, but it's certainly possible -- and they can definitely cut off all "dirty" power supplies, which will impact the energy business writ large across the Western US in a big way ... whether any of these companies, or others, will actually benefit is certainly an open question, these are just the initial ideas that came to my mind.

In the interest of full disclosure, at the moment I own shares in WFR, preferred (series D) shares in CHK, and call options on CY, and I've been toying with the idea of buying MMCN and may do so soon.

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Earnings Season Thoughts (GOOG, WFR, AKAM, ISRG, VRTX)

This is very likely the biggest single day for me in earnings season -- several of my strongest performing stocks like MEMC Electronic Materials (WFR), Akamai (AKAM), Intuitive Surgical (ISRG), and Vertex Pharmaceuticals (VRTX) are releasing earnings after the close today.

So this seemed an apt time to check up on the earnings releases that I haven't yet mentioned.

Yesterday, Cemex (CX) released their earnings -- and no one was particularly happy with them. The stock split recently, but that didn't have any real impact -- no, the impact was from declining US sales. Cemex had great sales increases in every other major area, including Mexico and Spain, but US sales dipped significantly. I found this very surprising, given the continuing cement shortage in this country, but I expect commercial and infrastructure construction to continue growing over the long term here at home, and with the rest of their markets performing very well right now I'm not terribly worried about a blip in the US. In fact, the news out today that GM was buoyed by its Latin American division gives me a bit of hope that consumption is increasing in that region, and any increase in automobile sales should help push demand for improved road infrastructure. That's a bit of a stretch, but at least it's a stretch on the positive side.

And Google (GOOG), another of my larger positions that has already released earnings, surprised me a little bit as well -- not because they continued to beat estimates handily (beat by more than 12% this time), but because it brought in virtually none of the volatility we've come to expect from GOOG earnings.

Google's now trading at less than a 40PE on current year's earnings (reported and estimated) -- that's about as cheap as it's ever been, though it's certainly not cheap in relation to the rest of the market. I sold about 40% of my Google holdings earlier this year at close to a 100% gain and will be holding these, but I think investors are now so afraid of growth stocks and technology stocks that GOOG is getting attractive again -- over the past two years they have steadily increased earnings, kept their noses clean, innovated with new products that may be monetized eventually, and, most importantly, continued to take market share from all of their competitors around the world.

And Gol Linhas Aereas Inteligentes (GOL), another of my bigger holdings, is managing to maintain very solid margins and increase market share even while they grow their fleet considerably and grow earnings by about 50% -- they're subject to oil prices just like all the other airlines (though Brazilian prices are a lot friendlier than US for jet fuel, in general), but they are growing very quickly without sacrificing profitability. The ADRs have been subject to the strength of the Real, and more significantly the shares have been on a rollercoaster as Varig's restructuring has played out ... but I don't see anything happening to Varig that will hurt GOL significantly, and I think the only thing that will bring trouble to the company is a recession in Brazil that curbs demand for tickets.

Looking forward, we've got AKAM, ISRG, VRTX and WFR all reporting today.

WFR is a company I've written about quite a bit recently -- the collapse of their deal with Motech was disappointing, but the cessation of their supply agreement with Evergreen Solar (ESLR) was an indicator of the upward trend in their market, and the signing of a deal with Suntech Power (STP) today to supply solar silicon wafers for ten years in exchange for an up-front payment and a warrant for STP shares came earlier than expected but is also a strong positive.

And today, WFR will release its earnings after the close -- and they've beaten estimates the last two times out, if not by all that much. Analysts are expecting something in the low-40 cent range for EPS, which would be close to twice their year-ago earnings (a year ago is roughly when the company began turning things around and their shares began climbing). WFR has been much higher than this, at around $48 before the bottom fell out of the market, and is priced at close to a market multiple -- for this kind of growth, that seems a more than fair price to pay.

VRTX should be insignificant -- their earnings don't mean much, because no one is buying this company for their current royalties on a few antiviral drugs that are in production now. No, people are buying Vertex for VX-950, their anti-hepatitis compound that has show remarkable results in early clinical trials. Vertex has made some solid partnership agreements in the last few months and is very well financed to complete these trials, so unless there is news about VX-950 or VX-702 (and I don't believe there will be), I don't think we'll learn much from the earnings release.

AKAM is feeling the pain of growth stocks everywhere -- it has gone up so much that it is hard to consider it cheap even on forward earnings. Add in the fact that now many folks are getting worried about Limewire, which has replaced Bittorrent and Google as Akamai's boogeymen, and I expect that the folks who are sitting on huge returns in this one have itchy trigger fingers. Limewire is actually a real competitor, with a similar business plan to Akamai's, but AKAM is so entrenched with their customers and has such a strong portfolio of clients that I think fearing the upstart is a bit premature right now. Still, any disappointment on earnings release this evening -- any worsening of margins that might bring in the specter of price cutting due to competition, or anything less than a big uptick due to heavy World Cup traffic, could bring another wave of selling. With the demand for faster commercial delivery of audiovisual files continuing to increase dramatically, I still think Akamai is a good place to be in the long run ... even if they get some competition in the space they have owned since they acquired Speedera. But it's not a slam dunk, and the shares aren't cheap right now in my opinion.

Intuitive Surgical has been actually fairly quiet lately. In the last few months it has recovered from the beating it took when they lowballed their first quarter sales numbers (especially since they then beat those lowballed estimates handily), but folks will certainly be watching very closely to see how many of the new Da Vinci S machines they sell, and what kind of penetration they're getting into the prostatectomy field (where they're shooting for 35% of the market by the end of this year) and, perhaps more importantly, into hysterectomies, where they are trying to build a presence in a much larger market. I looked into those with some channel checks in the Spring, but haven't followed up yet in any detail since the last earnings release eased a lot of my concerns. This company has the potential to revolutionize all kinds of surgeries in the years to come, but with hospitals generally hurting I'd be happy to see them just keep up with the sales they had in the first quarter -- in the long run, this will be a cash cow with lucrative instrument sales driving returns as more and more surgeries are performed, but in the short run the shares should bump up and down on the numbers of machines sold.

Should be an interesting day -- the next six hours will go a long way to determining whether or not my portfolio will shortly recover from the beating it has taken in the last two months, but so far I've heard nothing terribly disturbing from the companies I own, and I remain quite optimistic about their long term prospects.

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Intel and AMD sneeze, WFR and FORM carried out on gurneys

What an odd day. I wasn't watching the market this morning so didn't see how things played out at the open, but as I sit here now, near the end of the trading day, I am a little bit baffled about the wild movement in two strong semiconductor industry stocks that I own.

Both Formfactor (FORM) and MEMC Electronic Materials (WFR) are down dramatically today. FORM is down about 10%, WFR down about 13% as I type this. Neither company has issued earnings or guidance or, in fact, any news at all.

No, this is a reaction to AMD and Intel and various other semiconductor companies reporting disappointing results or lowered guidance.

And on the face of it, that's reasonable. But when you delve into the reasons for poor results at AMD and Intel, it makes less and less sense that those results should automatically hurt Formfactor or MEMC's businesses.

Formfactor is a semiconductor equipment company -- they sell testing products, specifically patented microspring test wafers that can be used to test semiconductor wafers during the manufacturing process.

They depend on several of the large foundries and manufacturers, including AMD and Intel, as large customers. But their profitability isn't related to the profitability of AMD or Intel, it's related to the number of testing devices and systems they sell.

