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CAPS Champion Contest: Idea #2

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May 21, 2009 – Comments (0) | RELATED TICKERS: AUO , SNE , KYO

It's Thursday in the AM (eastern), which means it is time for the next stock idea from our Global Gains research team eligible to be rated in the CAPS Champion of the World Contest. Remember you need to rate at least one of our team ideas and one of your own ideas each quarter to be eligible to win.

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Idea #2: Short AU Optronics (AUO) (from Global Gains co-advisor Nathan Parmelee)
 
Thesis: At a little over its tangible book-value AU Optronics looks cheap, but it’s a classic value trap.  AU Optronics two year string of profitable growth from sales of its LCD panels came to an abrupt halt last year when the recession set in and caused turned earnings in losses. With the economy showing signs of bottoming shares of AU Optronics have more than doubled off their lows and investors seem to be betting that growth and profitability are once again around the corner. I think such a rosy outcome isn’t likely and three primary reasons to be bearish on the company:

1. Sales volumes will improve off the lows, but in the developed markets of North America, Europe, and Japan consumers are saving more and spending less on discretionary items like electronics, which makes a recovery to previous volume levels and growth rates doubtful.

2. AU faces an incredible amount of competition and they’re all going to be looking to put unused capacity to work, which doesn’t bode well for pricing. Competition includes smaller players from Taiwan and China competing for business in the consumer electronics space, then there are the Korean giants Samsung and LG Display Co that control 55% of the market for LCD’s between them, and finally there are the Japanese firms such as Sharp, Sony (SNE), Kyocera (KYO), and Toshiba that have formed alliances to better compete.

3. In addition to their size and scale the weak Korean won gives Samsung and LG an additional advantage.

Company Description: AU Optronics is a Taiwan based firm that merged with fellow LCD panel maker QDI in 2006 to form the third largest LCD panel maker. The company makes TFT-LCD panels in sizes from 1.5 to 65 inches for PCs, TVs, consumer electronic devices, and industrial electronics such as ATMs. Across all product lines the multi-year trend is for lower average selling prices and increasing volumes. This trend was upset in the recession as prices continued to decline, but volumes declined as well.

Valuation: Going back to 2000 AU Optronics has generated free cash flow in only three years (2002, 2007, and 2008) and over that period is free cash flow negative in total. To justify the company’s current $9 billion market cap requires assuming that future years look much more like 2007 and 2008, something I think is very unlikely with lower consumer spending and big competitors. The big driver here is the continual capital expenditures necessary for new equipment and capacity to produce larger and higher quality displays. The company expects these investments to continue, which means cash profitability is likely to remain elusive and additional debt to support these expenditures might be necessary.

The other way to look at AU Optronics is by its tangible book value, which is currently $8 billion. This puts the company at about 1.1x tangible book value, which would be extremely cheap if it were mostly liquid or high quality assets.  Unfortunately, the company carries $5.3 billion in debt to just $2 billion in cash and $3.9 billion in current assets. So the tangible book value is supported primarily by its plants and equipment, which I wouldn’t count on fetching their depreciated value in a sale because of their specialized nature. 

With substantial competition, elusive free cash flow, and a leveraged balance sheet I think AU Optronics is worth substantially less than its current $9 billion market cap. How much less? LG Display Co has an $8.6 billion market cap, similar cash flow dynamics, and is less leveraged.  A discount to LG Display seems reasonable.

Agree/disagree?
Get started on the CAPS Champion of the World Contest by rating this idea. And if you want to see a few additional notes, including two other ideas in the electronics industry, check out our Global Gains discussion boards (membership required. Don’t have one? Click here to join our international investing research service where we put out many more ideas every month.)

Past contest ideas
Idea #1: Short Naspers (NPSNY.PK)

Enjoyable picture of Taiwan

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