United Microelectronics should give at least 40% upside

United Microelectronics (UMC) is the world’s second largest publicly listed semiconductor foundry. UMC is located in Taiwan like TSMC (TSM) and gets most of its revenues by producing semiconductor chips for mostly fabless customers based in the USA such as Mediatek, Broadcom and others. UMC was founded in 1980 and was one of the first companies to offer semiconductor foundry services to customers. UMC has been overshadowed by the growth of its Taiwanese peer TSMC which has become much larger than UMC. However, the company still operates at the leading edge of semiconductor manufacturing with two 300 mm fabs capable of producing 95,000 wafers per month. UMC has also started production on the 28 nm edge which is the most advanced process node for foundries currently. The stock is currently trading at a low valuation, with a P/B of just 0.7x which is far below that of other competitors. The company remains solidly profitable even though its revenues have remained stagnant in the last few years. Given UMC’s large manufacturing base, semiconductor expertise, its relationships with leading semiconductor companies and most importantly cheap valuation, I remain bullish about UMC.

What does United Microelectronics do?

UMC is a semiconductor foundry which means that the company is involved in the production of semiconductor chips for customers. The company does not design or market the chips; it simply produces chips at its fabs using designs provided by the fabless customer. After production, the company sells the chips back to the customer and is not involved in marketing or distributing them. UMC also provides assembly, testing and packaging services in partnership with Taiwan based Advanced Semiconductor Engineering (ASE) and Semiconductor Precision Limited (SPIL).

UMC’s Manufacturing Base

UMC operates 10 semiconductor factories or “fabs” as they are known. The company operates two leading edge 300 mm fabs; one of them is located in Taiwan while the other is located in Singapore. Seven of the fabs process 200 mm wafers while a lone fab processes 150 mm wafer. UMC provides wafer services to almost all major segments of the semiconductor industry.

Why you should Buy UMC

1) Stock Valuation is very cheap – UMC stock is trading at a cheap valuation with a P/B of just 0.7x and a P/CF of 3.7x. The company’s valuation multiples are about half that of the industry average. Though the company’s growth rate has been lower than peers, I think that the substantial discount more than discounts the risks. At the very least, the stock should have a P/B of 1x which means a ~40% upside from the current stock price. If you look at the company’s valuation record over the past 5 years, you can see that the company is trading at the extreme bottom of the range with a P/S ratio of just ~1.3x and an earnings yield of more than 9%. The company also gives a dividend yield of 2.5% which is a pretty good steady source of income till the capital gains materialize. Other foundries such as Semiconductor Manufacturing (SMI) and TSMC (TSM) trade at much higher multiples. SMI trades at a P/B of 1x, while TSMC trades at a P/B of 3.3x.

UMC Forward Price / Sales Ratio data by YCharts

2) Takeover Target – The semiconductor manufacturing industry is consolidating around the biggest companies such as Intel, TSMC, and Samsung. The world’s third biggest independent foundry Chartered was bought over by the owners of Global Foundries in 2009. There are only three pure play foundries producing chips at the leading 28 nm with UMC being one of them. As rivalries in the semiconductor industry plays out between Qualcomm (QCOM) and Intel, UMC might present a good target for QCOM which looks into expanding into chip manufacturing. Apple might also be a prospective buyer, as the company wants to break its dependence on TSMC.

3) Global Electronics Demand is Growing Rapidly – While the PC market is seeing a slow decline, the mobile devices market is growing at a furious pace. Tablet shipments will climb up by almost 60-70% in 2013, while smartphone should see a 30% increase this year. The increased demand for electronics is not only pushing up the demand for logic chips but also for memory chips. This is a good tailwind for UMC which heavily depends on global semiconductor demand for its revenues. The company saw more than 50% of its revenues being generated from the communication segment.

Table 1

Worldwide Devices Shipments by Segment (Thousands of Units)

Source: Gartner (April 2013)

4) Utilization is improving – One of the key metrics used to evaluate a foundry’s operation is its utilization level. UMC increased its utilization rate in the current quarter to 85% from 78% in the previous quarter and expects that the utilization rate will continue to remain in the 80s level in the coming quarter as well.

5) Technology Partnership with IBM – UMC is partnering with IBM to develop the 14 nm and 10 nm FinFET technology. The costs and expertise required to advance semiconductor geometries have increased tremendously in recent times. UMC has partnered with technology giant IBM to develop the technology for the sub – 28 nm nodes. This will help reduce the cost burden for UMC.