Each different semiconductor chip design requires a different testing product, and testing is a source of a lot of waste and time lag in manufacturing. So when innovation is driving the industry and the companies are fighting to come up with the next revolutionary product or to speed up their production or improve the efficiency of their assembly processes, it stands to reason that they would require more testing wafers of the most advanced variety, not fewer.

Formfactor is the leading company in this space, and has, to the best of my knowledge, the leading product -- their patents have withstood court challenges, and they seem to have a technological edge on their competition.

On the flip side, everything I hear from AMD and Intel tells me that the problem is not that demand is drying up for their products, or that they're no longer innovating -- the problem is that they're having a price war, which is likely to bring prices down for the end product but, in the longer term, increase demand for those products. The more these two companies innovate and the more they fight to deliver more products faster and more efficiently to salvage their margins, the more they need products like those produced by Formfactor.

So I don't see why Formfactor is going down ... even if there is somewhat of a slowdown in the semiconductor space in general, as the market clearly fears with tough numbers from Broadcom and others, I expect FORM to be largely immune to anything but a dramatic crash in the industry -- as long as demand exists and companies are fighting for market share, Formfactor should be in the catbird's seat.

The situation with MEMC Electronic Materials is somewhat similar, but even simpler.

MEMC sells the raw material that becomes semiconductors -- the machined silicon wafers themselves. For the most part, they depend on overall demand in the industry, across all product lines (not just computer processors like AMD and Intel, but flash for Ipods or control chips for cell phones or any of the myriad of other chips out there).

WFR does not care how much AMD and Intel are charging for their products -- when they look at the results today and see that AMD is reporting lower revenue because of this price war, they should look a little deeper and see that the volume of chips being sold is climbing, it's just AMD's margins that are suffering because they're cutting prices . They still need an increasing number of silicon wafers -- and since WFR is one of a limited number of suppliers in a business that is already charging premium prices because demand is so high, I would expect that they're not going to be very worried unless this price war reaches the point that AMD or Intel might suffer significantly and have to cut production. I don't think we're anywhere near that point right now.

And that's not even considering the other significant influence on MEMC's business -- their other major customers are the solar power companies, and from China to Germany to California demand for solar power is really ramping up, causing some real fights over the limited supply of polysilicon.

No, I don't think WFR or FORM needs to be that worried about an AMD/Intel price war just yet. Maybe there's more to this story today, and I've heard other say that options expiration is causing a lot of this dramatic volatility today. But business-wise, I don't we should worry about FORM and WFR's numbers, which haven't come out yet, not Intel's or AMD's.

When the giants throw rocks at each other there's always a danger that you'll get hit ... but there's also a nice profit to be made in selling rocks.

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Expanding with Other Peoples' Money (WFR)

I continue to be very encouraged by the progress MEMC Electronic Materials (WFR) is making in diversifying their revenue streams and expanding their production capacity.

WFR is a silicon wafer manufacturer, and supplies both the semiconductor and solar cell industries. In the past, the semiconductor industry has been the dominant consumer of polysilicon and of silicon wafers, but the surging growth of solar power due to high oil prices and higher government subsidies has completely changed the demand picture for MEMC's products over the past two years.

WFR announced earlier this year that they planned to double their polysilicon production and, as a result, doubling their revenue by the end of the decade.

Polysilicon shortages have been a critical problem for both wafer makers and solar power companies recently, as evidenced by the beating Evergreen Solar (ESLR) took when WFR announced that they were reneging on their agreement to supply ESLR. But WFR, unlike most in the industry, makes their own polysilicon and has a vertically integrated supply chain that gives them significant cost advantages over their competitors who have to buy this raw material on the overheated spot market.

But more recently, MEMC has taken a few steps to greatly reduce the cost and risk of this massive capacity expansion and give them some additional exposure to the solar power market.
Back in April, WFR made a deal with Motech, a solar cell manufacturer, that essentially gave them a big cash infusion and a piece of the action (a warrant for 5% of Motech shares). I wrote about that at the time, and I still think it was a smart deal.

But it fell apart. The parties announced today that the deal wasn't going to work for their needs and allowed the letter of intent to dissolve.

And good news sprung from the ashes -- MEMC has now signed a similar letter of intent with another solar company, Suntech Power (STP), that is seeing huge growth and is working hard to ensure adequate wafer supply to help them keep up with demand.

As a low-cost solar power producer in China, a market that has made a huge commitment to expanding solar power use, Suntech is probably a stronger upside bet for future growth of the solar industry, and I think the potential for WFR to acquire 5% of STP as a part of this deal is very promising -- more promising than a position in Motech would be.

We'll see if it works out this time -- the fact that they're essentially replacing one deal with another shouldn't have a huge impact on the stock (the shares jumped up huge in pre-market, but settled down quickly when realization set in that they weren't going forward with both deals). I do, however, think STP is a marginally stronger partner than Motech and I'll be happy to see this deal succeed if they can work out the details -- we should know by the end of August whether the Letter of Intent will generate a binding deal.

MEMC Electronic Materials has come a long way since it's lowest days about two years ago -- it's no longer the 200% winner for me that it was at the peak in May, but I have every confidence that this will remain a smart investment thanks to their continued solid growth, smart financing as evidenced by these two prospective deals, and diversity of income streams as the solar and semiconductor industries both continue to expand in volume.

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MEMC Makes Hay While the Sun Shines (WFR)

MEMC Electronic Materials (WFR) released some big preliminary news this morning that has given the stock quite a nice jolt, up close to 10% as I type this. WFR has had a great year, thanks to booming wafer sales to semiconductor companies and the growing demand from the solar power industry -- for background, this St. Louis Business Journal article does a nice concise job of explaining the current polysilicon supply crunch and its impact on MEMC for those who don't want to read semiconductor trade journals.

But the news today is that MEMC will be partnering with Motech, a large solar cell manufacturer, to supply silicon wafers at set prices over eight years in exchange for a significant amount of up-front cash and a piece of the action.

With this deal, Motech is essentially selling WFR their existing wafer manufacturing business, and paying up front for future wafer supply in the form of a loan that will help WFR invest in its ambitious plans to dramatically increase their polysilicon output over the next few years. As a kicker for WFR, they will also get the right to purchase 5% of Motech in the future at a set price (a warrant), allowing them some nice upside gain if Motech performs well in the ongoing bull market in solar power.

I like the skeleton of the deal, though it's only a letter of intent right now and could change or disappear in the coming months as they hammer out the details. It's great for Motech because it assures them of a steady stream of raw materials in a very competitive marketplace (to see what happens if you don't have this assurance, just look at what happened to Evergreen Solar when MEMC notified them that it would opt out of its contract to supply ESLR with polysilicon... perhaps in order to free up supply for Motech?)

For the solar cell markers right now, the key above all else is competing for polysilicon and /or wafers -- as solar and semiconductor markets are both in a rapid growth phase, the competition for this material is fierce and the supply very limited. Customers abound, thanks to generous government subsidies that seem to be cropping up everywhere, but raw materials are very tight.

And it's great for MEMC, too, because it allows them to go ahead with their big plans for doubling from 4,000 to 8,000 metric tons of annual polysilicon production over the next three years with less financial risk (I wrote about this after their last earnings release). This increase will enable them to better handle the increased demand from both the semi and solar industries, especially solar, and this deal with Motech gives them in effect an advance sale of that production so they don't have to produce it speculatively in hopes that solar power will be hot and they'll still have customers waiting.

