Photronics: Pull-Back On Soft Near-Term Demand Creates Long-Term Buying Opportunity

seekingalpha11-05

Significant revenue and profit growth between 2020 and 2023 drove the stock price above the $30-mark earlier this year.Following several earnings misses caused by softer than expected photomask demand...

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Monty Rakusen  Photronics (NASDAQ:PLAB) is a leading global producer of photomasks, which are high-precision quartz or glass plates housing microscopic images of electronic circuits. These photomasks play a pivotal role both in semiconductor and flat panel display production, serving to imprint circuit designs onto semiconductor wafers and flat panel substrates. Their utility extends to the fabrication of integrated circuits (\"ICs\"), various flat panel displays (FPDs), and to a lesser degree other electrical and optical components. Thesis In my initial analysis published early April, I provided an in-depth industry and competitive review of Photronics, Inc. (PLAB), and explained why the company is poised to benefit from its technological leadership and secular tailwinds in the photomask industry. Despite my buy rating at a stock price of $28 at the time, I cautioned investors against near-term price pressures towards the low $20-range both for fundamental and technical reasons, and recommended considering out-of-the-money puts as a way to gain exposure with an extra margin of safety. Now the stock trades at just over $23, following the unexpected YTD decline in photomask demand across Asia, where Photronics generates about 80% of its revenues. The good news is that fundamentally, neither my original thesis nor my fair value range of $31-$40 have changed much, which means that if PLAB was a good buy in April, it is an even better buy now. I am saying this while acknowledging that we may not have seen the bottom yet. In this article, I provide my view on YTD results and what to expect in Q4 and beyond. I also explain why the contraction in operating margins in recent quarters is no reason for investors to get worried. Finally, I discuss near-term scenarios for the stock, and what they mean for investors that are long or are interested in building a position in PLAB. Q3 YTD Results & Q4 Outlook reflect an industry-wide slowdown When I wrote my first article early April, Photronics had just posted +2% revenue growth for the first quarter, and management was still guiding for continued growth both for Q2 and through the rest of 2024. However, the tide turned in the second quarter, as the company recorded a -5% year-over-year revenue decline, followed by a -6% decline in Q3 2024 – both falling short of original guidance. To be fair, when you have been on an upward roll like Photronics, doubling your revenues in the past seven years, it is hard to accurately predict the inevitable \"bump in the road\" that any company faces sooner or later, particularly when operating in a cyclical industry. companiesmarketcap.com During the Q3 2024 earnings call, CEO Frank Lee called out continued macroeconomic demand headwinds, notably in Asia, as the main reason for the revenue slowdown: Lingering macro uncertainty and customer concern on elevated inventory caused some to limit or defer releasing new designs. As a result, photomask demand slowed, resulting in lower sales for both IC and FPD. Photronics reported a -3% revenue decline on a Q3 YTD basis, with gross profit down -7% and operating income down a whopping -12%. It is therefore surprising to see net income up +20% YTD. This reflects the combination of significantly higher interest income (up +90% to $17.1 million), the positive impact of foreign exchange relative to prior year (+$21 million vs. PY YTD), as well as the fact that China, where Photronics and Dai Nippon Printing (OTCPK:DNPLY) operate the Xiamen joint venture (reported as minority interest in PLAB’s results), is one of the markets showing the biggest underperformance. Based on the mentioned drivers, all of which are not sustainable, investors do not (and should not) give earnings growth much credit, and rather focus on revenue and operating margins. I will be discussing operating margin drivers in more detail in the next section, so let’s focus on revenue drivers for a moment.   