Having a margin of safety is important when choosing investments. Seth Klarman, one of the all-time great value investors wrote a book about it entitled just that. So when he buys 11% of a company’s shares recently, we should take notice. That company would be ChipMOS (NASDAQ:IMOS). They are involved in the industry of outsourced semiconductor assembly and testing. What would he see in this small cap company? Let’s find out.
I won’t go into the details of the business, and there has already been a great article on Seeking Alpha by Jaret Wilson on why it’s already an arbitrage opportunity but I’d like to present why in valuation terms it presents a great long-term investment with a large margin of safety which is critical in this environment of lofty market valuations.
Although ChipMOS is trading near its highs, it still presents an attractive investment for several reasons.
- It’s a bargain based on its valuation relative to peers in the industry.
- It has a phenomenal balance sheet loaded with cash and low debt.
- IDMs (integrated device manufacturers) are increasingly outsourcing stages of the semiconductor production process to companies like ChipMOS to shorten production cycles which should drive revenue growth.
- ChipMOS is increasing production capacity, ramping up Capex due to expected demand from customers. Their overall utilization rate held firm at 77%, despite expanding capacity by about 17%. This shows that there is solid demand growth in this industry.
Very rarely do we see a company that’s a value stock and at the same time growing revenue and margins like a growth stock. Now let’s look at a company comparable analysis.
Notes to Reader: ChipBond and King Yuan are denominated in Taiwan dollars. The EBITs I use are the sum of the most recent four quarters for each company. TEV or Total Enterprise Value is calculated as: Market Capitalization + Long-Term Debt – Excess Cash + Preferred Stock + Minority or Non-controlling Interests. ROIC is return on invested capital. NOPAT is net operating profit after tax or EBIT times an assumed tax rate of 35%. Invested Capital is calculated as: Total Equity + Total Liabilities – Current Liabilities – Excess Cash.
I’d also like to note that in my analysis above I am attempting to evaluate the enterprise of ChipMOS as a whole including its subsidiaries. The EBIT numbers represent consolidated numbers and the total enterprise value calculation includes non-controlling interests so all providers of capital are included. This way we have an apples-to-apples comparison in the numerator and denominator for a ratio like EBIT/TEV. When valuing the ChipMOS Bermuda holding company itself down below I’ll attempt to back out the value of the stock by subtracting out the non-controlling interests.
Based on a comparable analysis, we can see that ChipMOS has an EBIT/TEV ratio of 16%, or an EBIT multiple of about 6, which is far superior to any of its peers listed above. This is what makes it a bargain. The market is pricing the company at too low an EBIT multiple based on what similar companies are trading for. What could be the reasons for this? Perhaps it’s due to the fact that it’s a smaller cap stock that’s less covered by analysts than its larger peers, in addition to having their operations based in Taiwan and China, providing them with less visibility to US-based investors.
ChipMOS also has a ROIC higher than any of the companies listed, a higher amount of cash on hand per share, and an EBIT margin of around 15%, similar to its peers listed in Taiwan.
Now, let’s try to go through a couple valuation scenarios and come up with a conservative and a base-case value for the stock.
Note that the book value I use is that attributable to holders of ChipMOS Bermuda.
Note that the above valuation examples don’t include any assumptions of revenue growth or margin expansion, both of which ChipMOS is currently experiencing.
Let’s try to make some assumptions about growth and other things to come up with where the stock could be trading over the years. These are very rough approximations that I believe to be reasonable but as with any kind of assumptions, could also turn out to be very wrong, in a good way or a bad way.
Assumptions Used: Revenue for 2014 has been approximated based on management’s most recent guidance. Revenue then is assumed to grow at around 9%. I assume the EBIT multiple to eventually reflect companies that are similar to ChipMOS . I also assume cash remains about the same, and long-term debt is paid off at around 10% of the balance each year. Non-controlling interests I left constant over the years in addition to shares outstanding. If you would like a copy of the spreadsheet I used for the above tables to play around with the assumptions, let me know.
- A decrease in demand for assembly and testing services for semiconductors and LCD display drivers such as that experienced in 2008 and 2009 could reduce the company’s profitability.
- There is no guarantee that the market will adjust and price ChipMOS according to valuation ratios similar to its peers in the industry.
- ChipMOS derived 56% of its revenue in 2013 from its top five customers so there is a decent amount of reliance on the financial health of these customers. A decrease in demand for end-products like HD TVs, mobile phones, tablets, etc, could lead to decreased demand for outsourcing services, reducing profitability for ChipMOS.
Overall, I think ChipMOS is an under-followed company that’s a bargain based on several valuation metrics. Despite the run-up in the stock, it’s still undervalued especially compared to its peers. Currently in the midst of expanding operations due to high demand from IDMs, ChipMOS is poised to benefit from the growth in increased outsourcing of semiconductor testing and assembly.
This is also a business with a decent-sized moat with high barriers-to-entry. The fixed costs are high to buy the proper equipment in order to assemble and test semiconductors and IDMs are very careful about who they outsource their work to. ChipMOS has been around for many years and has a good reputation.
In addition, more people around the world are using mobile phones, tablets, and HD TVs than ever before and as wealth grows, the semiconductor industry should also see high growth. Finally, the high cash, low debt balance sheet of ChipMOS can give an investor comfort knowing there is a margin of safety here.