Add that to the fact that they're also acquiring a little more wafer manufacturing capacity from Motech, and the fact that they don't have to pay interest on this up front payment (WFR shareholders can be pretty sensitive to debt after their problems of a few years ago), and MEMC comes up smelling like roses, too ... even if the warrant for 5% of Motech doesn't end up being worth much.

So it looks like one of those rare deals that's good for both sides ... we'll see if that's how it plays out in the end, but I like it so far, and the market does, too.

I'm glad I didn't let my fear of the cyclicality in semiconductors scare me away from holding WFR after I saw it near a 100% return for me at the end of last year (average cost of $16.25, so it's now closer to 150% gain in my portfolio) ... looking backward makes you nervous about holding gains like this, but as I see WFR looking forward themselves, and aggressively building their business like this, I like what I see for the future and no longer want to do any selling. semiconductors brought MEMC to this point, but it may well be solar that takes them to the next level.

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Who Wins the Chip Wars? (INTC, AMD, FORM, WFR, RSTI)

After hearing about Advanced Micro Devices' (AMD) earnings this evening, which sounded pretty impressive to me, I started thinking about the chip wars that everyone seems obsessed with -- who will win, will it be Intel (INTC) with it's still-huge market share, agreements with big manufacturers, and price cutting, or will it be AMD with it's upstart, faster chipsets and aggressive moves at building a brand and chipping away at the INTC monopoly?

In the long run, I still cant' bet against Intel -- I don't own stock in either,
though I do have some Jan 07 calls in INTC at $20 that I picked up a while ago when Intel was looking ridiculously cheap. Unfortunately, it's looking even more ridiculously cheap now ... but I'm holding on to see if my thesis plays out, that large demand in the fall for the new machines that will be taking advantage of the Vista rollout will lead to increased profits and guidance that should boost the stock in the second half of the year. Hopefully, it won't get too far down before that kicks in, and hopefully Vista won't be delayed again ... but either way, this is just a small option position for me.

And I don't have much faith in AMD -- everyone seems enamored of their products right now, and they may well be better and faster, but Intel has not stopped work. They may be slightly behind on innovation and speed right now, but my bet would have to be that they should be capable of catching up with AMD specs-wise, and lapping them when it comes to marketing and pressuring manufacturers and, perhaps more importantly, driving prices down to cause AMD, with their significantly smaller volume, a lot of problems.

But in truth, I'm never going to be an expert on the chip wars -- that's why I haven't placed a big bet on my belief that Intel will win, again.

And it's why I have placed my semiconductor holdings primarily in two companies (three, if you want to stretch it) that all benefit from the growing volumes of semiconductor manufacturing and the demand for semiconductors in general.

Formfactor (FORM) is my investment in semiconductor equipment -- they sell the top of the line probe testing equipment, and they sell to all the big manufacturers and to all the sectors of the market. Not only does it not matter whether Intel or AMD wins or if SanDisk or Taiwan Semiconductor have good quarters, it doesn't even matter whether we're talking about logic chips or flash memory or analog ... FORM's equipment can be made to test them all, and with every advance in technology -- a new chip, a new architecture, another push at the limits of tininess that these manufacturers can achieve, they need a whole new testing system. Add on that FORM's testing can improve efficiency of foundry lines and save money, and any company in this competitive industry should be knocking on their door. I wrote about FORM's last earnings release here, and I think this should be a very strong year for them as they begin to really reap the rewards of their investment in new manufacturing capacity.

MEMC Electronic Materials (WFR) is my investment in the bones of the chip -- the silicon wafers that are the heart of every semiconductor. They manufacture their own purified polysilicon, form it into precisely tuned wafers, and sell to all the chipmakers (and as a kicker, they're upping their polysilicon production because the other major industry that uses it, solar power, is continuing to drive prices higher). Like Formfactor, they don't care that much which parts of the semiconductor industry are doing well or poorly -- if more chips of any kind are needed, and I believe they are, then WFR will be happy to supply the wafers to build them on. I've written a lot about WFR in the last six months, and they've had a remarkable year of recovery -- driven largely by multiple expansion, and I think soon to be driven by continuing earnings growth, especially if solar power remains hot.

And the one that doesn't really count? Rofin-Sinar Technologies (RSTI). This is a growing laser company, and they have a micro division that supplies the tiny lasers used in semiconductor manufacture. It's not the biggest part of their business, but these days it is growing pretty quickly and helping to offset the pain they're feeling from some old-line industrial sectors (though I think manufacturing demand for lasers is likely to pick up again as well -- laser welding is an investment in efficiency and automation, which generally tends to win out in manufacturing even when the overall economics aren't great in big sectors like automobiles). I wrote up RSTI after their last earnings, and my guess is that it's continued steady progress from here.

So keep up the fight, Intel and AMD. I'll be quietly watching to see if Intel beats up on AMD in the end, as I expect them to. But I'll be putting my money on the demand for their products, no matter which of them wins the market share wars.

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Conflicted -- losing money while being right (MIDD, VRTX)

It turns out that my concern was a couple weeks early on the short term valuation of Middleby and Vertex, but I was right (insert sound of patting self on back) to think that a significant amount of optimism was priced into the shares considering their near-term growth prospects.

So I'm a little conflicted -- I don't like to see any stocks that I own going down and I still own smaller portions of these ... but I am somewhat relieved that my thesis played out in the short term, since at least my rationale turned out to be reasonable.

For those who weren't listening, I lightened up a bit on my shares of Middleby (MIDD -- click to register for free RT streaming quote) and Vertex (VRTX) to protect some huge gains a few weeks ago because I thought the market was expecting absolute perfection from both companies -- Middleby because they are very richly valued relative to their current organic growth, and Vertex because they were valued as if both of their top tier compounds were on their way to blockbuster status without a hitch.

Vertex released a report that their phase II studies of VX-702 worked as expected and had a reasonable safety profile, but it sold off because people were hoping for another immediately obvious blockbuster like VX-950, the Hepatitis C drug that's also in Phase II and setting the world on fire. Not yet.

Middleby was exactly in line with expectations, which certainly appears to not be good enough in today's market ... not when the a stock has been bid up to more than double over the past year.

As I type this, MIDD is down about 8% and VRTX about 6%. Not that big a deal for a long term investor, but worth avoiding if you can.

I still like both of these companies and sold less than half of my position in each, which is the disappointing part. I sold some shares to protect a profit and pull my original investment off the table, but I certainly intend to hold on to the remainder for a very long time in both of these cases. I would have been delighted to see them continue to grow without respite, but of course that never happens.

Emotionally, I was frustrated that both of them climbed immediately after I sold them (Vertex climbed more than 10% in the day after I sold it, just to rub it in), but somehow it's reassuring that they're now back below my selling point because I got a short term call right (for once). Not something that happens often ... and as any market psychologist will tell you, sometimes idiots like me are more excited about being "right" than about making money.

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Alternative Energy?

I got a question a few days ago from a reader about why I don't own any alternative energy stocks:

"You have several up-and-comer stocks in various sectors, but one thing I was curious about is why you don't seem to be in any alternative energy plays (both of which have become "major policies" for both the U.S. as well as China), especially given all the recent hoopla over oil prices. Do you simply not like the sector in general? Or are you just unsure about the best way to play it? The reason I ask is because I am trying to find a "good play" in that group at the moment, and thought I would see if you had any ideas. The most commonly mentioned stocks in the category are STP, ESLR, DESC, IMCO, BLDP, PLUG, and CPST."

