In this time of bullishness for hard commodities (things you can drop and not break) like steel and coal, it's perhaps a bit ironic that technological commodities like memory chips and flat panel displays are cratering in the wake of overcapacity and inflated inventory. But like all commodity cycles, this too shall pass.
While business is still tough, Taiwanese flat panel maker AU Optronics (NYSE: AUO) believes that the end of the down cycle may be at hand. While prices for panels dropped by more than a third in 2004, the company is now predicting only single-digit price declines in the first quarter of 2005 and stabilization around midyear.
This will be good news not only for AU Optronics and other panel makers, but also for related companies like Planar Systems (Nasdaq: PLNR) and Genesis Microchip (Nasdaq: GNSS), to say nothing of capital equipment makers like Applied Materials (Nasdaq: AMAT).
Despite the pricing freefall, AU Optronics posted 2% revenue growth for the fourth quarter, largely on the back of double-digit increases in large-panel shipments. Gross margins were barely positive (3.5%), but the company posted a net loss for the quarter -- the first such loss in over two years' time.
What's more, for the full year, AU Optronics produced nearly 79% growth in earnings on a 60% rise in revenue. Of course, these numbers are calculated according to Taiwanese generally accepted accounting principles and thus can't be strictly translated to U.S. figures, but the magnitude of the growth should still be comparable.
Although capacity and fierce competition will always be present in the flat panel market, there are some positive industry dynamics. While prices are stabilizing, demand for new and larger indications like LCD TVs should begin boosting the higher end of the industry. In the case of AU Optronics, the TV business grew 48% sequentially and represented more than 13% of the business in the fourth quarter.
Fundamentally, AU Optronics offers a lot to like. For the full year, the company managed a return on equity exceeding 21% and reduced inventory turns by 20% compared with the prior year. Although the company is free cash flow negative, this is due in large part to the company's decision to add higher-end capacity for products like the LCD TVs.
Though flat panels will remain a highly competitive commodity business, I believe that demand is catching up to supply and that demand for advanced products like LCD TVs should allow AU Optronics opportunities for growth. As the trailing price-to-earnings ratio (based on earnings per depository shares) is below 9, I believe that the margin of safety is sufficient here to justify further investigation.
Fool contributor Stephen Simpson, CFA, has no ownership interest in any stocks mentioned.
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