Description

I recommend a position long TRID (Trident Microsystems) and short UMC (NYSE listed ADRs of United Microelectronics). Trident has no debt, breakeven cash flow, a market value lower than its stake in UMC plus cash, and several new products that should bring investor attention to the company.

BACKGROUND

Trident makes graphics processing chips used in computers (97% of revenues), DVD players and high-definition plasma TVs (3%). The industry trends for these products have been very favorable as more media gets distributed in digital format and computer applications become more graphics-intensive. The total market for graphics chips is over $8bn per year and is expected to grow into tens of billions of dollars.

Trident Computer Products: The major players in this sector have been Nvidia and ATI technologies making high-performance chips for discrete graphics cards and VIA technologies, Silicon Integrated Systems, and Intel making low-performance integrated chipsets. Trident has competed in this market for a long-time and has relationships with all the major players, but has never had a real breakout product. Over 50% of Trident’s sales last year were to Toshiba, which uses trident chips in several lines of thin/light notebooks. The second largest customer is Acer.

New Product: Trident recently announced the development of its XP4 chip with specifications providing significant advantages over competing products. The XP4 chip uses a smaller and simpler design to reduce power consumption, yet provides performance competitive to high-end power-hungry desktop chips from ATI and Nvidia. This provides an excellent opportunity to expand Trident’s share of the thin/light market where most manufacturers (except Toshiba) currently use the ATI Mobility Radeon 7500. Trident claims the technology can be extended to the desktop market and that the company hopes to expand its desktop PC market share from its current insignificant level.

Trident Display Products: These products have provided little revenue but offer potential for significant future growth. Trident makes processors for LCD displays and plasma TVs. Company guidance is that the LCD-TV business can grow to 10% of sales by year-end. The plasma TV business will grow in the next several years as it becomes more of a mainstream product.

FINANCIAL VALUATION AND THE UMC INVESTMENT

Trident has no debt and has been generating about breakeven cash flow. Cash equivalents were $23.5mm at 3/31($1.74 per TRID share) and Trident owned 64.2mm Taiwanese shares of UMC (worth US$101.7mm or $7.59 per TRID share based on the 4/25 price of UMC). Other long-term investments in start-ups are carried at $10.5mm or $0.78 per TRID share. The market gives the Trident operating business a negative enterprise value.

UMC has grown very successfully as a contract manufacturer of semiconductors. Purchase of TRID can be seen simply as a cheap way to buy UMC. But I recommend shorting UMC ADRs because they trade at a large and unsustainable premium to the value of the local shares held by Trident. As an example, on 4/25 UMC closed at NT$55.00 in Taipei. Each ADR represents 5 local shares so fair value for each ADR on 4/25 is US$7.92 (using 34.71 NT$ per US$). On 4/25 the ADRs are trading at $10.60.

The premium exists because Foreign Exchange Control laws prevent foreigners from freely buying and selling local Taiwanese shares and prevent the free conversion of local shares and ADRs. Recent enthusiasm over the rebound in UMC’s business has kept the ADRs at a high premium, however in the long-term the supply of ADRs can expand to meet demand and should inevitably put downward pressure on the premium. Currently 103.5mm ADRs are outstanding, but in 2001 UMC issued zero coupon bonds due 2004 that will be convertible into 24mm additional ADRs. Subject to approval from the Taiwan government, UMC may make additional secondary offerings of ADRs or ADR-linked securities. The government of Taiwan announced that it had granted itself permission to sell UMC shares acquired in market stabilization measures as ADRs (this would increase the supply by 47.5mm ADRs). Trident says there is discussion of granting permission for private investors to convert local shares into ADRs. The company is closely monitoring developments.

Trident indirectly acquired its UMC stake through acquisition of a small Taiwanese company that owned shares in a company that was acquired by UMC. Keeping at least 50% of the current investment guarantees Trident access to certain production capacity from UMC. Trident describes its outlook for the investment:

“We do intend to monitor the advisability of disposing of our UMC stock and intend to sell all or part of the stock when it is in the best interest of our shareholders to do so, however at present we do not have an intent to sell any of the stock in the immediate future.”

The relative prices of TRID and UMC ADRs have fluctuated over the past year and as recently as October TRID traded above UMC. This fluctuation should provide opportunities to realize profits without the presence of any special catalysts from TRID. The last time that TRID introduced a significant new line of chips was late 2000 and then TRID regularly traded at a premium to UMC. It reminds me of Sonicblue (SBLU) which traded below the value of its stake in UMC until a new product line and the sale of some UMC shares moved SBLU to a premium.

Trident has 3.2mm options outstanding (including unvested options) at an average exercise price of $4.39. If all options were exercised then cash would increase by about $14mm and outstanding shares would increase to 16.58mm.


BUSINESS VALUATION

While the market currently gives a negative enterprise value to Trident’s operating business, a look at comparable companies suggest it has significant value. Intense competition in graphics chips has driven many competitors from the field, but in nearly every case a competitor has been willing to pay a significant sum to acquire the patents and intellectual property. Significant transactions include: Nvidia acquired 3dfx, 3dfx acquired Gigapixel, ATI acquired Artx and FGL, SIS acquired the graphics business of STM, VIA acquired S3, and Creative Tech is acquiring 3dLabs. The main public comps for Trident are Nvidia trading at an EV of 3.8 times sales and ATI at 2.4 times sales.

With no special value attributed to Trident’s new products, a low valuation of 1x sales would value the business at $118mm or $8.80 per share.

If the company’s new products prove to be as popular as the company hopes then sales should at least double and could earn a market valuation of 2x sales that would value the business at $35.20 per share.

RISK/CONCERN

The company’s mediocre past performance suggests the risk that Trident fails to take advantage of the growth in its markets and cannot seize the apparent opportunity presented by its new graphics chip. The cash and investments will support the stock price, but the market may never be willing to give any value to the Trident business. A readily available demonstration of this risk is CEO Frank Lin’s amateurish performance on the 4/24 earnings conference call.

CATALYSTS

1) Negative enterprise value for TRID with breakeven cash flow
2) Unsustainable premium for UMC ADRs
3) Recent announced products will generate increased revenues starting in Q3
4) Several years of growth for the graphics chip market

Catalyst

) Negative enterprise value for TRID with breakeven cash flow
2) Unsustainable premium for UMC ADRs
3) Recent announced products will generate increased revenues starting in Q3
4) Several years of growth for the graphics chip market