Well, the short answer is that I do like the sector in general, but haven't done a lot of research yet or otherwise found any particular companies that I like.

I have looked in the past at Ballard Power (BLDP), but they look like they're just as likely to go bankrupt as they are to find success. I haven't looked at any of those other ideas in great detail, but I commend you to the alternative energy thread of articles over at Seeking Alpha -- they have articles and commentary and conference call transcripts for several of those names from folks who certainly know more than I do about the sector. I've been looking there for some ideas myself.

The longer answer is that I do have some exposure to solar energy, at least, through my investment in MEMC Electronic Materials (WFR) and a smallish LEAPs position in Cypress Semiconductor (CY).

WFR I've written about a lot lately, but I like that they are exposed to the solar cell manufacturing industry in that they sell the silicon to those companies -- but thanks to their broad customer base they aren't subject to the whims of national subsidies in solar power to nearly the degree that the pure play solar companies are. I am a little nervous about what happens to solar power subsidies across Europe and in various US states if the oil shock of the last year wears off or oil prices drop significantly.

Cypress Semiconductor you may have heard mentioned over the past few months by a lot of market commentators, including Herb Greenberg, who I don't particularly endorse but who published what I thought was some solid analysis of this company.

CY is 80% owner of SunPower, a former division that they spun off last year and a manufacturer of solar cells. Thanks to the huge bull market in solar power recently SunPower has really rocketed up the charts ... but no one likes CY nearly as much. CY's shares of SPWR account for something like 75% of their market cap at this price, so if you think solar companies are going to continue growing then CY is a lower risk way to ride SPWR's success -- you get CY's semiconductor businesses, which seem to be in a bit of a turnaround (I hope), for a pittance. The former child is now almost exactly the same size as the parent.

This hasn't been entirely ignored, and CY has climbed a fair amount already, but I'm guessing that sometime between now and 2008 when my options expire CY will see a significant boost from either solar power expansion or from their own businesses.

In the meantime, I agree that the growth in alternative and renewable energy is an important trend -- but I haven't really figured out how to invest in it. This is almost like 2004, when anything with China in it's name doubled in price ... now anything associated with Solar or Hybrid or Alternative Energy is booming, in many cases without much regard for current earnings or even potential earnings.

I have taken a glance at Headwaters (HW), which is an established chemical and coal gasification/clean coal company that shows some real promise and has real earnings, but haven't taken a bite yet. If anyone has ideas for alternative energy companies I'd love to hear them ... especially if they're companies that don't depend entirely on government subsidies.

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Chip Chop (INTC, FORM, WFR, AMAT)

I did something that I don't often do today -- I bought some options. And I'm also doing something I do even less frequently, which is writing about buying options.

I am not an options expert, and while on the whole I've profited from them in the past my good and bad moves have come close to cancelling each other out. I trade in options on occasion when I just want to take a small flier on a stock, or when I want to leverage an equity position ... or when I've got the gambling jones and there's not a casino nearby.

In this case, I opened a small position in VNLAD, the Intel January 2007 $20 LEAP options. I paid $2.70 for them. I'm not generally a megacap investor, nor am I excited enough about Intel to buy a full share position -- but I think the market is really beating Intel up way too much today and over the past several weeks. I think a 10% gain at some point between now and next January is quite likely, with one possible influence being what I expect to be a significant replacement cycle coinciding with the release of Vista in about a year. INTC at a PE of 14 seems silly -- any hand-wringing by analysts and any reasonable downside should now be priced in, and I wanted to place a small bet on the presumption that they will not long be priced at a discount to the overall market.

Let me be very clear that this is just a little bet -- I could easily be wrong, and I can live with losing all of this investment if that's the case.

There really seem to be two sides to the chip debate lately. My two semiconductor-related companies, Formfactor (FORM) and MEMC Electronic Materials (WFR) are on a tear in the tools and supplies business, but INTC, the heart of the industry, seems to be the wounded giant -- let down by Dell's underperformance today and being circled by upstart AMD, and the other companies in the space seem to me to be wildly unpredictable -- though I am tempted by Cypress (CY) thanks, in large part, to their 80% share of SunPower.

Is the story of the chip sector that RBC is right when they write that Intel's customers appear to be getting choked with inventory, or is it that AMAT's significant order growth means a big capacity buildout is underway to meet growing demand? I have no idea what will happen in the near future, but all the indications that I see from FORM and WFR indicate that capacity is ramping up and that demand for chips of most varieties is ramping up even faster. And past experience has led me to be awfully cautious about relying much on analyst "channel checks" in assessing the health of a company.

I think the popular opinion these days is that the personal computer semi line is just blah -- it's not sexy anymore to build the chips that run the computers that sit on all of our desks or laps. What's sexy is Flash -- people want to be in fast-growth supplies for the Ipod and digital camera markets. My gut feeling is that this will rebound -- and that Vista and the rest of the next generation of Windows software should drive a fairly big market in the faster chips, even dual-core, that will better be able to handle this software. It's hard for me to bet against the need for more advanced personal computers and servers, or to believe that Intel has really been beaten for good by little AMD.

I do believe that the variety of chips now in production for all kinds of products makes the industry much harder to figure out, which is why for my equity positions I've focused on WFR, which supplies the raw materials for all varieties of semiconductors, and Formfactor, which supplies an extremely broad range of top-of-the-line testing equipment for most types of chips -- they should both do well as long as semis in general are in increasing demand. I hope.

But I thought Intel was just too cheap to ignore today. I guess we'll find out in the months to come whether I was wrong on that.

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Multiple Expansion? (WFR, GOL)

I've been thinking a bit about Price/Earnings ratio expansion lately. We all know that when earnings go up the stock price should go up as well and by roughly the same amount, since we're used to big stocks that have relatively stable PE ratios.

But there are two other things that happen with some frequency -- the first is very unpleaseant, ratio compression (also called multiple compression), and that is what has bedeviled nearly all the large cap tech names except Google for the last five years. Earnings climbed dramatically over that time period for Microsoft, Yahoo, Cisco and the like ... but the multiple that the market was willing to pay for those companies shrank just as significantly and the stocks therefore more or less treaded water over that period.

The second is what you really want to see -- not only increasing earnings, but an increasing PE ratio. The Big Picture Blog last month ran a little analysis of PE expansion's role in the market boom of the late 1990s, it's worth a look and it helps to understand the downside of multiple compression that many of those big companies have suffered.

I've seen this expansion with two companies in particular in my portfolio of late, and for two very different reasons.

MEMC Electronic Materials (WFR) has really been a turnaround story, a story truly cemented by their last earnings release and guidance. This supplier of silicon wafers to the semiconductor and solar power industries went from being a very undervalued stock just a year or so ago with a PE of 10, to a fast-growing powerhouse in its segment with a PE over 20. During that time earnings have grown as well, so the shares have had a huge run of just about 200%, though I missed the bottom of the trough and at an average cost of about $16 my returns are closer to 100%. If you look at it mathematically, both the result (PE) and the denominator (earnings) have grown substantially, which means the numerator (price) had to go up quite dramatically. That's exactly what I like to see.

That tells me that the ideal scenario is to look for companies with the potential to grow earnings, but who are not trusted by Wall Street. WFR was very much unloved not only because they were seen as being in a highly cyclical industry in a downturn, but because they were coming out of a financial quagmire. As the earnings increased and the semiconductor industry recovered significantly even as the solar power industry exploded into unexpected growth, the company also began to get its financial house in order and show good earnings, sober management, and reduction of debt. That allowed the Street to trust WFR again and allow them to trade at a higher multiple.

