|Shares Out. (in M):||28||P/E||0||0|
|Market Cap (in $M):||100||P/FCF||0||0|
|Net Debt (in $M):||97||EBIT||0||0|
|TEV (in $M):||197||TEV/EBIT||0||0|
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Elevator pitch: Hutchinson Technology Inc. (“HTCH”) is a speculative small cap company not suitable for most investors, but the risk / reward is very compelling given recent positive fundamental changes. First, the company is gaining back lost market share in its core business of supplying a key component to the hard disk drive industry and has better visibility into further share gains than it has had for over a decade. Second, HTCH has entered an exciting new and very large potential market that involves a new technology component used in smartphone cameras. Our diligence checks with consultants and potential customers regarding this new product have been very favorable with respect to market adoption and HTCH’s competitive positioning. Management’s tone regarding this new product area has also become much more bullish recently (select quotes from the CEO during the last earnings call are below). The company will be able to leverage its existing excess manufacturing capacity and process technology for this new product implying potentially high operating leverage. Over $1 per share of EPS power is a realistic possibility within a couple of years assuming modest success with the new product area. While the stock will likely always have a low earnings multiple given customer concentration and high exposure to the mature hard disk drive industry, the multiple should benefit from diversification into a new growing end market. Third, tail risk has significantly been reduced with a recent refinancing. Part of the financing also involved a substantial prepayment from one of the company’s largest customers. There was no discount on pricing for the advance. This advanced payment demonstrates the importance HTCH has in the hard disk drive supply chain. While HTCH’s hard disk drive customers will always be difficult to deal with, this advanced payment and recent share gains could be signals that the relationship has taken a turn in the right direction or has at least gotten past the point of being as bad as it is going to get. Fourth, the stock trades at just a slight premium to tangible book value, less than 1x sales, is down over 90% from 9 years ago and has line of sight to positive free cash flow. Due to excess capacity, depreciation is and will be much higher than capex unless the new product really takes off so free cash flow should be higher than net income for the foreseeable future.
Hutchinson Technology (HTCH) has been written up a few times on VIC. The last writeup was by tumnus960 in June of 2012. Please refer to these prior write-ups for a more in depth description of the business and the company’s history.
The Company’s core business involves making suspensions, which are key components for hard disk drives. HTCH is one of three players in this industry. The main difference between HTCH and the other 2 players is that it is vertically integrated and makes its own flexures, which are the highest value-add parts of the suspensions. HTCH is only one of two manufacturers in the world that makes flexures. The other flexure manufacturer is Nitto Denko. HTCH was the historical leader in the suspension industry. In 2006, it had about 60% share. For various reasons, including a horrible job by the company’s former CEO, this share declined to less than 20%. The prior CEO made several strategic mistakes, but one of the main errors was that he was too late in developing an Asian manufacturing footprint. The company has been recently gaining share back. For example, in the September 2014 quarter, HTCH’s unit volumes rose 20% sequentially vs the industry that was just up 6%. Its current share is at about 23%. Management is confident that its share will return to 30%+ within the next couple of years. Given the high amount of fixed costs in this business and after factoring some of the incremental cost saving actions the company is doing, 30% share would equate to about $32m per year of EBIT or $64m of EBITDA excluding any impact from the new business I will describe below. A big driver of this share gain will be gaining back share at Seagate (“STX”). Its current share at STX is just 10%. Putting myself in STX’s shoes, I can understand why they would want HTCH’s share to grow. STX wants to make sure it has diversity of supply, especially for flexures. It also cares about getting low pricing and just in time delivery. Finally, it cares about its suppliers continuing to invest in R&D. STX and WDC would rather have one of HTCH’s competitors go out of business than HTCH, because of the potential risk of having a monopoly flexure manufacturer. Since HTCH is vertically integrated and has less relative variable cost, HTCH benefits much more than its competitors from incremental unit growth. The company has been ramping production in a new manufacturing facility in Thailand that is close to STX’s factories. HTCH is also the only US based company in the industry and has historically led the suspension industry in innovation. HTCH used to have the highest share at STX. It seems reasonable that this can get back to at least 30%. HTCH has always had a high share at Western Digital (“WDC”) at around 60% but it had a very low share at Hitachi, which WDC acquired. HTCH’s combined WDC / Hitachi share is in the high 30% range today and the Company is confident that its strong relationship with WDC will lead to at least 10% more share at the combined WDC / Hitachi. This appears less obvious than the snap back at STX to me, but seems to be trending in the right direction given recent results. One obvious risk is that while the share may trend in the right direction, pricing may not. The company has historically been too optimistic with respect to pricing. While pricing hasn’t been going up much recently, it has been stable to slightly up over the past few quarters, which is a positive change vs the last several years. The above EBIT and EBITDA numbers assume a gross margin of 20%, which is still significantly lower than what HTCH’s gross margin was when it was the industry leader.
The stock has the potential to double within a couple of years just based on the core business, assuming management’s targets outlined above are achieved. Including dilution from the recently issued convert, outstanding warrants and stock options, there will be about 44m fully diluted shares. Net interest expense excluding the interest from the convert will be about $2.4m per q. The company has a huge NOL and tax holidays in Thailand so will not be paying taxes for a very very long time. The difference between capex and depreciation is expected to be positive 12-14m next year. Therefore, management’s goal of 30% market share implies FCF per share of around 80c from just the core business.
