Description

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. This is a true value investment opportunity that is the result of being “a great house in a bad neighborhood”. It’s an opportunity to buy an industry leader with a strong balance sheet and solid cash flow and earnings at historical low valuations. I believe the story is very simple and easy to understand. 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. The recent sell off in the stock has not been a result of anything the company has done or said. Actually, they pre-announced positive earnings for the two preceding quarters. .Their primary customers (aka the “bad neighborhood”) Western Digital, Maxtor and Seagate have all given the market enough reason to be concerned about the disk drive industry. While the customer issues are certainly of concern to Komag, I believe the market has over penalized Komag and thus the value opportunity has been created. The current market capitalization is $344 million with the enterprise value being roughly the same. They should generate approximately $100 million in EBITDA this year, hence the stock is trading at just 3.4x EV/EBITDA. Additionally, they are expected to generate $2.00 in earnings. At the current market price of $12.58 the stock is trading just over 6x earnings.

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 1.3 disks per drive, capacity is at near full utilization, the suppliers have consolidated from 10 to 4, cost per GB was $10.00 in 1997 and is under .10 today and demand is growing. The industry does not face the same issues as they did in 1998 and 1999. It is very unlikely the number of disks per drive can go any lower as every computer needs at least one hard drive and many of the servers and PVR/DVR’s use multi-platter drives.

Customers
Maxtor (45%), Hitachi (21%), Western Digital (19%) and Seagate (8%) (based on Q1 2004 data)
Maxtor and Seagate’s problems have been well publicized over the last two quarters. They have been struggling with an oversupply of desktop drives in the distribution channel and aggressive pricing in the enterprise market. They have felt pressures from the OEM’s (Dell, Hewlett Packard, etc.) to reduce prices as a result of excess inventories. While I am not 100% certain, I believe the majority of the excess inventories were the 40GB platter drives which Komag has phased out. Maxtor pre-announced their second quarter results on July 1st, missing their numbers due to an aggressive pricing environment and lower than expected unit shipments. We have not yet seen the Q2 results from Western Digital or Seagate. Investors seem to have concluded that if Maxtor and Komag’s other customers are having problems, then Komag must be struggling also. That would appear to be a reasonable conclusion, but as you read on you will see that that is not the complete picture.

Competitors
Komag has 37% market share. (Source: TrendFOCUS) Their primary competitors are Showa, Fuji, Hoya and Trace (merging w/Showa) with 32%, 15%, 8% and 8% market share respectively. A main point of concern in the stock recently is that many of the players in the market are adding capacity. Komag will have increased their unit capacity by 5 mln (up to 25 mln per qtr) in time for the typically seasonally stronger Q3 and Q4. Given that the industry has been running at near full capacity and the market is growing, this concern is overblown. The combination of Trace and Showa could be a positive as the pricing environment won’t be affected by a smaller player trying to compete on price to get the higher volumes.

Business Model
The primary drivers to Komag’s business model are finished disks sold and average selling prices (ASP). Over the last five quarters, the finished disks sold have increased from 16.7 mln to 19.2 mln units per quarter. The disk ASP has grown from $5.57 to $5.94. The combination of rising units and rising ASP’s has been evident on the income statement. The company generated .65 in Q1’04 vs. .21 in Q1’03 and EBITDA grew from $21 mln to $30 mln. The increasing ASPs were due to the upgrade to 80GB platters from 40GB platters. 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 believe the ASPs did peak in Q1 at $5.94 as the company completed their transition to 80GB in the quarter. I would anticipate there will be ASP erosion until the next technology (120GB platters) comes online, likely within the next 12 months. While ASPs will likely be declining, it should be a gradual decline that will be largely offset by increased units.
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 – 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 (IPODs, etc.) they are waiting for the right time to enter the market and will likely do so when the economics are viable. Conversations with Tivo and Scientific Atlanta reveal that TIVO anticipates adding at least 1-1.5 mln subscribers this year and Scientific Atlanta expects to ship over a million DVR’s this year. Each of the players requires a hard drive and depending on the # of recordable hours they will likely contain multi-platter drives. Gartner estimates that Worldwide PC shipments grew 13% in Q1 vs. prior year. Total shipments were 45.3 mln units. Komag’s units increased by almost 15% in the same period. I believe this is the result of them taking market share and the growth from other areas such as the PVR/DVR opportunity.

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. HTCH has also been beaten down and trades at a similar valuation to Komag; however they pre-announced negative Q1 results. They are scheduled to report earnings on 7/22. It is important to be aware of this because KOMG seems to be very correlated w/HTCH. Interestingly, HTCH and KOMG both generate EBITDA margins in excess of 20%, much higher than any of their customers but they both trade at a discount to the group.

It has been a rare occurrence to see a company that solidifies their balance sheet, grows their cash flow and earnings and achieves declining valuation multiples. The EV/EBITDA multiple for Komag has gone from almost 7x in 2003 (9 months after emerging from bankruptcy) to 3.4x. Management is very strong and has consistently achieved/exceeded the expectations they have set. They have not missed a quarterly earnings estimate since emerging from bankruptcy. Q2 results are scheduled to be released on 7/28. The guidance is for $105 mln in revenues and 9%-12% net margins (.33-.43 in EPS).
I have included a few summary tables for you to review below. I find it amazing that the Enterprise Value has only increased by 20 mln during the past year even though they went from a net debt position of over $110 mln to a slight positive net cash position and grew their EBITDA by about $30 mln. Applying a multiple of 5x (which is not rich) and assuming no growth from the TTM EBITDA of almost $100 mln, the stock would be trading over $18, a 44% increase from current prices.
Obviously we would like to see growth in the EBITDA #s, but until we see how the pricing settles out over the next few quarters I believe it is prudent to value the business on a more conservative number. Management has said that a 2% quarterly decline in ASP’s is manageable. I would suggest you visit the company website www.komag.com, as they update their investor presentation frequently.

Historical Multiples
In Millions of US Dollars, except per share items and ratios

For the 12 Months End 3/30/03 6/29/03 9/28/03 12/28/03 4/4/04 4/4/2004*
TEV/Total Revenue 1.0x 1.1x 1.1x 1.2x 0.8x 0.7x
TEV/EBITDA 6.7x 6.3x 5.9x 5.9x 3.6x 3.4x


Operating Results

For the 12 Months End 3/30/03 6/29/03 9/28/03 12/28/03 4/4/04 4/4/2004
Total Revenue 330.9 385.6 424.6 438.3 456.4 456.4
EBITDA 47.3 69.1 81.1 88.8 99.4 99.4
EBIT (2.9) 20.6 36.0 46.4 58.0 58.0

Diluted EPS before Extra11.56 (0.92) (0.33) 1.47 1.92 1.92
Book Value/Share 5.69 5.91 6.31 7.01 9.18 9.18
Tangible Book Value/Sh 5.33 5.59 6.03 6.83 9.06 9.06

Catalyst

- Earnings announcement on 7/28
- New product introductions
- Other potential, but no determinable time frame, include new customer wins and the eventual demand for 120GB platters (w/in next 12 months)