Tight working capital management
It is clear that Pure Wafer now has a tight grip on cost control of its capital expenditure and working capital needs. So although the 46 per cent rise in pre-tax profits grabbed the headlines in the six month trading period to end December 2013, I was just as impressed by the fact that a net debt position of $1.6m (£0.97m) last June reversed into a net cash position of $1.3m at the end of December. Cashflow generated from operating activities increased by 12 per cent to $3.16m year on year, enabling the company to pay down bank borrowings as well as funding a £500,000 plus purchase of plant and equipment.
The benefit of this can be seen in the profit and loss account as finance costs which totalled £162,000 in the first six months of calendar 2013, declined to £115,000 in the latest six-month trading period. In turn, a greater percentage of operating profits are falling to the pre-tax line. True, the third increase in operating profits to £2.18m in the period can be partly explained by a change in Pure Wafer's depreciation and amortisation policy, inline with the board’s previous guidance following a review. However, it also reflects a $260,000 reduction in administration costs, or 11 per cent of the prior half year's total.
It's worth noting that having booked pre-tax profits of $2.2m in the latest six-month period the company is comfortable on target to hit WH Ireland's profit estimate of $3.9m for the 12 months to end June 2014. On that basis, expect EPS of 14.7c, or 8.8p. Admittedly, that is little changed from the previous year, but that only reflects the extra shares in issue following a share placing, which transformed Pure Wafer's balance sheet. A better way of looking at it is on a proforma basis, which shows that EPS would have risen by 2c a share in the first half alone. In any case, I would much prefer to invest in cash rich highly operationally geared tech company rather than one that also carries significant financial risk.
The absence of borrowings not only helps Pure Wafer boost its pre-tax line, but having refinanced credit lines with HSBC just over a year ago, the company has the flexibility of being able to tap credit facilities if it needs to. These include a £3.5m term loan over four years and a £1m revolving facility, both of which are attractively priced on interest rates of 3 per cent over Libor.
Furthermore, with the benefit of strong cash generation, the board intend paying a maiden dividend at the full-year stage. Analyst Eric Burns of WH Ireland is pencilling in a payout of 0.5p a share, doubling to 1p in the 2014/15 financial year. On this basis, the forward yield is 0.6 per cent, rising to 1.2 per cent.
The other key point for me is that Pure Wafer's current valuation implies the shares are ex-growth. A PE ratio of 10 is hardly exacting for a business that is set to grow pre-tax profits by 30 per cent in the current financial year to $3.9m, and by a further 10 per cent to $4.3m next year. In fact, such a modest rating is more common amongst companies that are struggling to grow profits at all. Clearly, that is not the case with Pure Wafer given the strong industry drivers its business is supported by.
Growing industry demand for chips
To recap, global market demand for semi-conductors/silicon chips is rising strongly which has been driving demand for 'test wafers' silicon chips. These test wafers are needed for testing, maintenance and calibration of semi-conductor manufacturing equipment. As a result, wafer reclaim is now an essential and highly specialised industrial process enabling the multiple re-use of silicon test wafers. This is where Pure Wafer comes into its own as one of the world's leading providers of wafer reclaim services which enable semi-conductor manufacturers to gain further efficiencies through greater re-use of silicon test wafers.
Importantly, demand is expected to continue to rise. Latest research from industry specialist IC Insights suggests that the global semiconductor industry will enjoy 9 per cent annual growth rates in the next three years out to 2017. It's worth noting that the majority of this growth will come from foundries: TMSC, Global Foundries, Samsung and UMC. Industry experts predict growth of 14 per cent from this segment in 2014, which in turn should be good news for wafer reclaim and Pure Wafer, in particular, given that all these companies are clients. This adds further credence to the view that the business will continue to enjoy a favourable backdrop and one underpinned by the increasing requirement of memory, or DRAM, and technological change.
For instance, wireless chips have been growing at a compound annual growth rate of more than 20 per cent for the past decade, while demand for units of integrated chips are predicted to drive demand for silicon and therefore wafer reclaim. Analysts anticipate demand from this segment will grow by about 8 per cent annually over the next couple of years.
Indeed, in order to meet growing industry demand, primarily from Asia and the US, Pure Wafer has added capacity to its production facilities in Swansea, south Wales, and Prescott, Arizona. As the leading European and US provider of 300mm wafer reclaim services, the company boasts a 'blue-chip' customer base including most of the world's largest semi-conductor manufacturers. Intel, IBM, Texas Instruments and HD MicroSystems are all clients. It's an important source of income as revenues from 300mm wafer reclaim services account for over two thirds of Pure Wafer's business. In the latest six month trading period, volumes of 300mm wafer reclaim sales rose by 6.5 per cent, and those of 200mm wafer rose by 8.5 per cent, reflecting industry growth and market share gains.
Expect further market share gains too because the company's investment in a planned 40 per cent ramp up in capacity of 300mm wafer reclaim services is almost complete at its Swansea facility. The planned ramp up in capacity at the Prescott plant is set to become fully operational by June. The benefit of these investments is that they will enable the company to operate at record levels of capacity without incurring additional labour costs, thus improving the unit cost per wafer reclaim and maintaining its competitive pricing.
Factoring in the pricing environment
That's important right now because Pure Wafer has been facing pricing pressures due to the weakness of the Japanese yen versus the US dollar. This has enabled Japanese rivals, who are already facing a declining domestic market, to aggressively price their business to a global customer base. That said, Pure Wafer has absorbed the pricing pressures through cost control to date and there has been no impact on profits.
It's worth noting too that since the start of the year, the yen/dollar cross rate has moved sideways which has relieved some of the pressure Pure Wafer was facing following a steep depreciation in the yen in the final quarter of 2013. I am not complacent about this particular issue as clearly it increases risk, but my view is that ultimately it will be market growth that will put a floor on reclaim pricing and protect earnings of Pure Wafer.
Positive technical set-up
Interestingly, having pulled back to their 200-day moving average earlier this year on profit taking, Pure Wafer shares have regained much of the lost ground and printed at 90p intra-day yesterday. This signalled a break-out on both the swing chart and the point and figure chart. In my opinion, it should be acted upon. The 14-day relative strength index (RSI) reading is still only 60, so there is ample scope for recovery in the share price back to the 12-month highs of 105p and beyond. For good measure the moving average convergence divergence (MACD) indicator is positive and above its signal line, having just given a buy signal. This adds further weight to the view that the share price is set to run up back to the 12-month highs around 105p.
Needless to say, I rate Pure Wafer's shares a buy on a bid-offer spread of 87p to 90p. My initial target price is 105p, but if this is surpassed then a run up to WH Ireland's target price of 115p is a distinct possibility. Even that could prove conservative as the shares would still only be trading on 11.5 times EPS estimates of 16¢ for the financial year to June 2015. Please note that I have taken into consideration the fact that Pure Wafer is a small-cap company with a market value of £23m, the volatility of the shares and the bid-offer spread when making this buy recommendation.
Please note that I have written five other columns this week, all of which are available on my homepage. I am currently working my way through a large number of announcements from companies on my watchlist and which I plan to update. These include: LMS Capital (LMS), BP Marsh Partners (BPM), Eros (NYSE: EROS), First Property (FPO), Trading Emissions (TRE) and Polo Resources (POL).