Stock Research Platform Photronics reports revenue both by product type and by geography. Looking at the product breakdown, we can see that high-end IC photomasks are the only product type with growth both in Q3 (+9%) and YTD (+23%). For reference, high-end IC photomasks are defined as those being 28nm or smaller, i.e., more complex/high tech to manufacture. These are typically used in high-end smartphones, high-end wearable devices (e.g., watches), augmented & virtual reality headsets, and drones. Unfortunately, high-end IC only represented 22% of total revenues in FY2023. Therefore, while faster growth in high-end is generally positive (also due to comparatively higher margins), it could not offset the -10% (Q3) and -13% (year-to-date) decline from Photronics largest segment, mainstream IC photomasks (51% of FY2023 revenues). Moving to FPDs, both the high-end and the mainstream segments were down, although high-end FPDs held up much better on a relative basis, staying almost flat YTD. For reference, Photronics defines high-end FPDs as AMOLED, G10.5+ and LTPS. Again, those can be found on high-end devices with screens requiring strong contrast and brightness levels. Fortunately, the shift to these new technologies is already quite advanced, and high-end FPDs already represent over 80% of Photronics total flat panel display photomask sales. As a reminder, this is the segment that has seen the biggest growth through 2023 (a whopping 24% CAGR from 2019-2023), and where management expects continued growth in the future, supported by the company’s technological leadership in AMOLED. Photronics Q3-24 10Q Report Although Photronics does not provide a breakdown of IC and FPD demand by market, the fact that the United States and Europe demand is up significantly both in Q3 (US: +31%, EU: +2%) and YTD (US: +14%, EU: +8%) while Asia is down (Q3: Taiwan -16%, China -11%, YTD: Taiwan -8%, China -8%) suggests that a lot of the mainstream demand comes from Asia, while the mix of high-end is likely much higher in the US and Europe. That said, high-end IC seems to be growing across the board, as shown by $31 million YTD growth, which is significantly more than the combined $15 million total growth we have seen in the US and Europe so far this year. Photronics Q3-24 10Q Report Turning to Q4 outlook, the mid-point of revenue guidance implies a sequential improvement in year-over-year decline to -5%, with FY 2024 revenues down -3% (in line with YTD). The range of $213 to $221 million implies a Q4 growth rate between -6% and -3%. CFO Eric Rivera called out \"good order rates at the beginning of the fourth quarter\", but we had seen the same in early Q3 2024 and this did not translate into the expected outcome, as Photronics grossly missed the $221 to $229 million range (landing at $211 million). As a result, I believe it is appropriate to remain cautious. Hitting the guidance range at this stage would be a huge step in the right direction – both for credibility, but also as this would mark a stabilization or even improvement in year-over-year decline. Meanwhile, the remainder of the P&L should largely follow the recent trends, assuming revenue hits the mark. Management guided for 25-27% operating margins and diluted non-GAAP EPS of $0.48 to $0.54, much in line with Q3 results. In the P&L below, I kept operating income and net income in line with their guidance mid-point, while filling in the blanks with what, I believe, are reasonable assumptions.   Stock Research Platform To conclude, Photronics is headed to record its first year of decline since 2016, with gross and operating margins contracting from 2023 record levels. This setback drove the stock price down by almost -30% so far this year, and the stock could still go lower if Q4 guidance is missed or the 2025 outlook disappoints. I will talk more about this risk later when I describe short-term stock price scenarios. Meanwhile, let me first explain why I believe that margin compression is temporary and why Photronics remains well positioned to win in an attractive industry, making this pull-back a buying opportunity for long-term investors. Operating Margin compression is volume-driven and temporary As we have seen from the P&L above, gross and operating margins have come down from 2023 all-time highs. Specifically, gross margin is expected to land around 36.2% for 2024, which is 150bps below the 37.7% achieved in 2023. Operating margin is expected around 25.8%, down 260bps from the 28.4% high in 2023. Below chart shows the quarterly evolution of gross, operating and net income margins since 2021. As a reminder, the fluctuations in net income margin are largely attributed to foreign exchange swings, which is why I will focus my analysis on the gross and operating margin level. Stock Research Platform Starting with gross margins, there are essentially three material drivers for profitability: (1) price, (2) product & geography mix, and (3) utilization (of the manufacturing capacity). Obviously, there are other factors influencing gross margin, like manufacturing losses and shipping expenses, but I expect those to be far less material drivers over time. Let us start with pricing. Most companies decompose their revenue growth into price, volume and rate. Photronics does not, and you may wonder why. The following note in the company’s financial disclosures (e.g., the latest 10Q report) provides an explanation: Photomasks are manufactured to customer specifications in accordance with their proprietary designs; thus, they are individually unique. Due to their uniqueness and other factors, their transaction prices are individually established through negotiations with customers; consequently, our photomasks