I also carry out the same exercise when companies release upbeat trading updates. More often than not shares spike on the day of the announcement, or over the following week or so, only to relinquish part of the gains as the speculative money exits. So, by adopting a patient and disciplined approach to investing, it is possible to catch shares in such companies just as the selling pressure abates and prior to another assault on the high reached after the positive news announcement. Moreover, assuming the fundamental case stacks up, and the technical set-up favours a continuation of the uptrend, the odds of a favourable outcome can be heavily skewed in our favour. With that in mind I feel the current valuation of a small cap provider of wafer reclaim services on my watchlist, Pure Wafer (PUR: 7.25p) not only offers ample upside to my target price, but the share price action over the past fortnight indicates this could be an opportune time to buy into the shares, too. Profit drivers in the industry are pretty compelling, too.
Strong demand for wafer reclaim
Given technological advances, global market demand for semi-conductors/silicon chips continues to rise strongly and, as a result, so has demand for 'test wafers' silicon chips. And with semi-conductor companies making huge investment in highly advanced, specialist fabrication facilities, large quantities of test wafers are needed for testing, maintenance and calibration of semi-conductor manufacturing equipment.
In turn, wafer reclaim has become an essential and highly specialised industrial process enabling the multiple re-use of these silicon test wafers. And this is where Pure Wafer comes into its own as the company is now 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. These have become an integral part of the demanding and technically advanced production process.
Pure Wafer operates from two high-tech manufacturing facilities in Swansea, south Wales, and Prescott, Arizona, and following a period of consolidation within the industry, is now the leading European and US provider of 300mm wafer reclaim services. This segment accounts for about 70 per cent of revenues and the company boasts a 'blue-chip' customer base that includes most of the world's largest semi-conductor manufacturers and independent foundries. Intel, Samsung, IBM, Texas Instruments and HD MicroSystems are all longstanding clients and the company works closely with clients to design and develop a service that delivers reclaimed wafers to exact specification.
The numbers back this up. In the financial year to end-June 2013, Pure Wafer's volume sales shot up 21 per cent with the second half of the period showing greater growth over the first half. Demand from Asia and the US are driving growth and industry trends are supportive of this momentum being maintained. IHS iSuppli, a market research firm, indicates that excess inventories in the semi-conductor market have been cleared ahead of a likely second half surge in consumer electronics demand. This can only be positive for Pure Wafer's wafer reclaim services.
The increasing requirement of memory, or in tech speak DRAM, is also driving demand for Pure Wafer's services as this currently accounts for 30 per cent of all chips. Changes in the way we have adapted our lives to technological change are also factors. For instance, wireless chips have been growing at a compound annual growth rate of more than 20 per cent for the past decade, while increased demand for units of integrated chips will drive demand for silicon and therefore wafer reclaim. Analysts predict demand here will grow by about 8 per cent annually over the next couple of years. The foundry market is important, too, and industry experts predict growth of 14 per cent in 2014. This could prove conservative as Taiwan-based TSMC, the world's largest dedicated independent semiconductor company, is expecting growth nearer 19 per cent. Either way, this should be good news for wafer reclaim.
Profits uptrend
The company was founded in 2000 and has invested heavily in its facilities. In fact, total investment in the two manufacturing facilities is around $115m (£72m). However, analysts have believed for some time that the true profitability of the business was not reflected in the reported numbers because the company was being too conservative on the remaining life of its fixed assets (high-end clean room and wafer processing equipment). In fact, following a review, the depreciation and amortisation charge on $23.7m of plant and equipment and $7m of intangibles has been reduced from $5.5m in the 12 months to end-June 2012, to $3.2m in the financial year just ended. This reduction in the non-cash charge falls straight through to the bottom line, and in combination with cost savings, this led to a dramatic improvement in earnings.
This helps explain why Pure Wafer reported pre-tax profits of $3m on revenues of $37m in the 12 months to June 2013, quite a turnaround from the loss of $675,000 on revenues of $35.7m in the prior year. Admittedly a placing and open offer last November to strengthen the balance sheet helped, too. This raised £4.5m at 3.5p a share so investors backing the fundraising have already done well. In addition, the board sensibly refinanced credit lines by transferring banking arrangements to HSBC in February. A £3.5m term loan over four years and a £1m revolving facility, which is available to be drawn down at any time during the period for any capital expenditure requirements, attract interest rates of 3 per cent over Libor for all utilised funds, with a one-off arrangement fee of £75,000.