The other company I hold that calls itself to my attention in regards to multiple expansion is Gol Linhas Aereas Inteligentes (GOL) the discount Brazilian airline. I've written a lot about GOL lately (here, here and here to start) and don't want to overstate it, but I do like them a lot and the company is currently the fourth largest holding in my portfolio.

GOL has been growing rapidly ever since the company began operations, and this year their earnings continued to climb the ladder.

But earnings weren't the only thing moving GOL's stock up -- multiple expansion has moved them up just as much. In GOL's case, I think its projected future growth, discounting of Brazilian risk, and growing excitement about management that is allowing their multiple to expand. Just since December, when I first purchased shares, GOL has moved from a trailing PE of about 20 to one near 30 -- that on its face seems ridiculous both for an airline and for a Brazilian company.

But GOL grew traffic more than 50% last year and is expanding rapidly with very little debt, and it seems to me that people are more comfortable with the leftist leanings of South American leaders given their so-far hands-off treatment of the most successful companies in the region (for the most part). GOL in fact benefits from governmental regulation, as air routes are tightly controlled and it would be very difficult for a new competitor to get approval to dramatically expand capacity (not to mention Brazil's governmental control of fuel prices, which helps dramatically to reduce GOL's costs when compared with global carriers).

The market's newfound enthusiasm for GOL, and their recognition that a dollar of GOL earnings is worth more than they had previously thought, is also related to management -- the company is family controlled and recently won an award for their top-notch investor relations and disclosure policies. A careful eye on the press release wires will call your attention to all of their detailed monthly traffic updates and clear announcements of new routes and services, and their company presentations and conference calls are truly illuminating. They seem to take very seriously the need to communicate transparently and effectively with their investors, which is important for all companies but really critical for emerging market companies -- look at Shanda for the opposite amount of disclosure, and you can understand why I love GOL but SNDA makes me very nervous (though I still own it).

That, in its way, gets back to the same thing in my opinion: Trust.

The market now trusts WFR because they have recovered from some financial problems and have clearly set priorities and goals to serve their largest markets effectively, even as they've proven their success in their industry with increasing earnings. That trust means we're willing to pay twice as much for a dollar of WFR earnings as we were a year ago.

And the market is growing to trust GOL as more than just an emerging market airline with big growth potential -- they are proving their ability to manage new services and new routes at reduced cost, and they are going above and beyond the disclosure of most other companies in the world to show their hand to investors. As a result of that (and their continuing rapid growth that we can see in their monthly traffic statistics), the market is willing to pay more for GOL than for a typical South American company.

So where do we look for other companies like this, with both the ability to grow quickly and some kind of hook that will bring them into Wall Street's good graces and allow for significant multiple expansion? One at a time is the only way I know to find them, though I guess you could screen for low and growing PE ratios to start, but it certainly takes a lot of wide reading and some patience.

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Nice news from MEMC Electonic Materials (WFR)

MEMC Electronic Materials (WFR-- click to register for free RT streaming quote) just released 2005 full year and 4Q earnings, and they sure look pretty nice to me. They are still preliminary due to the tax confusion they've had this past year, but it sounds as though the annual figures, if not the 4Q, should at least be accurate, which is fine with me. And if you believe the wacky after hours trading, the market likes it just fine too -- up 5 or 6% at the moment, even after climbing more than 3% pre-earnings during the day today.

I guessed in my annual checkup that WFR might have gone up too far, too fast and be due for a little pullback of some kind ... but not if they're going to continue putting out good results and very solid guidance like this. If that continues, I'm very happy to have guessed wrong.

Their guidance for next year is in a very broad range, which makes sense given their reliance on overall demand in the volatile semiconductor industry and on pricing that they can't entirely control, but the low end of their range is just two cents lower than the average street estimate (at least, according to Yahoo Finance). The high end of their range is $1.70 a share, which blows away the high analyst's $1.56. They're putting together improving margins, growing sales, investing in dramatically increasing their polysilicon capacity and defending their intellectual property to differentiate their products, and paying down debt ... all good.

What struck me most was their announcement, which I hadn't heard before, that they're aiming to double polysilicon capacity to help them reap the advantages of a vertical supply chain even further, and they're really focusing much more than in the past on supply to the red-hot solar market.

Here's the quote from CEO Gareeb that was in the earnings release, in case you don't feel like reading the whole thing:

"Although MEMC has been quietly working on expanding its polysilicon capacity, we are now formally announcing that we are targeting our polysilicon capacity to grow from approximately 4,000 metric tons per year to approximately 8,000 metric tons per year over the next three years, as dictated by market conditions. The majority of this capacity will be usable for both semiconductor and solar wafer production and is anticipated to be accomplished within the constraints of our business model. This will provide us with significant opportunities to take advantage of a vertically integrated supply chain as compared to our competition, by providing security of supply for semiconductor wafer expansions and significantly increasing our penetration of the solar market. This polysilicon capacity expansion coupled with the opportunities available in the semiconductor and solar wafer industries would support an approximate doubling of our first quarter 2006 revenue run rate by the end of the decade, if market conditions allow"

I added the bolding. Still a little pie-in-the-sky, but I like that they have an ambitious plan.

I was pretty optimistic about WFR after seeing Taiwan Semiconductor's great earnings report and commentary on the explosion of demand for semis in late 2005 and into this year, which reinforced what we're hearing from most of the industry. It looks like WFR is really in good position to leverage it's vertical capabilities and it's exposure to tight polysilicon supplies to continue growing and, as importantly, to continue expanding their multiple now that management is beginning to run a tighter, very low debt ship. I think Wall Street can trust this company again, and though I'm nervous about being aboard if the semiconductor industry has another inventory glut, I'm hoping there will be some significant warning signs before that really comes into play in this cycle.

Good news for WFR ... now I'm looking forward to see if some of these same trends spell good news for Formfactor as well.

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Annual Checkup -- WFR

Well, this looks like a reasonable company to examine today, thanks to the killjoys at Morningstar. MEMC Electronic Materials (WFR -- free RT streaming quote & portfolio tools) has had a very good year as their c0meback bid truly took hold amid a good market for their products. My shares were purchased back in June at an average price of $16.25, which seemed like a bargain even after WFR's 50% run earlier in the year, and now Morningstar has come out with a report pegging them as one of the more overvalued stocks on the Street (to be precise, they say WFR is trading at 328% of its fair value). Their complaint is that MEMC is in a commodity business (the supply of silicon wafers -- they're one of the top three or four worldwide suppliers, and the only big US one), and that their industry is very capital intensive and subject to significant downturns. All quite possibly true, though there are competitive advantages to be had in wafer design and production, as well as competitive pricing possibilities. One of my arguments when I first purchased shares in MEMC was that their capacity to produce their own polysilicon, which is in high demand from both the solar energy and semiconductor industries, might give them a bit of a pricing advantage over their competitors -- they don't need to buy polysilicon at high prices on the spot market. I wrote a bit about WFR back in November when their shares made a big turn, and it's been up up up since then. With semiconductors still on a tear and the solar power industry gobbling up all the silicon it can find, I still like WFRs prospects even if the price may have gone up a bit too far, too fast. I wouldn't be too surprised to see a minor selloff at these prices, but I think with chip manufacturers working at capacity WFR should still see a good market and good prices for the coming year ... no reason to sell, in my book.

