GT Advanced Technologies Inc fka GTAT

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$GTAT,...GT Advanced Technologies: Is The Street Missing Forest For The Trees?
Sep. 15, 2014 6:15 AM ET


Summary

GTAT stock price is down about 25% since Apple 9/9 event.
Street concerns about GTAT not meeting 2014 guidance do not appear to be based on reality.
Street concerns about Apple walking away from the venture and causing cash crunch at GTAT are overblown.

GT Advanced Technologies (NASDAQ:GTAT) stock fell by about 25% in the last few days on the realization that Apple (NASDAQ:AAPL) will not be using the Company's sapphire product in Apple's iPhone 6. Several analysts downgraded the Company to a hold or a sell. Current analyst estimates show the Company's 2014 revenue forecast at $508M with an EPS of negative $0.02. This is quite a revenue, earnings, and valuation revision in this poorly understood company that we believed was undervalued prior to this valuation compression. So, what went wrong?

To understand the current situation, one must first understand the history and scope of the Company's deal with Apple.

On November 4, 2013, GTAT announced a multi-year agreement with Apple. As part of the deal, Apple agreed to provide the Company with a $578M interest free loan to develop and operate a massive 1.3 million square foot sapphire manufacturing facility in Mesa, Arizona (payment disbursements subject to GTAT meeting 4 different sets of milestones). Apple also spent an estimated $113 million to purchase the Mesa facility from First Solar (NASDAQ:FSLR) and signed a seven-year below market lease with the Company.

When it came to disclosing the impact of Apple contract on GTAT, the Company management has made it clear that it is bound by Apple confidentiality needs and is unable to share any material facts about Apple's products plans. The Company could not even divulge the timing and revenue potential from Apple's business. Even though Apple and GTAT have been tight lipped about the details of the operation, the size of the deal and the scope of Mesa operation indicate that Apple intends to replace the glass face plate of its high volume iPhones with a sapphire. Apple's considerable amount of IP relating to sapphire supports such an assumption.

Lack of meaningful guidance regarding Apple business has caused many analysts to speculate about Apple's product plans and GTAT's revenue potential. A look at analyst opinions on GTAT shows a wide diversity of opinion on this subject. As recently as a few weeks back, analyst opinions ranged from no sapphire on any iPhone 6 face plate to sapphire on all iPhone 6 devices. In addition, there was also considerable amount of speculation in terms of sapphire usage on iPod, iPad, and Apple Watch (iWatch).

The Company's and Apple's intent to rapidly ramp the Mesa plant was abundantly evident since inception of the deal. While the milestone timeline is redacted from public SEC filings, it appears that GTAT was able to meet the first three milestones on a timely basis as evidenced by prepayments of $225,000, $111,000, and $ 103,000 which were received on November 15, 2013, January 23, 2014, and April 4, 2014, respectively. (Readers should note that the last two milestone dates were several weeks behind the original schedule per the MDSA but we consider such a slippage to be normal for projects of this scope).

However, something went wrong at the Mesa plant in May/June of this year. The Company's SEC filings and public statements indicates that there were several significant ramp issues. GTAT missed the milestone for the fourth and final payment from Apple. In the first two weeks of July, when the news of the problems leaked, several analysts downgraded the stock with concerns about the Company missing revenue guidance for 2014.

Subsequently, during its second-quarter earnings call in August, GTAT announced it was facing production problems and revised its annual guidance to the $600-700M range from the prior $600-800M range. The Company incurred $45M in additional production ramp costs in Q2 and forecasted that it will have additional ramp up costs in the next quarter. The Company also indicated that its revenues for the year were likely to be heavily backend loaded. This timing of the revenues made it unlikely that the Company's sapphire product would have meaningful penetration into Apple's iPhone 6. An analyst exchange during the call highlights this scenario.

"Krish Sankar - Bank of America

And the follow up question, just to think about if I look at your full-year guidance heavily weighted towards Q4. I mean if I look at what your sales run rate in the U.S. has been, has been extremely low. Is it fair to assume that any shipment of Sapphire products is not going to really materialize into any final mobile product this year given that most of the revenues are going to Q4, which means it will be production for next year?

Tom Gutierrez - President and CEO

Who do you think is going to win Superbowl this year? I can't answer that question obviously. As I indicated I really cannot comments on Apple's product line plans or timing or revenue streams or anything else like that. I wish I was in a position to do that, but I can't."