In addition, Pure Wafer negotiated certain discounts and fee waivers with its previous bankers, RBS and Citizens, in consideration for full repayment of their debt and facilities. These discounts and fee waivers amount to a total saving £384,000 to the company. The combined benefits of the placing and open offer together with the refinancing resulted in savings to Pure Wafer through discounts and fee waivers through negotiations with its debt providers of £636,000 and an annual cash flow benefit of £2.5m.
So with Pure Wafer generating $5.9m of cashflow from operating activities in the past year, the company's net debt has been slashed to only $1.6m at the end of June, from $12.5m a year earlier. This not only greatly improves the risk profile, but means that Pure Wafer has been able to fund its capital spend programme entirely from cash flow in the past year without having to tap credit facilities.
Moreover, with debt almost wiped out, this opens up the real possibility of Pure Wafer making dividend payments.
Compelling valuation
The company can certainly afford to because based on further rise in revenues to $39.5m in the current financial year to June 2014, analyst Eric Burns at broking house WH Ireland predicts Pure Wafer will increase pre-tax profits by a further 30 per cent to $3.9m to produce EPS of 1.5 cents, or almost 1p. The hike in profits largely reflects the operational gearing of the company as the margin on incremental sales has an accentuated impact on profits given the high costs base. So, with the shares trading on a bid-offer spread of 6.75p to 7.25p, valuing the company at £19.4m, the prospective PE ratio is less than eight.
The company is also too lowly valued on cash profit multiple. Based on a rise in cash profits from $6.3m to $6.6m in the current financial year, and factoring in a net cash position of $600,000 by June 2014, Pure Wafer is only being valued on a enterprise value (market value less net cash) to cash profits multiple of 4.6 times. This compares favourably with Pure Wafer's peer group - AXT, Entegris, SunEdison (formerly MEMC) and Shin Etsu. These companies are currently being valued on between seven to eight times their enterprise value to cash profits. In other words, even though Pure Wafer is forecast to ramp up profits by a further 30 per cent this year, the valuation being attributed to the company is between 35 per cent to 40 per cent lower than its peers.
That is not only anomalous, but makes for a compelling case to buy the shares. And for good measure, so does the technical set-up.
Share price ready to reassert uptrend
Having hit a resistance level of between 6.8p to 7.1p between the start of August and end of September, Pure Wafer's share price took off in the last week of the month after the company released an upbeat trading update that led to massive earnings upgrades from analysts.
This led to gap up in the chart on Monday 23 September, when the price opened at 7.88p, hit an intra day high of 9.3p and closed at 8.88p. As a result there was a gap between the prior day close of 7.1p and 7.88p, which at some point needed to be covered. The bumper full-year results released on Tuesday 1 October proved the juncture for traders to book their profits with the shares opening at 9.5p, hitting an intra-day high of 10.5p, a low of 8p and closed at 8.25p.
The price action since then has been textbook stuff whereby the share price drifts lower as the overbought RSI unwinds and the aforementioned price gap is filled. Support then kicks in around the prior resistance level before buyers start returning. I think we are at that point right now with the 14-day RSI having retreated from a massively overbought reading of 90 late last month to a neutral reading of about 40 now.
Needless to say I rate the shares a buy on a bid offer spread of 6.75p to 7.25p and have a target price of 10.5p to offer potential upside of 45 per cent. The timeframe for this trade is four months and incorporates the release of the half-year pre-close trading update, which is scheduled for mid-January. I expect it to make for a good read.
In the past fortnight, I have published 14 other articles on the following companies or trading strategies:
■ Global Energy Developments ('Waiting for pay dirt', 23 Sep 2013)
■ IQE ('IQE profit-taking presents buying opportunity', 23 Sep 2013)
■ 32Red ('32Red worth a punt', 23 Sep 2013)
■ Spark Ventures ('Banking on more cash returns', 24 Sep 2013)
■ Macau Property Opportunities ('Blue sky territory', 24 Sep 2013)
■ KBC Advanced Technologies ('Riding an earnings upgrade cycle', 24 Sep 2013)
■ Inland ('Buying opportunity ahead of results', 25 Sep 2013)
■ US Dog share portfolio ('Easy as pie', 27 Sep 2013)
■ Conygar ('Shrewd insider buying at a property play', 30 Sep 2013)
■ Netcall ('Ringing the right tune', 1 Oct 2013)
■ Eros ('Ringing the right tune', 1 Oct 2013)
■ Bloomsbury Publishing ('An e-commerce winner', 2 Oct 2013)
■ Simon Thompson's share recommendations, 2 Oct 2010
■ Inland ('Property plays with foundations, 7 October 2013)
■ Terrace Hill ('Property plays with foundations, 7 October 2013)
■ Sanderson ('A smart tech share', 9 October 2013)