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More on MEMC (WFR)

I wrote a few weeks ago that I was just as confused about MEMC's movement and earnings as everyone else. Their last earnings report was filled with special one-time charges and confusing setasides and pushforwards and, in the end, was a "miss" according to the Street consensus.

But since then, MEMC Electronic Materials (WFR) has been on a tear, returning to around $20 from it's earnings letdown price of around $17. Not bad, and I think more good things are coming.

As many folks have noted, extremely tight polysilicon supplies and high demand for wafers and silicon products from both semiconductor companies and the burgeoning solar power industry are both great growth trends for MEMC, and it seems as through the Street is coming around to accepting that the turnaround at MEMC after their past troubles is now well in place and they can be trusted to get a market multiple and, perhaps in the near future, a premium multiple comparable to their compatriots in the semiconductor sector.

Read a good SmartMoney article on MEMC today -- here's the salient quote:
"All told, analysts figure that MEMC will boost its earnings by 15% annually over the next five years. At about 15 times projected 2005 earnings, then, the stock carries a price/earning-to-growth, or PEG, ratio of 1.0. The average for semiconductor stocks is 1.5, roughly the broader market's average PEG. What are those who bought shares at the time of our last story to do with their now-pricier position? Nothing. With a still-clean balance sheet, improving fundamentals and forecasts for more of the same, this wafer maker offers thin reason for shareholders to sell."

I agree. I'm holding and see no reason to sell as long as chip production appears to still be on the upswing, though I expect the coming years to offer some significant volatility if WFR begins to trade more in step with the Semis. Should be interesting.

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Ouch! (FORM and WFR)

I suppose it's not the most elegant phrase, but today's glance at my portfolio makes me feel as though I'm really getting pantsed.

Now, those of us who are investing for the long term with a multi-year horizon should love days like this -- as Warren Buffett says, we should want to watch our stocks go down to the depths. After all, in general we're buyers, not sellers -- we should want to watch a sea of red while we're in our investing years, and a sea of green as we approach our divesting years. But investor psychology doesn't work that way, and I'm not wired any differently than anyone else.

So it's hard to watch the companies you own go through some troubles, even if they are (hopefully) relatively minor. Netease (NTES) and Shanda (SNDA) both fell a bit today thanks, I expect, to Baidu's problems -- good thing I didn't ever get too interested in that one, though I'd still buy it at the IPO price of $20 if anyone offered. I did even note today that, as usual, my morning investment was a great contrary indicator for the stock's performance for the rest of the day, as Intuitive Surgical (ISRG) has continued to fall another percent or two since my purchase. So I try not to care about these short-term blips, but I certainly do notice.

Two in particular are of note today -- MEMC Electronic Materials (WFR) and Formfactor (FORM). It seems to be a coincidence that these two are in the semiconductor industry and are both moving down at the moment -- the big guys in the industry like AMAT, INTC, and TXN are all down, too, but just by a hair or two. WFR and FORM have fallen significantly, and for specific reasons.

WFR's earnings report was a little disapointing the other day. I came away from it feeling reasonably well because the forward guidance and their expectations for sales and margins were better than I or the analysts were expecting -- good news. But they also announced that they were being forced to restate earnings for earlier in the year due to a tax problem. Nothing serious, in my opinion, though it does make them look a little silly. The operating earnings for this quarter were a little bit light, too, but again -- pretty close to expectations, and nothing I would normally worry about.

It seems to me as though people are overreacting to this restatement of 1Q and 2Q earnings -- I have not heard any evidence that this is a result of accounting shenanigans, which often is a reason to sell, or of any other malfeasance. The company's explanation, that they received some new opinions from experts and decided they needed to revise their tax deductions for those quarters on a complex transaction, seems perfectly valid to me even as it is unfortunate. The impact on earnings, having to revise the per share number down by 8 cents for this year, does not seem all that bad. I've always believed that we should price stocks based on expected earnings, which in this case look like they might be significantly improved from this year even if you include that 8 cents -- this is not a high-flying growth superstar that ought to move more than 10% on news like this, in my opinion. The forward PE is still 12, give them some slack.

The good news, beyond the solid projected numbers going forward (both significant sales growth, which is not a surprise given the rampups of capacity in the semi industry, and, significantly, margin improvement due to better pricing), is that they are also getting some pretty good business with the solar folks. I hadn't expected MEMC to sell polysilicon or wafer products to the solar power industry, but they have begun to, and in pretty significant volumes. The need for polysilicon in the solar power industry is one of the things driving prices higher overall for this material, and I'm glad to see that it may also help WFR to expand it's product line and diversify it's earnings a bit if we do see another semiconductor downturn in the coming years. And the bottom line? I'll take minor restatements or slight earnings misses and raised guidance over hitting the numbers and lowering guidance. It's all about what these companies and stocks are going to do for us over the coming years, not what they've done for us this quarter.

Formfactor may be another story, and this is something we'll have to keep our eyes on. I still like the company's product line and leadership position in the semi testing industry, but they had some significant bad news today -- though not as bad as it may have first looked. FORM has been in a patent dispute with Phicom for a long time in both the US and South Korea, and they have recently won several disputes and had their patents validated. Today the Korean court ruled in favor of Phicom for two of the four patents in question, which apparently does not impact the other two patents or any of their US patents (some of which are also in dispute, again with Phicom).

I am not a patent attorney, nor an engineer. My concern is that I know how critical the unique nature of Formfactor's microspring technology and their other testing advancements are to their continued perch at the top of this particular food chain. The company has issued a press release on this and is trying to explain why it is not particularly critical, at least in the short term. You can see from a daily chart this the market accepted that explanation to some degree -- they very briefly sold down on the breaking news by about 20%, but that was for just a few minutes and they remain, for now, down about 5% on the news. That seems fair, and this is certainly something we'll have to watch.

So some bad news across the board on the nasty declining day in the market, but nothing that I would consider a reason to sell any of my holdings (except Cendant, which I should have sold when I first made that decision a couple days ago ... it keeps trickling down and now I'm just being stubborn hoping for a fairer price to sell)

One of these days I'll be selling Cendant and choosing something else to take it's place in my portfolio -- at this point, I'm thinking it will probably be one of my existing holdings. Exelisis (EXEL) is looking solid and should have some clinical trial news out in the next few weeks, with much more to come in the months to follow. SpaceDev (SPDV) just came to a merger agreement with Starsys that I think might be really big -- they're getting closer to their goal of becoming large enough to list on the exchange, which I think would be huge news, and, more importantly, this opens up a wider door to them in the space industry with a much broader array of products and capabilities. Or perhaps I'll settle on something completely new that's still percolating in the back of my mind ... I'll let you know.

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What's up with WFR?

MEMC Electronic Materials (WFR -- get free real time quote from ADVFN) has been a hard stock to figure out for the past couple months.

Is it the stock that wowed everyone during the last few months after riding the wave of increasing silicon wafer demand from the semiconductor manufacturers, or the stock that has now been downgraded twice by brokers?

Is it the stock that is benefitting from the same trends that have led one of WFR's major competitors, SUMCO, to go public next month, or the company who just won a significant patent suit against that same company?

I'm not sure which of these news items should carry the most weight, but I'm still quit confident in MEMC's long-term success. You can read my earlier article on them here. My argument remains the same:

WFR is the biggest US and one of the biggest international manufacturers of silicon wafers. Not only do they have defensible patents, as we have just seen from their win in a European patent court, but they have another advantage in that they produce their own polysilicon, the raw material for silicon wafers. That has some significance in that there is currently a very tight market for polysilicon due to both increased semiconductor demand and increased demand from the newly-hot solar power industry, so having your own cost-controlled supply of the raw material should be an advantage -- but be careful, as no such imbalance is likely to exist for long. Competitors will open new plants to increase supply ... but still, I believe having their own supply will remain an advantage for MEMC.