In addition to the revised revenue guidance, the Company suggested that it may be past the early issues and indicated that the final milestone payment from Apple was likely to be realized by the end of October. The Company also indicated that it would take several months for Mesa production to reach an optimal level.

Unfortunately, given the lack of transparency on the details, it was unclear how much of the change in guidance was related to the Company's ramp problem. Without adequate guidance, and with no clarity on Apple's past or current plans for sapphire, the markets cannot easily comprehend the future of GTAT/Apple partnership. This has led to several competing hypothesis for Apple's original product plans as can be seen here. In our view, Occam's razor would suggest that Apple was planning one or more iPhone SKUs with sapphire that did not materialize due to GTAT's ramp issues and likely other product problems. It is also conceivable that iWatch timeline may have slipped from earlier plans.

On September 9th, Apple introduced two flavors of iWatch with sapphire faces and continued the use sapphire for the iPhone touch sensor and lens cover. However, none of the iPhone faces were going to be covered with sapphire.

The absence of sapphire on iPhone cover plates was clearly disappointing to GTAT bulls but to a large extent the handwriting was on the wall. While neither Apple nor GTAT released any specific information on the subject, all the available data indicate that Apple's product plans were revised during the June time frame coincident with GTAT's ramp problems.

Looking back, the problems that GTAT faced should have been expected with an aggressive volume ramp. In this particular case, the problems were further exacerbated due to usage of a new material and because of GTAT's inexperience with volume materials manufacturing.

The Company is changing its business model from being an equipment supplier and adding on the capabilities of a material manufacturer. Unfortunately, this move downstream was not done on a pilot scale as is usual in such situations but was done on an ultra large scale with what is likely one of the fastest product ramps in the history to date. It was a gutsy and risky move on the management's part and it backfired. However, we do not blame the management for taking this risk given the potential for outsized returns. As we go on to show, the risk factors of the deal are not that big either.

Nevertheless, several analyst downgrades followed Apple event with a thesis that the lack of sapphire iPhone face plates meant the Company is unlikely to meet its 2014 guidance. Some even mused about the Company's dire future if Apple pulls the plug on the sapphire venture.

Our view is that the concerns about GTAT missing the 2014 guidance are overblown. By all indications, GTAT's second-quarter guidance was given after Apple finalized its 2014 product plans. The Company, in addition reducing the guidance had this to say in the Q2 conference call regarding 2014:

"We continue to expect more than 80% of the year's revenue to come from our sapphire segment. While we anticipate significant contributions from both the equipment and materials businesses, the mix of equipment will now be higher than originally anticipated. The mix shift is expected to have a favorable impact on gross margins. As such, we are updating our non-GAAP gross margin guidance to between 27% and 29% for the year."

In other words, the Company expects the already reduced guidance to be met by increased revenues from the equipment business. In the context of Apple's 4th and final prepayment the CEO said:

"The fourth prepayment from Apple is contingent upon the achievement of certain operational targets by GT. GT expects to hit these targets and receive the final $139 million prepayment by the end of October 2014. We remain very positive about our sapphire materials business."

"I would say that these are milestone based, right and so when you reached a milestone, you get paid, they are not cliffs per se. And so I feel very confident based on the progress that we are making that we will achieve the milestone in that time frame but as I indicated with the projection of having close to $400 million in the bank at the end of the year, it's not a world-ending event, if it slides although again I don't anticipate that it will slide."

The statement above clearly demonstrate the management's confidence in the current situation as well as the limited cash flow risk involved even if the Company does not meet the final milestone.

Given the timing of the Company's guidance, we do not see the failure to land the iPhone 6 face plate as being material to the Company's 2014 revenue forecast. This does not mean there is no risk to the Company's guidance. It is entirely possible that the iWatch revenues could be delayed or the Company's equipment sales could come below expectations. However, neither of these are related to the Apple announcement and we do not find the revised analyst expectations for 2014 justified.

Looking at the future, the biggest risk factor seems to be that Apple could back away from its sapphire commitment and will leave GTAT out in the cold with a large factory and very little sapphire consumption. This fear arises from some very specific language in the Company's agreement with Apple. Per the Company's 10-Q:

"While the MDSA specifies GTAT Corp.'s minimum and maximum supply commitments, Apple has no minimum purchase requirements under the terms of the MDSA."

