Third Time's a Charm

Last October we gave the stock a second look in a search for improving levels of profitability. We decided, "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." The stock's up 148% since then.

Should readers who bought the stock after either story now lock in their gains, or should those who don't own it buy? We'll look into that today. MEMC turned up again on our Profitability screen.

A company's level of profitability is gauged by looking at its margins. Gross margin, for example, is the percentage of a company's sales left over after deducting what's called its cost of goods sold: the cost to buy raw materials and manufacture goods, basically. Operating margin is what's left after further subtracting operating expenses like executive salaries, marketing and administrative overhead. Profit margin is what's left after all expenses, taxes and accounting charges have been taken out.

Expanding margins, more so than already-plump margins, tend to lead to higher share prices. An increase in profitability shows something is changing for the better. Maybe demand is picking up. Maybe supply is constrained. Or maybe both events are contributing to profits, as is the case with MEMC. Such improvements tend to evolve over several quarters or years, rather than all at once. That makes companies undergoing margin expansion well worth a look by investors.

Use our stock screener anytime to run our search for yourself. Our recipe of search criteria calls for improving margins, rising earnings estimates, manageable debt levels and more. Recently the screen produced seven survivors from a starting database of 8,000. Let's look at MEMC.

Based in St. Peters, Mo., MEMC is the world's largest pure-play maker of silicon wafers. Chip manufacturers use such wafers to make memory for everything from PCs to iPods, as well as processors and CMOS chips, or battery-powered chips that control your computer's boot-up process. Wafers are also used to make things like voltage regulators and solar cells.

MEMC's wafers are the biggest in the business. That's important, because larger wafers allow chip makers to cut more chips at a time, thereby reducing manufacturing costs. The company's first wafers in the 1960s were the diameter of a nickel. Today it makes wafers the size of a Frisbee: 300 mm. Other companies make 300 mm chips, but none has the capacity and flexibility of MEMC. That's partly because MEMC makes 95% of the poly silicon it uses. A raw material used to make wafers, poly has soared in price to more than $50 a kilogram from $9 a kilogram in 2000. Wafer makers have struggled to increase production as supplies of poly have become scarce. MEMC has cashed in nicely on the high selling prices of wafers, while suffering much less than its peers from poly price hikes and supply shortages.

Strong chip makers get stronger, as we said. MEMC, thanks partly to its reliable output, scored a deal last week to supply wafers to Motech Industries, a solar-cell maker based in Taiwan. The eight-year contract is worth $1.2 billion. Pricing was set in line with MEMC's current 30% operating margin, analysts say.

The forces behind the sharp increase in wafer demand should be obvious to anyone who owns an iPod or cellphone. But investors may not be paying enough attention to the potential for growth in the solar-cell market. High oil prices make the payoff to solar technologies larger, as do improvements in solar power, which have been steady in recent years. Right now, solar cells account for 23% of wafer demand. That figure could hit 38% by 2010, say analysts.

As we mentioned in our October story, MEMC today is twice as profitable as it was in 2002. It may become more profitable still. Industry watchers don't expect supply and demand in the wafer industry to reach equilibrium until at least 2008. It's expensive to create the capacity to make industry-approved 300 mm wafers. Only four companies have done so thus far. That's down from 10 companies that were qualified to make 200 mm wafers. MEMC's financial strength makes it likely to step out in front of the next wafer-size increase, too. It ended 2005 with debt just 4.9% of total capital, down from 24.1% in 2004.

MEMC shares go for 26 times forecasted 2006 earnings right now. How expensive is that? Not very. The average semiconductor company fetches 22 times earnings, but MEMC is forecasted to increase its earnings by 18% a year over the next five years, vs. an average of 15% for the group. That gives the stock a PEG ratio (price/earnings divided by earnings growth projection) of 1.4, lower than the 1.5 shared by the company's peers and the broad market.

It's hard to think of a stock that's up several-fold since we started writing about it as a bargain. Nonetheless, the numbers convince us the stock has plenty higher to climb.