do not have standard or “list” prices. The transaction prices of the vast majority of our revenue contracts include only fixed amounts of consideration. In certain instances, such as when we offer a customer an early payment discount, an estimate of variable consideration would be included in the transaction price, but only to the extent that a significant reversal of revenue would not occur when the uncertainty related to the variability was resolved. In other words, in the absence of year-over-year product comparability, one cannot mathematically compute the annual price (nor volume) increase/decrease. That said, the overall price level for (similar-type) photomasks does fluctuate over time, driven by a multitude of factors – the most critical one being demand. Here is what the company 10Q report says about historical downturns in the photomask industry: Historically, the microelectronics industry has been volatile, experiencing periodic downturns and slowdowns in design activity. These negative trends have been characterized by, among other things, diminished product demand, excess production capacity, and accelerated erosion of selling prices, with a concomitant effect on revenue and profitability. Obviously, the reverse is also true, as supply bottlenecks in periods of high-demand drive prices up, also in the form of so-called \"delivery premiums\" (a premium paid by customers to jump ahead in the production schedule). On the Q3 earnings call, CFO Eric Rivera explained that while Photronics has some (price & volume) protection through long-term agreements, supply lead times have normalized in 2024 vs. 2023, which caused a year-over-year headwind from the loss of delivery premiums. Our long-term purchase agreements continue to provide protection against downside risk during times of market softness, helping us maintain market share and pricing. Delivery premiums, which were meaningful last year are no longer material to our results as lead times have normalized. Meanwhile, CEO Frank Lee confirmed that so far, the industry is not operating at over-capacity, keeping \"base prices\" stable. Our mainstream business actually is very stable because as we reported several times in the call, in the mainstream manufacturing side, there are many end-of-life tools. So with that we have to replace the equipment to add capacity. But in general the capacity for mainstream segment is not increasing. So that enabled us to keep the stable price. To conclude on pricing: like in many industrial sectors, photomask prices are significantly influenced by demand levels relative to production capacity. This results in a compounding effect both during booms and busts, as revenue growth tends to drive prices up, while revenue decline tends to come with price stagnation or erosion. The disappearance of 2023 delivery premiums is responsible for part of the gross margin erosion in 2024. That said, I am positive on pricing long-term for two reasons: first, the volume demand for photomasks is likely to continuously outpace growth in production capacity; and second, the shift to high-end (i.e., higher price) photomasks is set to directionally drive price levels up in the future. The latter brings us to the second major gross margin profitability driver: mix. This equation is fairly straightforward: more and more electronic devices require smaller and smaller node ICs and higher quality displays (e.g., Photronics’ AMOLED FPDs). This trend is evidenced both by the strong performance of high-end ICs in 2024 (the only growing product type this year), and the strong growth in high-end FPDs since 2019 (despite being slightly down this year, I expect the 2019-2024 CAGR to be in the 15-17% range). Meanwhile, as noted in the company’s 10Q, high-end photomasks do not only come with higher prices, but also higher margins. This means that the trend to high-end has been and will continue to be a tailwind to gross profit. While it is impossible to quantify this accurately based on publicly available information, I believe that the meaningful shift to high-end in 2024 (NB: high-end IC+FPD as % of total sales was 44% in FY 2023 vs. 49% in Q3 YTD 2024) has been a significant positive to margins this year, likely offsetting most if not all of the aforementioned lost delivery premiums. This brings us to the final key component of the gross margin equation: utilization. In simple terms, this refers to the amount of product output generated with the equipment and other \"fixed\" resources, and is a form of cost leverage measure. In general, the higher the product volume that runs through a given production line, the lower the unit cost will be, and vice versa. The relative impact of volume throughput on the total cost per mask is visualized on the chart below, which was published in a BACUS Newsletter (by SPIE, the international society for optics and photonics).   