While one can justify an investment in HTCH based on the improving share position in its core business, this alone is not enough to make an illiquid stock like this very interesting. The most exciting part of the story is the Company’s new opportunity in Optical Image Stabilization (“OIS”) actuators for smartphones. OIS actuators enhance the ability of smartphone cameras to capture images in low light settings and help to stabilize images for video. HTCH’s technology partner for OIS is a private company called Cambridge Mechatronics Ltd. This company actually approached HTCH, because of its existing manufacturing capacity and process technology. While HTCH will be paying a royalty to Cambridge Mechatronics, management believes that the gross margins for OIS actuators should be higher than 20% - better than suspensions. Our checks with respect to this market have been very favorable. We talked to several engineers involved in camera module development and they seem to think that OIS will be part of most high end smartphones at some point. It appears to be a question of when not if. Our checks indicate that HTCH’s specific flavor of OIS is superior to anything currently on the market. Since HTCH can utilize its existing manufacturing capacity, its lead versus potential competitors that have to invest in capacity, is likely to grow. The Iphone 6+ and the Samsung Galaxy Note 4 both use OIS but have a different technology called Voice Coil Motor (“VCM”). Industry sources tell us that HTCH’s newer Shape Memory Allow (“SMA”) technology is expected to be superior in terms of performance. It is also a smaller part. The average selling price for the VCM part is about $2. SMA OIS is likely to be cheaper since its manufacturing is easier to automate. It is likely that HTCH charges less than $2 per unit, but its selling price should compare very favorably to the current 58c per unit the Company gets from suspensions. The company is already delivering product this quarter to a customer in China (most believe this to be Foxconn). The tone from management on the last earnings call regarding the potential in the OIS was extremely positive. Here are some quotes from the CEO:
“There is growing interest in our solution among smartphone and camera module makers. We are focusing on winning positions on new programs and increasing our production efficiency and capacity.”
“The advantage of the shape memory alloy approach is really three areas. There are performance advantages particularly for smaller lenses and larger lenses in these phones. There is better ability to redo sort of miniaturize the components which is a pretty important value for the smartphone guys. They want a smaller and smaller package because they want the space for other things like battery space and so on. And we think ultimately the cost can be better than the voice coil approach. It’s more automatable and we think ultimately it’s more economical. So it’s size and performance and cost. And that’s why we’ve got our first win and we’re really talking with all the major players and kind of getting pulled into it because of those potential advantages. So it looks good. We’re getting pulled in.”
“It is early and so there is just lots of unknowns around when we get some of those next wins, although we feel pretty good about where we’re sitting with some follow on wins.”
“When it comes to OIS and really the mechanical feature that allows you to let more light in, it’s really low light improvement. And that’s a big deal. That’s an important feature. So that’s what’s compelling about this and what’s real about this. And I think it will be, depending on how expensive the phones are, it will be sold in combination with some of these other features to get really good picture quality or video quality.”
“It looks to us, as we’re interacting with the customers, that it’s going to be pretty mainstream. And maybe the other thing to remember is when you’ve got a billion plus market that’s growing with two cameras in each of the phones, that’s a huge market.”
These were some pretty bullish statements for a market that has billions of potential units! These statements indicate HTCH is far along in discussions with several potential customers. Our industry checks also give us confidence that there seems to be reality behind these words. Less than 10% penetration of the smartphone market and assuming only 1 camera on each phones has OIS (front facing cameras are actually getting much more sophisticated which means that there is potential for 2 OIS actuators per phone) would yield incremental revenue in the $120 to $180m range at 20%+ gross margins and with minimal incremental operating expenses and capex. Win a large customer like Apple and the earnings power can get silly. What is also great about OIS is that if it does well, it absorbs fixed costs of the suspension business. Passing on the cost savings to disk drive customers and having extra money to invest in R&D and process development, could allow HTCH to take even more share in hard disk drives longer term.
While the stock has had a strong move recently - it is up around 80% from its low in June, it is worth noting that it is also still down 90%+ from 9 years ago when the company started losing market share in suspensions. The recent move up is also justified given the market share gains and its first OIS customer win. The company’s recent refinancing was dilutive but also eliminated a large overhang on the stock. The new convertible notes are not due until 2019. The fact that one of HTCH’s customers stepped up to provide financing in the form of an advanced payment is also a sign of the company’s importance in the hard disk drive supply chain. Not the best comparison, but it reminds me of when Intel, Samsung and TSMC actually invested into one of their key suppliers – ASML. That proved to be a major inflection point for ASML’s stock. HTCH has been described as a “turd” in messages following previous write-ups on VIC. It has suffered from the consolidation of its customer base. However, it should not be forgotten that HTCH was once a dominant supplier to this industry. It used to have much higher gross margins than its customers. It achieved that dominance because its vertically integrated model allowed it to produce more efficiently than its competitors. It also was able to invest more in R&D which allowed it to lead the industry in innovation. Its customer base has definitely consolidated, but was arguably still relatively concentrated when HTCH had much higher margins. There are also many other industries in technology that have concentrated customer bases where the suppliers have significantly higher returns on capital than HTCH. For example, most chip suppliers into the smartphone market have much higher gross margins despite the fact that many of them outsource manufacturing and have more competitors. While the stock has historically traded down to large discounts to its tangible book value, we think downside is limited (at least in the medium term) given significant less risk of bankruptcy and because of the new upside optionality from OIS. It does not seem like investors are currently paying much, if anything, for this upside optionality despite the bullish comments both management and industry contacts are making about it.
customer wins for OIS
continued share gains at STX and WDC / Hitachi
continued strength in the overall disk drive market.
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