Summary
- Photronics is a leading provider of photomasks for the IC and FPD's (flat-panel displays) markets.
- The company has pursued a growth strategy centered on winning the "lion's share" of a fast growing TAM in IC and FPD photomasks in China.
- Despite a few years of excellent financial and operational performance, and my previous BUY rating, today I am downgrading PLAB stock to a HOLD. Here's why.
Photronics ( PLAB ) is a leading global supplier of photomasks for the IC and FPD markets. Back in January of last year, I wrote a Seeking Alpha BUY rated article on PLAB and suggested the stock could rise to $25 for a ~35% gain. That is exactly what happened (see chart below). However, as you can also see, the stock suffered a serious correction last August and has been unable to regain much of the drop. While I continue to be bullish on the long-term outlook for growth in the global photomask market, today I am downgrading PLAB to a HOLD given its China centric growth strategy, coupled with the potential of high-tech sanctions on that country that could actually impact PLAB, along with a strong foreign currency headwind.
Investment Thesis
The investment thesis in PLAB was, and still is, rather straight-forward. The company makes critical photomasks for the semiconductor sector that is poised for long-term growth driven by a number of relatively low-tech technology sub-sectors that are right up PLAB's alley. These include smart cards, LED drivers, automotive components, image sensors, IoT, and other relatively low-performance applications. These type chips are typically in the 65 to 45 nanometer range. These ICs are not considered to be "high-end" by any stretch of the imagination - which is why I previously thought PLAB would not come under pressure from any potential high-tech sanctions on China and would continue to grow at a relatively impressive clip.
What Changed
And PLAB did demonstrate relatively strong yoy growth last year. However, Q1 FY23 was relatively weak and future expectations have been tamped down as well:
Photronics
As you can see, PLAB had been on a nice growth trajectory, but FY23 revenue is expected to grow only 5.2% yoy, while Q2 FY23 earnings expectations of $0.44/share would actually be below the $0.49/share delivered in Q2 of last year.
The Q1 FY23 earnings report was released last week. Non-GAAP EPS of $0.40 met expectations, while revenue of $211.1 million (+11.2% yoy) was $10.1 million beat . GAAP EPS of $0.20/share was down from $0.38 in the year earlier period, and down significantly from the $0.60/share in the previous quarter.
- The IC photomask Segment grew revenue +0.2% qoq and +21% yoy.
- The FPD photomask Segment grew revenue +0.8% qoq but - 9% yoy.
- China revenue was - 10% qoq but +18% yoy.
Overall, not too bad. However, Q2 forward guidance was disappointing:
- The midpoint of revenue guidance ($210 million) came in shy of the consensus ($214.00).
- The midpoint of net income attributable to Photronics ($0.43/share) was also lower than the consensus ($0.47/share).
Shares actually ended up for the week, but going forward there are some headwinds. Investors can clearly see one significant headwind from a slide in the company's Q1 Presentation :
Photronics
As can be seen, on a GAAP basis foreign exchange unrealized gain/losses equated to a $25 million headwind as compared to Q4 (i.e., considerably above 10% of quarterly revenue). As most of you know, hot inflation data in the U.S. last week caused a sharp rally in the U.S. Dollar index meaning this FX headwind is likely to further dampen expectations for PLAB going forward:
MarketWatch
In addition, commentary on the Q1 conference call was a bit worrisome. My previous opinion on potential high-tech sanctions on China was that PLAB's relatively low-tech photomasks would not be materially impacted because they were, generally, not considered to be highly strategic in nature. However, this comment by PLAB CEO Frank Lee caught my attention:
... I would like to offer a few comments on the continued evolution of export control laws. Japan and the Netherlands have recently agreed to tighten restrictions on the export of chip manufacturing technology to China. T his may create additional risk for us as we rely on some Japanese firms for material, tools and services necessary to manufacture photomasks .
That being the case, I must acknowledge the fact that my previous take on this issue may have been naive at best, and off-base at worst. The bottom line is that the combination of FX and potential sanctions headwinds, along with the relatively soft Q2 guidance, have - in my opinion - materially changed the risk/reward opportunity with PLAB. When you add in the China/Russia "special relationship" given Putin's war in Ukraine (why China would risk its crucial international economic relationships - and sanctions by the West - to support Putin's violation of international law is beyond my comprehension), and the high uncertainty the company mentioned on the conference call multiple times, I am changing my rating on PLAB from BUY to HOLD.
Risks
However, it could be argued that my original investment thesis - that PLAB was considerably undervalued given its growth potential - is still intact. I say that because PLAB currently trades with a TTM P/E of only 9.9x, and a forward P/E of only 9.7x, both of which are a significant discount (~50%, give or take) of the broad market as defined by the S&P500.
PLAB also ended Q1 with a very strong balance sheet: debt was only $34 million while cash and cash-equivalents were $374 million, or a net cash position of $340 million. That equates to a cash position of $5.53/share based on the 61.47 million average fully-diluted shares outstanding during the quarter.
Summary & Conclusion
While I am still bullish on the long-term growth of the global photomask market, FX headwind and uncertainties related to China have changed my opinion on Photronics' near- to mid-term prospects. At this point, and given relatively muted consensus expectations for PLAB this year, I am changing my rating from BUY to HOLD. Had the company not had such a strong cash position ($5.53/share), I would have gone all the way to an outright sell.
I'll end with a 3-year total returns chart of PLAB versus the semiconductor sector as represented by the VanEck Semiconductor ETF ( SMH ) and suggest that investors stay in SMH - or the SPDR S&P Semiconductor ETF ( XSD ) ETF for those that are worried about SMH's large stake in Taiwan Semiconductor ( TSM ) - instead:
For further details see:
Why I Am Downgrading Photronics