Description

This is a true value stock.  I originally wrote this idea up in July 2004 when the stock was at $12.58 and after a rather bumpy ride the stock went to a high of $52 and is now back to the low $30s.  The valuation is just as compelling today given the recent pullback after their slight earnings pre-announcement and the significant growth the company has experienced in the past 2 years and continues to experience. 

Description:

As opposed to most write-ups on here I’m going to start with the financial metrics and then give you the company background and comps because I feel the valuation is so compelling.

2006E PE – 7-7.3x

2006E EV/EBITDA – roughly 4x (assumes EBITDA of $217-$220)

Strong B/S – Net Cash of $110 mln

When I wrote this idea up before, the stock was trading at 3.4x current year EV/EBITDA (not trailing) and a 6 PE with earnings expected to be $2.00.  Well, in 2004 they only generated $1.71 in earnings but grew that to $3.55 in 2005.  You can do the easy math of over 100% earnings growth on about 50% growth in revenues.  The stock got to $52 at the beginning of 2006.  With >100% EPS growth and 50% revenue growth the company was rewarded with a PE of under 15x.

For the 1^st 6 months of 2006 the company has already grown their earnings by 52% YOY ($2.30 vs $1.51) and are on track to generate earnings of $4.40 to $4.60 for 2006. They had given guidance for Q3 of 5% sequential earnings growth and net margins of 16-17% which they revised on 9/9/06 to revenues flat to up 3% and net margins in the range of 14-16%.   The stock is down 11% since that announcement.  Even if Q3 is flat with Q2, that still represents 30% YOY revenue growth and at least 15% EPS growth.

What does Komag do?

Komag is the world’s largest independent supplier of thin-film disks, the primary high capacity storage medium for digital data in computers and consumer appliances.   Komag was founded in 1983 and went public in1987.  Their business peaked in 1997, a time when demand had grown significantly, the number of disks per hard drive was three, there was overcapacity and the industry was very fragmented.  The number of disks/drive began to decline, growth began to slow and irrational pricing in a high fixed cost environment caused most of the companies into bankruptcy.  Komag emerged from bankruptcy on June 30, 2002.   Currently there are approximately 1.67 disks per drive (up from 1.3 in my last report), capacity is at full utilization, the suppliers have consolidated from 10 to 4, cost per GB was $10.00 in 1997 and is under .05 today and demand is growing.  The industry does not face the same issues as they did in 1998 and 1999.   

The demand for data storage in the way of disk drives continues to grow as a result of the digital era in which we want to store our movies on DVR/PVR boxes, or store lots of music files on our computer hard drives.  Their primary customers are Western Digital (38%), Seagate (32%) and Hitachi (26%).

Competitors

Komag has 37% market share.  (Source:  TrendFOCUS) Their primary competitors are Asian independent disk manufacturers Showa Denko, Fuji Electric and Hoya. HGST and Seagate also produce some thin-film media internally for their own use.   An ongoing point of concern in the stock is that many of the players in the market are adding capacity.  Komag will have increased their unit capacity by 19 mln since 2004.  They are on track to have 39 mln finished disk capacity in time for Q3 and intend to exit 2006 with a capacity of 43 mln disks a quarter (up from approx. 37 in Q2).  Given that the industry has been running at near full capacity and the market is growing, this concern is overblown. 

Business Model

The primary drivers to Komag’s business model are finished disks sold and average selling prices (ASP). Capacity utilization is the key metric to focus on as it will drive the margins more than anything else.  Over the last five quarters, the finished disks sold have increased from 27.6 mln to 36.6 mln units per quarter and they have been running at 100% capacity utilization.   The disk ASP has grown from $5.53 (Q2 ’05) to $5.74 (Q2 ’06).  The combination of rising units and rising ASP’s has been evident on the income statement.   The increasing ASPs were due to the higher % of 120GB platters in ’06 vs ’05.  As is the case in most commodity type products, newer technologies have the ability to drive higher margins, but they are not typically sustainable.  I would anticipate there will be some ASP erosion until the next technology comes online. However, with 120GB (higher margin product) platters representing only 44% of sales today there should not be any significant declines in the near term.   

The company is covered by many Wall St. firms who have varying opinions.  I’ve reviewed many of the models out there and would point you towards the Needham model as a realistic, yet conservative view of the company prospects. 

What is driving growth?

The short answer is the same as it was 2 yrs ago – Worldwide PC growth and DVR/PVR deployments.  The longer answer is increased demand for storage and the growing variety of products that require storage.  In just the last few years, products like the IPOD and Tivo like PVR’s have become hugely successful.  While Komag does not currently participate in the 2 ½ inch platter market or flash memory market (IPODs, etc.) they are waiting for the right time to enter the market and will likely do so when the economics are viable.

Valuation

Due to the lack of publicly traded U.S. comps, many investors and analysts use their customers as their comps.  I do understand their logic but would argue that they have very different operating structures and while they are peers they are not ideal comps.  Hutchison Technology (HTCH) is also a supplier to the HDD manufacturers, but is not a competitor.   For the sake of comparison, I have included a valuation table with their largest publicly traded customers and comparable company.

What is it worth??

I would apply a 6x EV/EBITDA multiple on current year estimates and a 10x PE at a minimum, getting me to a valuation of $46, 40% appreciation from current levels.  There is risk in that they do have 3 large customers and are subject to the challenge of maintaining full capacity utilization.  If not for those 2 factors, I would certainly ascribe higher valuation multiples.  They have already pre-announced for Q3 and Q4 is their seasonally strong quarter so I would anticipate the near term risk is limited to the typical market risks.  Q3 results are scheduled to be released on 10/28. 

.I would suggest you visit the company website www.komag.com, as they update their investor presentation frequently. 

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