Unwafering Support

Is it time for shareholders to cash in their gains, or might shares of MEMC have further to run? We'll look into that today; the company turned up recently on our Profitability screen.

A company's level of profitability is gauged by looking at its margins. There are several types. Gross margin shows how much of its sales are left over after paying for raw materials and manufacturing costs. Operating margin subtracts those costs plus corporate expenses for things like advertising and executive salaries. Net margin takes out everything, including one-time costs associated with things like legal settlements and past acquisitions.

Our screen looks for companies whose operating and net margins are on the rise vs. their five-year averages. The companies it turns up have figured out a way to reduce their administrative costs, or to grow their businesses without adding new administrative costs. They also show that the benefits of such increased efficiency are flowing through to their bottom lines, rather than being consistently negated by special charges.

That kind of fiscal stewardship can lead to strong share-price gains. For example, we featured software maker Macromedia (MACR) in a profitability screen a year ago ("Flasher!"). Its shares have since climbed 95%.

See our recipe of criteria for details on all of our search requirements. And use our stock screener anytime to run a search for yourself. Recently it produced a list of eight survivors from a starting database of more than 9,000. Let's look at MEMC.

The world's largest maker of the wafers used to make semiconductors, St. Louis-based MEMC posted sales over the past year of nearly $1.1 billion. That's up from $885 million at the time of our last story. The company's products are used to make memory chips like the DRAM kind employed in PCs and the flash memory used in hand-held electronic devices. They're also used in computer processors and CMOS chips. (The latter stands for complementary metal oxide semiconductor; it's a battery-powered chip in your PC where software controls your computer from the time you turn it on until the operating system takes over.) Finally, MEMC makes wafers for analog circuits, which include things like voltage regulators and sensors that essentially bridge the real world with the digital one.

Founded in 1959, MEMC was the first merchant manufacturer of silicon wafers. They measured 19 millimeters in diameter at the time, or about the size of a nickel. The company was the first to commercially produce 100 mm wafers in 1975, 150 mm wafers in 1981 and 200 mm wafers in 1984. Today 300 mm wafers are the standard — roughly the size of a medium pizza — and MEMC is on track to produce 350,000 of them a month by the end of 2006, up from 175,000 a month today. Those sizes may seem counterintuitive; in the world of electronics the parts are supposed to get smaller, not bigger. But the wafers MEMC makes aren't parts themselves. They're the platters from which chip makers cut out tiny pieces to make chips. Bigger platters, just like smaller chips, reduce manufacturing costs, since the innards of more gadgets can be made at once.

Analysts consider MEMC a classic turnaround story. Buyout firm Texas Pacific Group took over the company in November 2001, and put a new management team in place in April 2002. Since then productivity has increased sharply on a lower headcount, production costs have fallen by double-digit rates each year and cycle times have improved by 25%. The company today is twice as profitable as it was in 2002. Then it took $1 billion in revenues for MEMC to break even; today it takes just $500 million.

MEMC's fast-climbing shares have cooled off during October, slumping about $6 to below $17 as of Thursday's close. Third-quarter results for the company, reported Oct. 26, showed sales increasing 5% to $288.3 million. The quarter contained a labyrinth of special credits and charges and accounting changes, such that analysts disagreed on how much the company actually earned. About $7.3 million in both sales and profits was deferred to the company's fourth quarter due to a change in its revenue recognition practices. Profits jumped 164% to $97.9 million during the quarter. But operating income actual dipped to $69.2 million from a year-earlier $83.6 million. Bottom line, the Street was looking for adjusted earnings per share of 29 cents, and MEMC missed by between a penny and four cents, depending on how one does the math.

That said, many on Wall Street see the company as primed to take advantage of a strong price and demand outlook in the chip market, driven by end markets like cellphones and consumer electronics — and solar cells. "We believe MEMC will benefit immensely starting the end [of] 2005 through 2007 from the short supply of poly (raw material to manufacture silicon wafers)," wrote Needham & Company analyst Pierre Maccagno in a Thursday research note. "The price of poly has been increasing sharply (from $9/kilogram in 2000, $25/kg in 2004, $35/kg at the beginning 2005 to more than $50-$55/kg this month) driven by growing demand from the solar cell industry while supply is limited." Maccagno notes that MEMC, which unlike its competitors produces 95% of its raw polysilicon, should have limited exposure to price increases and shortages, and could grab market share as a result. (Maccagno doesn't own shares of MEMC; Needham & Company has an investment-banking relationship with the company.)

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.