BACUS Newsletter, SPIE An empirical analysis on Cost & Profitability in Photomask Manufacturing also concludes that the majority of production costs are fixed, depending on \"the utilization of highly expensive capital equipment\". This (admittedly old, dated from 2006) study estimates the material cost, which is the main variable cost component, to only 15%. While exact numbers may vary by type of photomask, these two data points give us a good idea of the high correlation between production volumes and unit cost. In other words, the lower the photomask demand, the higher the cost to produce a photomask becomes, creating another \"double whammy\" set-up during recessionary periods. This is what CFO Eric Rivera was referring to when commenting on Q3 gross margins during the last earnings call: Overall, our gross margin was 35.6%, down slightly as we would expect given the softer revenue and our level of operating leverage. Moving now to operating margins, the key factor (other than the gross margin itself) is obviously the level of operating expenses [Opex] in relation to revenues. From 2019 to 2023, revenues grew at a 13% CAGR, with Opex growing only 5% per year on average. This was a major contribution to operating margin expansion through positive operating leverage, i.e., the fixed expenses grew at a far lower pace than sales. Looking at 2024, revenue is expected to decline -3%, while Opex are set to grow about 8%. In isolation, this is obviously the opposite of what we would like to see, but in aggregate we are still looking at revenue growing at a 9% CAGR vs. Opex at a 5% CAGR from 2019 to 2024. The Q3 2024 10Q report provides some insights as to the drivers for the Opex increase on a YTD basis, which are expected to continue into Q4:  Selling, general, and administrative (SG&A) expenses increased $4.1 million in YTD FY24 to $56.8 million, compared with $52.7 million in YTD FY23. The increase was primarily driven by higher compensation and related expense of $1.8 million, with the remaining difference mainly due to increase in professional service fees. [...] Research and development expenses increased by $1.0 million in YTD FY24 to $11.3 million, compared with $10.3 million in YTD FY23. The increase was driven by the expansion of development activities in the U.S. and Taiwan.  While both the compensation increase ($1.8 million) and the R&D investment ($1 million) make directional sense to me, the nature of the professional service fee increase would be interesting to know, as it is much larger than usual. Unfortunately, CFO Eric Rivera was not prepared to provide more details on the earnings call (or should I say, unfortunately the one and only analyst covering PLAB did not ask that specific question). Overall, while I was not expecting management to make drastic cuts in SG&A on the first sign of market slowdown, this is an area where I would expect decisive action in case we are slipping into a prolonged recessionary phase. Given the healthy investments made over the past years, I am confident that management would be able to find places to streamline operations if the revenue re-acceleration is further delayed. All-in-all, the main driver for margin compression in 2024 is lower volumes, that resulted in the elimination of delivery premium income and lower operating leverage across Photronics' manufacturing and operational footprint. So far, management has not pushed hard to contain SG&A expenses, which can be justified looking at the total 2019-2024 performance and assuming a return to growth in 2025. I am saying this as restructuring and other cost-cutting interventions come with disruption to the business, which has its own cost. However, if revenue headwinds persist, management will have to take action. One way or another, this is why I believe that margin erosion will be temporary. Management has (so far untapped) levers to sustain margins should recessionary pressures persist, while operating margins will naturally recover as soon as volumes expand. This brings us to the next section, where I want to briefly cover why Photronics remains well positioned for growth in the mid- and long-term. Photronics remains well positioned to benefit from growing industry I will keep this section short to avoid repeating what was published in my prior article, where I provided a deeper dive on the industry outlook, competitive dynamics, and why I believe Photronics is well positioned within the photomask industry. In a nutshell, it comes down to the following two key points: Secular industry tailwinds to drive average 4% growth in photomask industry from 2023-2030. Even if growth will never be linear, secular industry tailwinds will drive continued mid-single digit growth in the photomask industry, driven by the following megatrends:  The rising demand for semiconductors is driven by 5G, cloud computing, AI and the general but continued expansion of consumer electronics on a global scale. Advancements in semiconductor technology drives the ongoing need for more complex (high-end) photomasks with smaller nodes and EUV lithography. The expansion of semiconductor foundries is driven both by heavy government and private investments in semiconductors fabrication plants, fueled by the latest home-shoring trend in light of geopolitical tensions.  