UMC Risks

a) Competition from IDMs has Increased Significantly – A number of strong players have entered the semiconductor foundry space in recent times. Samsung (SSNLF.PK) has become one of the biggest foundries by becoming a supplier to Apple’s (AAPL) hugely successful iPod, iPad and iPhones. Samsung is also the world’s biggest producer of memory chips and is a substantial supplier to its own smartphone and tablet divisions. Global Foundries has become one of the top 3 pure play global foundries, after it was carved out of AMD (AMD). Intel (INTC) which is the world’s largest semiconductor company by revenues has also announced its intention of becoming a major foundry. The company poses a big threat to high margin products as Intel is 1-1.5 nodes ahead of everyone else. The company has recently bagged some top semiconductor accounts such as Altera and Cisco. These moves have even alarmed the industry leader TSMC.

b) Capex Heavy Industry – The semiconductor industry has moved towards the fabless model because of the massive investments required to build and sustain semiconductor manufacturing. It can take almost $4 billion to build a cutting edge 300 mm factory which might become obsolete in 3-4 years. Only 4-5 companies have the heft to make such sizeable investments. UMC has been hamstrung as it does not have the balance sheet to finance the $10 billion plus investments made every year by top semi producers. The return metrics are also lower for UMC, given the large capital investments it has to make each year.

c) Investing in Advanced Process Nodes is becoming Difficult – United Microelectronics is one of the few players to be producing chips at the 28 nm process node. All the foundries had a tough time in ramping up yields at the 28 nm, with TSMC being the first to get good yields at the 28 nm process. Global Foundries and Samsung are seeing improved yields while UMC has not got major orders as it yields seem to be still low. As the semiconductor process geometries are reaching the single digit nanometer level, the technology is becoming highly complex and difficult to fund. The movement to the next generation of process geometries will require advanced technology and equipment. Only Intel is currently investing in 450 mm wafers while the other companies have deferred investments citing the huge costs. The massive investments needed for such advanced technology is also straining semiconductor equipment makers such as ASML. The companies with bigger R&D and capex budgets have an advantage over UMC.

Financials remain Decent without being spectacular

UMC’s valuation would make you think that the company was an indebted one making losses. However, the company’s financial shape remains decent without being spectacular. Though the company has not managed to grow as fast as TSMC, it has managed to slowly grow its revenues while maintaining its margins. The company has shown a CAGR of ~8% in the last 3 years and its operating margins remain in the 3-5% range.

UMC’s balance sheet also remains quite strong with a debt equity ratio of just 0.3x and the company had net cash of ~3 billion TWD at the end of 2012. The company’s inventories and receivables also remain well within the normal range.

Future Prospects and Estimates

UMC’s stock is cheap as the company faces delays in ramping up the yields at the 28 nm process. However, I think that the stock more than discounts these issues with a P/B of just 0.7x. Analyst estimates the company will earn 15c this year and the earnings will remain flat next year. This puts the forward P/E at just ~12.5x which is quite low. As the company ramps up production at the 28 nm production, earnings should show an improvement leading to both earnings and valuation increase. I think that the company should get a P/B of at least 1x which is what SMI trades at. A P/B of 1x implies that the investors should see a 40% return on their current investment, as the PT would be ~3.6. SMI is a smaller foundry than UMC and it is also technologically inferior to UMC with a shorter operating history.

Stock Price Performance

UMC has traded in range of $1.5-$4 in the last 5 years and is currently trading near the bottom of this range. The company’s performance has been more or less flat over the last year giving a negative ~5% return. I think that most of the risks have been discounted by the stock and it is has reached its floor price. There is solid valuation support at these stock prices and the risk reward seems quite attractive at this price point. The stock has traded in range of $1.75 to $2.44 over the last 12 months.

UMC Total Return Price data by YCharts

Summary

UMC has taken some blows in recent times as it has lost market share to bigger rivals in the foundry space. The company’s revenue growth figure has been less than stellar and it faces increasing competition from the IDMs. However on the positive side, UMC is one of the few companies capable of producing 300 mm wafers at the 28 nm node. The company has a solid manufacturing base, is solidly profitable and the stock valuation is very cheap. The company is also an attractive takeover target given that its $5 billion price tag is quite affordable to a bigger electronics or a semiconductor player. The dynamics of the semiconductor industry are changing rapidly with consolidation happening around the bigger companies. This trend might play into UMC’s hands as a bigger semi player such as Qualcomm (QCOM) might acquire UMC’s sizeable manufacturing capacity to get an in-house reliable supply of leading edge semiconductor chips. I would advise investors to buy UMC stock given its cheap valuation, which does not seem to discount its strengths.