While it is conceivable that Apple could move away from sapphire or otherwise leave GTAT high and dry but we find such a development unlikely. Investors should note that in addition to the $578M interest free loan to GTAT, Apple spent approximately $115M to buy the Mesa facility. Apple has invested, by itself and with its partners, considerable amount of engineering resources to develop sapphire related IP. The depth of Apple's IP indicate a plan for widespread adoption of sapphire across its product lines. Decisions of this scale are not made on whim but with considerable amount of diligence. It is unlikely that a setback on what appears to be an extremely aggressive ramp can derail a project of this scope.

In our view, GTAT's execution failure is a temporary problem. The fourth and final Apple prepayment, when it occurs, would be a confirmation that GTAT has met all the necessary product and yield benchmarks set by Apple. From a marketing perspective, sapphire is consistent with Apple brand image about finer things in life. Apple already uses sapphire for its iPhone touch sensor and lens cover. Apple has announced two iWatch models with sapphire cover plates and backsides. Barring a significant engineering problem, which we find unlikely, we see little reason for Apple to not move to sapphire across all of its product lines.

However, a case can be made that the fourth payment may not ensure Apple will use sapphire for iPhone cover plate. Considering this risk factor, we can model three different sapphire adoption scenarios that give a range of potential results for GTAT in 2015.

In a pessimistic scenario, sapphire at Apple could be limited to the already announced iWatch cover plate and backside along with touch sensors and lens covers for all Apple products. This scenario would yield a total Apple TAM of 200M mobile devices @ $1 and 20M sapphire clad iWatches @ $3. Total revenues from Apple in this scenario would be $260M.

A more realistic scenario, where sapphire is designed into the face plate of next iPhone with a fall 2015 release, would bring the Apple TAM to approximately 140M sensors and lens covers @ $1, 20M iWatches @ $3, 60M and iPhones @ $6. The combined revenues in this scenario would be $560M.

A more optimistic bull-case scenario may call for an early 2015 or a midyear iPhone refresh or an introduction of sapphire clad iPad in fall. Such a scenario could bring Apple TAM to approximately 80M sensors and lens covers @ $1, 20M iWatches @ $3, 100M iPhones @ $6, and 20M iPads @ $15. The combined TAM in this case would be $1040M

It is important to realize that these scenarios only show revenues from Apple and not from other sources. In the unlikely event that the manufacturing capacity at Mesa far exceeds Apple sapphire needs, we expect GTAT to reduce the manufacturing ramp and to start selling excess sapphire to customers other than Apple. We believe that GTAT could even use the Mesa facility to ramp production of laminates for sapphire, SiC, and polysilicon. In such a scenario, we do not believe Apple will have much of a commercial cause to disallow the expanded facilities use.

Could Apple be unreasonable and force GTAT to an early payment terms or otherwise cause GTAT to default on its obligations? While that may be a theoretical possibility, we do not see a conceivable reason for Apple to take such a path - especially once GTAT meets all the milestone requirements and collects the 4th and final payment. At such a point, Apple would not have a reasonable basis to terminate its agreement with GTAT. Even if Apple were to take such a step, our preliminary reading of the MDSA indicates that the Apple prepayments are secured by the assets of GT Advanced Equipment Holding LLC and not GT Advanced Technologies.

While some of the significant details of the relationships of various entities is opaque to us, it appears that GTAT management created this LLC structure to limit the liability of failure to GTAT shareholders. If our reading of the situation is accurate (readers who have taken a closer look can chip in in the comment section), then Apple walking away from the deal would mean a limited damage to GTAT other than the lost opportunity. As such, we do not see a significant impact on the Company's cash flow situation. In this worst-case scenario, Apple may be left holding a large sapphire manufacturing facility with very limited use. Taken in context, this scenario appears highly improbable barring a colossal execution failure on GTAT's part.

In summary, we believe that all the GTAT bear scenarios are farfetched and we see no reasonable basis for GTAT to either miss the 2014 guidance or to suffer from a catastrophic Apple pull out.

The value proposition of scratchproof glass and the savings Apple could derive from lower warranty repair costs by reducing screen damage can be substantial. The transition to sapphire will help Apple further justify a higher ASP for its products. Considering the last quarter's manufacturing setbacks, it is likely that Apple has taken a more cautious approach toward sapphire product launches.

As one of the readers in these forums pointed out, the code name Apple uses for this project, Cascade, implies a phased rollout of sapphire along Apple's product line. Regardless of whether one places any credence in that theory, it makes strategic sense for Apple to create a customer perception of premium product and to maximize its competitive advantage by rolling sapphire across its entire product line.

http://seekingalpha.com/article/2494555-gt-advanced-technologies-is-the-street-missing-forest-for-the-trees