The market seems completely complacent about the patent win, so we can assume that the win was already factored into the price -- and I imagine a win in US courts is predicted as well.

No one blinked an eye when MEMC reported that their facilities in Texas were unscathed after the hurricanes.

The competition from the other big three wafer companies remains the same, even though one of them is now going public in Japan -- though I'm balancing in my head the fact that this IPO means the market is hot for this sector right now, versus the point that now one of WFR's major competitors is going to get a big cash infusion.

But really, for those of us who are planning to hold WFR long term, the question is simple:

Will semiconductor demand continue to rise over the next (insert your holding period here)?

Intel, the behemoth of the industry and a major MEMC customer, reports tonight ... stay tuned, their conference call and projections for future growth are likely to impact WFR just as much as, if not more than, WFR's own earnings and estimates.

(Oh, and by the way -- my other holding in the semiconductor industry, FormFactor (previous FORM writeup here), reports earnings tomorrow evening as well ... and they'll also likely move based on Intel's assessment of industry demand as well as on the latest information on their soap-operatic struggle to get their new facility up and running. I'll be paying close attention to that call, too.)

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Earnings Updates

About half of the companies I own have reported their quarterly earnings, and it is a decidedly mixed bag. I'm going to do a quick summary of how they did, and what I'm thinking about the companies going forward.

So what has happened of significance so far this earnings season?

First, the best ...

Middleby (MIDD) clobbered the baked-in estimates, and showed that CEO Selim Bassoul is still on top of his game at this maker of commercial ovens and cooking equipment. I was lucky enough to buy into this great company earlier this year when it faltered slightly while the founding family was trying to sell out their holdings -- bought some at about $46 and more later on at around $50 over the winter (I found out about this company because it was a Motley Fool Hidden Gems recommendation, one that has since been re-recommended -- that's a great newsletter and I recommend at least giving it a free trial).

Middleby keeps some of the fun in investing by never pre-announcing their earnings release date, so one day the market closes and a lovely surprise bounces up on your browser, as happened last Thursday afternoon. Sales up 15%, international growth still doing great, earnings well above the estimates of the few analysts who follow MIDD ... even with increased debt, which we knew about due to the buyout of the founders shares, and slightly lower margins and higher costs largely due to the acquisition of NuVu and higher steel prices, it's all good news.

Now, some of that might be overstated -- some of the second quarter growth was backlog from Q1's big order volume that squeezed in before a price increase, some of it was from the NuVu acquisition, but I still like the growth going forward. Middleby's fast, efficient, patented cooking systems are being used by many of the restaurant chains that are quickly carpeting the globe with familiar logos and food products, and that doesn't appear to be anywhere near an ending point. Dining out is an international phenomenon, one that certainly began in the United States but that has legs around the world -- and familiar brands that roll out huge numbers of shops with Middleby cooking equipment are leading the way. Even something as seemingly unrelated as energy prices can help Middleby, because higher energy costs mean that the more advanced but much more energy-efficient Middleby ovens are just that much more appealing for restaurant buyers.

And the worst ...

Great Wolf (WOLF) -- bigger, and unfortunately much badder. I was one of I believe four shareholders to not sell out on their latest earnings release, and that could have been a mistake. Thankfully, my WOLF position was relatively small (and is smaller still now) since it's a pretty new portfolio position that I haven't gotten around to really filling out yet.

Normally, if I saw a stock drop like this that I owned and was confident in it would be extraordinarily tempting to buy ... and when I saw the ticker drop like a stone, that was indeed my first reaction, I thought we might just be dealing with a management team that was having a hard time getting to know the "underpromise, overdeliver" Wall Street culture.

Then I read the earnings release, and while I'm holding on because it's not worth selling such a small position and I still have some hope for the company, this one is not going to rocket back up the charts anytime soon. Not only was this a rough spring for Great Wolf in terms of competition eroding their occupancy rates in the few places where they face competition, but man oh man oh man, their occupancy rates fell EVERYWHERE over this six month period, and they weren't exactly super high to begin with. Check out the earnings release here and scroll down to the individual resort results -- nothing promising there.

Now, the silver lining is that Great Wolf is expanding into some very promising areas -- their Williamsburg location openened recently and is getting pretty high room rates, though occupancy is not great yet, and they have very promising parks opening in their core midwestern region -- a partnership park in Ohio and a franchised location in Niagara Falls, Ontario -- as well as some brand new locations that will really be the test of the concept. If they can succeed in the Poconos and in the Pacific Northwest, where the indoor water park is a heretofore unseen novelty, I'll feel much better about their long term future.

So, it's possible that this is a great buying period (A.G. Edwards downgraded it right before earnings, and upgraded it right after with the stock almost 40% lower) ... but not for me, not yet. I'll revisit this holding next year around this time and see how they're doing. The guy who recommended Great Wolf for the fool's Rule Breakers around the time I bought in, has a writeup on his disappointment here, and there's a news article with some quotes from management that are a little less gloomy (though they also give weight to the concern that dependence on leisure spending from the midwest may be a problem for a while with automaker troubles).

And all the rest ...

Akamai (AKAM) reported a great quarter and it looks like the acquisition of Speedera is going to be just as good a decision as we had hoped, though short term cash flow and margins might be a little lower than some were dreaming of. AKAM bumped up a bit on the solid but not breakout news, and I'm happy to keep holding on. Quarterly numbers from the Fool here. Guidance upped about 10%, so it's trading at a pretty fair PE of 30 or so for the current year -- not bad for the growth I expect we'll continue to see.

Marvel (MVL) reported a slightly disappointing quarter, and fell a small amount -- really not significant in the grand scheme of things. Earnings were a little lighter than last year and the spiderman 2 licensing cash flow wasn't quite as long lived as some analysts had hoped -- hard to get worked up about it. They're still backing earnings estimates of a bit over a dollar for the year, which means they're pretty close to a market multiple even in a year when they don't have a blockbuster franchise release (F4 has been a solid hit so far, but it's certainly neither an X-men nor a Spiderman when it comes to blockbuster ticket sales or licensing -- we'll see the next X-Men next year, and Spidey 3 the year following ... plenty of reason to buy huge potential at a fair price right now if you're interested).

MEMC Electronic Materials (WFR) reported a slight drop in earnings, but what I'm looking for from them is in the future -- the next 6 months to a year. Now that the backlog is almost worked out of world semiconductor inventories and business is beginning to boom again, what kind of advantage will WFR be able to gain from having their own low-cost supply of polysilicon? And even without the impact of that, world demand for wafers should be very strong. Earnings made the shares drop slightly, but investors, including me, are mostly interested in what happens for the next year -- is the semiconductor recovery for real? If so, WFR and FORM will boom. According to MEMC's CEO, the company's results may indicate "the bottoming quarter" after a 9-month industry slowdown due a surplus of inventory. I hope he's right.

Formfactor (FORM) reported just a few days after I did my company writeup, and altough the stock tumbled a bit due to delays in the new plant going online, my opinion hasn't changed -- I'm still happy with them, and the market has already found some of the love it had lost for FORM, it has recovered about half of it's earnings-miss fall.