Photronics is the largest \"pure play\" manufacturer of photomasks with several competitive advantages. While Photronics may only be the third-largest photomask producer in absolute terms (after Toppan (OTCPK:TOPPY) and Dai Nippon Printing (OTCPK:DNPLY), both Tokyo, Japan-based), it is by far the largest pure-player, and the only player based in the United States and listed on a US stock exchange. The latter may become more of an edge in itself as the United States invest in semiconductor foundries and look for US suppliers where possible. Also, size matters in this industry when it comes to price and cost competitiveness, linked to the operating leverage dynamics I described previously. This definitely provides these top 3 players an advantage over the broader competitor base. Finally, Photronics seems to have a clear technological edge in FPD AMOLED technology, which is still gaining share from other display technologies as it gets applied to larger screens as well. While it is probably a matter of time until the next technology emerges, it seems that Photronics has been a consistent leader (or at least part of the leading group of photomask companies) when it comes to innovation, also in the IC space. So, while Photronics is headed to negative growth in 2024, I continue to look at the glass half-full. The company’s performance has been really strong in recent years, growing revenue at a 13% CAGR from 2019 to 2023. This means that even with -3% expected for 2024, the 2019-2024 CAGR would still be 9%. That is well ahead of the long-term photomask industry growth, suggesting Photronics has been able to outgrow the industry, which management expects to continue doing. Here is how CFO Eric Rivera put it during the Q3 2024 earnings call: As uncertainty abates, we anticipate achieving above-market growth due to our leading technology, scale, market share and strong customer relationships. With that, let’s turn to a brief update on valuation. Photronics’ fair value I will refer you to my previous article for the full details of my simplified DCF model. In a nutshell, I started from PLAB’s 2023 adjusted FCF of $163 million (NB: adjusted FCF = cash from operations less stock-based compensation less CAPEX), and modeled a 5.5% average FCF growth for the next 10 years in my base case scenario. Using a WACC of 10.1% and a terminal growth rate of 0.75%, I got to an enterprise value of $2.38 billion. Adding back the net cash position of $512 million (end of FY2023) and subtracting the estimated value of DNP’s minority stake ($632 million or 8.5x FY2023 minority income), I got to an equity value of $2.26 billion, or roughly a fair value of $36 per share. So, what has changed since (and why does it not matter much)?  Well, clearly FCF won’t grow by 5.5% in 2024. However, I am not worried about getting back on track later in the period, for all the reasons mentioned in this article. A 5.5% CAGR was always meant to reflect an average, understanding we may see years of decline and years of strong double-digit growth. For sake of illustration, FCF was negative in 2019 and just $67 million in 2020, implying a 34% 2020-2023 CAGR. Now, we are far away from negative FCF (my est. range is $120-130 million for 2024), and we know that FCF will rebound significantly when demand returns. The WACC has barely moved, as the beta remains at 1.4 and with a risk-free rate down to 4.3% and an equity premium of 4%, I get to 9.9% vs. 10.1% … not material enough to bother. Meanwhile, the net cash position is up to $606 million as Photronics continues to rack in cash, while arguably the value of the minority stake has diminished somewhat, due to much of the underperformance this year coming from China.  All in all, these different factors are not material enough to warrant a full valuation update at this point in time, which is why I chose to maintain the fair value of $36, with a range of $31 to $40. If you disagree with me on the future growth potential from secular tailwinds and the company’s ability to sustain margins, you will want to run your own DCF with your respective assumptions. I would also take this opportunity to point out the exceptional A+ valuation grade Photronics currently has on Seeking Alpha. For the reasons mentioned (notably foreign exchange variations), I am not a fan of using the P/E ratio for PLAB, but even looking at more consistent metrics like EV/EBITDA and Price/Cash Flow, it becomes very clear that the current price is very attractive, both relative to the sector and the Photronics five-year average (which I believe is the more meaningful comparator here, as the sector is defined a bit too broadly to offer a meaningful benchmark). Seeking Alpha Despite the potential deep value buy a long-term oriented investor could make at current prices, I do