(08/22/11) Unclear Earnings Spell Big Opportunity

Confusion is not an asset, especially in this market...but if you know the story of this company, you have a chance to get in on the cheap, writes Paul McWilliams of Next Inning Technology Research.

I have received several questions requesting an update on Tower Semiconductor (TSEM). The short story here comes in two pieces.

The first is the shiny side of the coin—from what I can see, TSEM continues to execute beautifully and well-aligned with my expectations. Via acquisition and organic development, TSEM is expanding its customer base, growing revenue, and developing new technologies that I believe further differentiate it in high-growth and high-value segments in the semiconductor fabrication business.

In the latter case, these developments include new technologies used in Radio Frequency (RF), Micro-electronic-machine systems (MEMS), and high-power semiconductor fabrication.

In addition to these factors that have driven, and I believe will continue to drive TSEM's income statement, TSEM is also doing a wonderful job of managing its leveraged balance sheet.

Unfortunately, there is also a not so shiny side of this coin.

While TSEM did a good job of communicating the points noted above, for some reason it chose to obfuscate other parts of its story that are critical for investors to understand clearly.

In my opinion, this is why the price of TSEM has been under high pressure relative to stocks that present similar risk profiles, ever since reporting results for its June-ending quarter on August 4, and has not responded as positively during relief rallies.

Revenue Growth
In its press release, TSEM stated it grew revenue for the June-ending quarter by 11% year-over-year, and by 16% sequentially. Further, TSEM stated it expects to grow revenue during the September-ending quarter by 32% year-over-year and 27% sequentially. TSEM was not shy to term the latter as a "massive" increase.

However, for some reason, TSEM forgot to mention the acquisition of Micron Technology's (MU) Japanese fabrication plant was largely, if not entirely, responsible for the sales growth in the June quarter, and would also be largely, if not entirely, responsible for the forecasted sales growth in the September quarter. As a matter of fact, for all we know, without the addition of MU's revenue, TSEM may have actually reported and guided for declining revenue.

TSEM announced the completion of its acquisition of MU's Japanese fabrication plant on June 5. This means it had nearly one full month of benefit from the revenue generated by this plant in the June quarter, and will have a full quarter of revenue from the plant by September.

Due to the fact this plant is currently dedicated to production efforts for MU, I fully realize TSEM cannot reveal the exact revenue generated by this plant.

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However, at the very least, TSEM should have mentioned the fact there was benefit from this acquisition, and preferably it could have stated whether or not it realized organic growth for the June quarter, and whether or not it was anticipating organic revenue growth for the September quarter.

While I have no idea what revenue TSEM gained via this acquisition, given the fact the majority of the $28 million sequential increase in inventory was due to Work In Process (WIP) at the acquired MU plant, it would appear there was little to no organic growth in the June quarter, and that TSEM anticipates little to no organic growth in the September quarter.

Given the guidance we've heard from other companies in the wafer-fabrication sector, flat to even down guidance (on an organic basis) would not have been a materially negative issue. However, failing to mention something of this material nature, and instead trumpeting a claim of "massive" growth, leaves some investors wondering what else may have been glossed over.

For a company doing as well as TSEM, that was a bad decision.

Share Count
TSEM chose to omit any mention of share count in its press release, or in the prepared comments of its conference call, and was less than candid about it when initially asked about it during the Q&A session.

In response to a question during Q&A, TSEM stated only the outstanding share count, and offered no clarity or discussion beyond that. This again leaves some investors to wonder if there are other hidden aspects to the story.

In short, the company has capital notes outstanding that represent potential dilution of about 400 million shares.

However, due to a number of complexities that I've covered in past reports on TSEM, I think it is unlikely we'll see that full dilution. I believe there will be a negotiated settlement with the capital note holders, an outside investor, and TSEM that results in only about 25% to 50% of that dilution.

However, as I've also noted in past TSEM reports, until this situation is resolved, the capital notes will remain "the elephant in the room" that will keep a lid on the price of TSEM.

Non-GAAP Presentation
As I've noted in past reports, TSEM chooses to present its non-GAAP performance in a "non-traditional" manner.

It should be noted right up front there are no standards for non-GAAP presentations. Non-GAAP presentations are designed to give investors a clearer picture of company performance, but the format of these presentations is totally up to the company's discretion.

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A company like Towerstream (TWER) operates with a high one-time capital investment model. TWER has to build out a network in a given city, and then takes several years to fully leverage the revenue-generating power of that network.
These are the low revenue and high depreciation years and, therefore, depreciation masks incremental profitability. Sure, there are ongoing capital investments, but those are generally small relative to the initial investment. TSEM operates with a different model.

While TSEM will get many years of benefit from its capital investments, like TWER, its tendency is to maintain a capital spending rate that is similar to its depreciation. Therefore, while I want to see an EBITDA statement that rightfully excludes depreciation from TSEM, I would strongly prefer to see a more traditional non-GAAP presentation.

Short-Term Debt
TSEM shows short-term debt under current assets of $128.7 million, and cash resources of $138.9 million.

TSEM also lists short-term investments of $17.1 million. This represents the book value of TSEM's 10% holding in HHNEC, which TSEM anticipates selling for about $32 million during the September quarter.

Therefore, we can reasonably boost our view of net cash to about $161 million. This, particularly when we assume future positive cash flow, will easily cover the current portion of TSEM's debt.

Aggregate Obfuscation
Investors who could take significant long-term positions in TSEM see right through the above points that I've termed as "obfuscation." In other words, these investors have the knowledge, time, and ability to see beyond these practices.

The problem, however, that TSEM creates by being less transparent than I think is desirable, is these investors who can see past the smoke are then left to wonder what they might be missing—are there other aspects to the story that are not being fully and transparently presented?

Please note, I'm not implying in any way that TSEM is doing anything wrong at all—well, wrong to the extent that TSEM is misrepresenting fact. However, I think TSEM is clearly wrong in its choice of how to communicate with its investors and present fact in a way that optimizes investor trust.

I think due to these decisions TSEM is lessening the trust investors could have in what I view as its stellar performance. As a result, its stock is trading below where I think it could and should trade today.

Bottom Line
I'm very happy with TSEM's strategic and tactical execution as it relates to the income statement, its balance sheet management, and longer-term prospects for growth and profitability.

However, I'm disappointed by the presentation of fact in the press release and, to some extent, in the prepared remarks of the subsequent conference call. It's my hope that TSEM will take these comments as constructive criticism.

Setting aside that criticism, however, is my continued belief TSEM will prove to be a profitable investment over time. However, due in part to the capital structure, which includes the capital notes discussed above, and the fact TSEM is still a small player in the highly competitive and capital intensive semiconductor fabrication sector, there are substantial risks that go along with what I view as a very attractive upside potential.

While I think the upside potential will continue to be limited by the aforementioned "elephant in the room," I expect TSEM will continue to deliver growth and improving profitability while it finds a way to deal with the elephant in a way that is beneficial for its shareholders.

If it succeeds in this quest, and continues to grow revenue and profitability in line with its stated objectives, I think the stock could move into the $3 to $4 range. [The stock opened under 76 cents on Monday—Editor.]

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