Vertex Pharmaceuticals reported too ... but I don't much care about their quarterly earnings, for this one and all my other biotechs the earnings matter much less (they're all still losing money, though PDLI is close to going cash-flow-positive) than the results of their ongoing clinical trials. The trial results will move the stocks, the earnings almost never do unless they're wildly surprising. VRTX's report was pretty much as expected, and, most importantly, all of their trials for potential blockbuster drugs are on schedule -- nothing pending that should be a big surprise or impacton the stock in the next few months as far as I can tell.

Next Week

I'll have to do this again in a week or two -- I'm taking a no-market-info vacation, which is painful for info addicts like me, and during that time earnings should come out for Click Commerce, CV Therapeutics, Exelixis, FARO Technologies, Lions Gate Films, Protein Design Labs, Rofin-Sinar Technologies, Shanda, Taser and Universal Display. Almost all of these companies are reporting on either Monday or Tuesday of next week, so I'll at least have to read a paper or two while lounging at the beach.

And to add to that, Netease reports tonight (preview from ChinaStockBlog), and Overstock and Radyne tomorrow ... and the biggest quarterly non-event of all, the Berkshire Hathaway quarterly earnings release, is coming at the end of this week. This is way too much to absorb if you're planning on acting on the information that all these companies release, so I guess it's a good thing that I almost never react to quarterly earnings -- my account isn't big enough that I can afford to do much active trading, and I generally use a long time horizon when evaluating my portfolio companies (with some exceptions).

Unless management loses my confidence, or I see a trend developing that counters my long-term investment thesis for a particular company, I'm not going to buy or sell based on whether they hit or miss their numbers (though I am often tempted to buy when companies have short term problems that impact their share price -- as I wrote about in Catch a Falling Knife -- it turns out I should have jumped on FARO when they fell, and on Formfactor when it fell a bit later ... Shanda's still roughly where it was when I wrote that, and I have bought a small position in Jan 06 $40 call options in lieu of more shares to leverage my firm belief that it's got to eventually stop being the most undervalued tech company in China and break out of the top of this trading range it's stuck in).

But that's not to say that I don't watch earnings pretty closely, and still get excited to read up on what my companies are doing and have my choices reinforced by good news or challenged by bad news -- that's just human nature. So here's looking forward to a strong week of earnings releases, and a dozen or so good conference calls with enthusiastic, optimistic management teams. I'll write about what I think of what happened in about two weeks.

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MEMC Electronic Materials (WFR)



Bought June 10, 2005 at $16.25

[note: see my other writeup on a semiconductor industry company, Formfactor, here]

MEMC Electronic Materials (WFR) has been a hot property lately – a week or two ago they were even yelling about it on CNBC. What put this bland little company on the hot seat this summer?

One word: polysilicon.

Polysilicon is what semiconductors are made out of, eventually. You see, MEMC is a supplier to the semiconductor industry, they make the actual highly polished, ultrathin wafers of precisely tuned silicon that Intel and the gang use to punch out the little tiny doohickeys that power and control our computers, phones, cars, and smart toasters.

Still awake? Well, it turns out that polysilicon has had a wild ride as a commodity during the past six months or so. At one point this Spring, spot prices jumped 25% in just a few days. And this isn’t one of those “China commodity” plays like steel or oil – no one in Shanghai is using polysilicon to build malls or factories, and it’s not being manipulated by the NYMEX crude oil futures traders.

There are a couple reasons for this increase in the price of polysilicon – first, semiconductor manufacturers are actually starting to make things again, recovering from the huge inventory surpluses that smushed their stock prices last fall.

And second, it turns out that the folks who make photovoltaic cells and similar equipment for solar power systems rely on polysilicon, too … so an industry that has been boom or bust on the volume of semiconductor manufacturing for years is now forced to serve two growing industries, with solar power growing very quickly thanks to some big subsidies from places like Germany, New Jersey and California.

The increased polysilicon demand is very real, for more information on what it is and why it's critical to this industry, read the briefing from SEMI (Semiconductor Industry Association) here, and a good article explaining the recent market trends and shortage from EE Times here

So why does that matter for MEMC Electronics?

Well, unlike the other major manufacturers of wafers, MEMC is almost completely vertically integrated. That’s right, they make their own polysilicon at a factory in Pasadena, Texas. And polysilicon has not gotten more expensive to make, according to the company, it’s just in higher demand. MEMC needs almost all of the polysilicon it makes, it seems, so it’s not as though they’re going to ride this boom in the spot market to boost their sales. They’re still focused on designing, manufacturing and selling wafers. So how do they get value out of this vertical integration thing?

One (more) word: margins.

The other wafer manufacturers in the world have to buy their polysilicon from someone else, so unless they wisely hedged against the rising price by buying their supply well in advance (remember Southwest doing that to great acclaim last year with jet fuel?), they’re going to have to raise their prices or suck up losses. MEMC can either raise their prices, too, and reap the benefits of higher margins, or they can cut prices and try to pick up some more customers – either way, that sounds like good news.

Now this might be overplayed – MEMC has already advanced significantly, up close to 50% in the last six months. But the trailing PE is under 13, and the analysts who follow the company guess that the coming year’s earnings will put the PE at about 11. None of the other major wafer manufacturers trade on the US markets, so it’s hard to compare, but next to any other company that relies on overall increased demand for chips this PE has to be at the bottom of the list.

Why did I buy it?

I believe in the silicon economy. I think that the increasing prevalence of semiconductor chips in consumer products is a continuing trend, which will mean greater overall demand for semiconductors. That greater demand means that the few manufacturers who supply them with high quality silicon wafers will have some pricing power and should see continued good business. I see this industry as a long term good bet, but I wasn't comfortable betting on a specific chipmaker. I think the semiconductor services and supply companies show more promise for those of us who can't predict who will design the best new chip (or in the case of Intel and AMD, win the next lawsuit). Applied Materials seems overpriced to me even at this point, and I generally prefer to invest in smaller companies that are either undiscovered or underappreciated or that have potential for more significant growth. The other stock I particularly like in this area is FormFactor (FORM), which supplies high-tech and patented testing devices for semi manufacturing.

WFR is cheap, and very competitive within its industry, which means the downside should be somewhat limited even if the industry goes through more turmoil (though I hope the turmoil has worked itself out of the system over the past couple of years).

There are good writeups in Smartmoney from last fall and in the most recent print issue (July? Not available online yet). This is a "cheap growth" story, in my opinion.

Why would I sell?

My primary concern with MEMC is that other competitors in Asia might succeed in building lower cost platforms and increasing their polysilicon supply to the point that MEMC's edge in their integrated business plan is moot. I don't expect that to happen, but the major competitors at the top of the list of wafer suppliers are building capacity for more polysilicon and new chips. I expect the demand to continue to keep up with and at times outpace supply, especially with the move to the larger, 300 mm wafer as the standard for the industry that is now underway.

It is likely that I would sell if MEMC becomes overvalued, just because the history of the industry makes one extra interested in taking profits, but I don't see that happening. I foresee continued solid performance, strong growth from this point in line with increased wafer demand -- but not a meteoric rise, or, one hopes, a meteoric fall.

The only reason I might sell at a loss or breakeven in the next three years is if a price war develops in the wafer market and MEMC's competitors are able to overcome MEMC's advantage in lower polysilicon prices -- but with price increases looking more likely this summer, I'm not very worried. Even with a price war, if MEMC's positioning looks solid I would consider buying more if it appears that they can maintain better margins than their competitors going forward.

Technorati tags: wfr, memc, , semiconductor

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