see an elevated near-term risk for further downward price pressure. Thus, I would like to finish today’s article with a view on possible short-term price scenarios. Short-Term Catalysts & Stock Price Scenarios On a fundamental level, the most critical measure to watch in Q4 (and subsequent quarters) is revenue growth. If instead of slowing down to -5% (mid-point of guidance), Q4 revenue misses the $213-221 million guidance range and declines -7% (or more), I expect renewed price pressure to push PLAB out of the ascending channel it has been trading in most of the time since 2020 (see chart below). In this unfavorable scenario, we will likely at least test the $20 mark, if not $18, before year-end 2024. This effect could be accentuated by tax loss harvesting pressures on the stock, according to Morgan Stanley. In case of an outright recession and prolonged muted demand in the first half of 2025, I see a scenario where we retrace all the way back to $14. To the extent we get there, driven by industry-wide headwinds, I would personally enjoy the buying opportunity. On the upside scenario, it will take revenue to return to growth for PLAB to move back up in the $30s. Any other catalysts, such as the recently approved $100 million stock repurchase program (see note 14 of Q3 10-Q report), which replaced the existing program (that still had $31.7 million of unused budget, making the net add only $68.3 million), are too small to matter. I also believe that Photronics will have a hard time returning to 2023 gross and operating margin levels until revenue returns to growth, limiting the upside potential until then. Stock Research Platform (using Trade View) In between these two scenarios, I believe the base case is a sideways consolidation in the low to mid-$20s for the next three to six months, assuming Photronics is able to deliver in line with their Q4 guidance while also guiding to sequential improvement in 2025. This scenario would assume that we are not entering into a global recession, while also not entering the next phase of economic expansion. If I had to put probabilities on each of these scenarios, I would give the base case (#1 on the chart) a 60% chance, the low case a 30% chance (going back to $18 at least), and the high case only 10% given the lack of economic catalysts in the near-term. Conclusion On the Stock Research Platform, I am looking for asymmetric low risk, high reward opportunities. Photronics is a well-positioned company in the photomask industry, which is facing temporary headwinds amidst secular growth tailwinds. My previous investment thesis remains unchanged, and the recent drop in stock price presents a buying opportunity. Meanwhile, the challenging economic backdrop requires some caution when it comes to position sizing and the overall approach to entering a long position. The photomask industry is expected to grow in the range of 4% per year through 2030, driven by the generally rising demand for semiconductors (from 5G, cloud computing, AI, VR, etc.), the technological advancements in semiconductor technology (smaller process nodes, EUV lithography, etc.), and the expansion of semiconductor foundry capacity (new fab investments, also driven by geopolitical tensions). This means that the current industry slow-down mainly driven by Asian markets will be temporary. The challenge lies in predicting how bad it may get before it rebounds. In recent years, Photronics has been able to expand margins through a combination of positive mix shift towards higher-end photomasks, as well as operating leverage achieved by maintaining a slow-growing cost base amidst accelerated revenue growth. This year’s expected step-down in operating margins from 28% in 2023 back to 26% will be transitory, as revenues flip from growth to decline for the first time in 8 years, reversing some of the previous operating leverage gains. As management continues to run a tight ship when it comes to pricing and cost controlling, when revenues reaccelerate, so will margins. Bottom-line: PLAB now has more than 50% upside potential to its fair value of $36, and trades well below the low end of its fair value range of $31 to $40. I am maintaining my buy rating on the stock, with an investment horizon of 1 to 3 years.  The reason I am not rating the stock a \"strong buy\" right now is that we may not have seen the bottom yet when it comes to photomask demand weakness. While the broader market seems to disagree, I still see an elevated risk for at least a mild recession in the coming 12 months, which would translate into a slower rate of design innovation for electronic devices and thus a slower demand for photomasks. In such a scenario, we could go back and test resistance levels at $18 or even $14.  Personally, I have been and will continue to sell out-of-the-money puts on PLAB with strike prices in the low $20-range, with the intent to generate cashflows while progressively building up my position. 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