The Obscure Analyst’s Stance on Canaccord’s most recent GTAT investment report

Posted: February 21, 2014 by mattmargolis24 in Uncategorized
Tags: , , , , ,

Matt Margolis – 2/20/14 (I am long GTAT and have no plans to buy or sell any holdings in the next 72 hours)

Below is my stance regarding the recent Canaccord Genuity investment report on GTAT that was issued on 2/18/14.

  • You stated GTAT is using the “$600m loan” from Apple to buy furnaces and finishing equipment but there are a few problems
    1. If indeed GTAT is spending upwards of $300m (1,000 furnaces at $300k each) of their own capital in 2014 with Apple’s money) the SG&A expenses (n your mode have not been updated to reflect $10m+ of depreciation expenses in 2014 (2013 vs 2014 YOY are flat)
    2. Over 250 completed furnaces were delivered in December 2013 along with at least 420 Sapphire Chambers. GTAT’s capital guidance was $2m for Q4 2013. If $300k per furnace is accurate it would indicate GT spent at least $75m on Cap EX in Q4 2013 versus guidance of $2m.
    3. GTAT needs to front the cost of raw materials and storage of sapphire screens. If GTAT is spending nearly all of the “$600m” from Apple on equipment and limited to $578m of Cap EX how would they fund the accumulation of inventory? If screens are indeed selling for $12 (25% margin would be yield a $9 cost). GTAT’s furnace operation began in February and they will be cranking out Boules that will be converted into sapphire screens around the clock. They will need to store millions of screens, even if the number of screens in inventory is low (20-40m screens) this would tie up $180-360m of cash that GTAT does not have available under your thesis, since GTAT spent almost all of Apple’s “loaned” money on Cap EX.
    4. Under the agreement it appears GTAT is responsible for designing the operations and ordering the Capital equipment. Apple will review the orders and present GTAT with a cash reimbursement every 2 weeks and take ownership of the equipment (furnaces). The equipment is owned by Apple and the contract limits where the sapphire produced from Apple’s equipment can be used. The $578m from Apple is being used as a revolving credit line to acquire capital equipment (furnaces) for Apple. Once GTAT receives the reimbursement from Apple the credit line becomes fully available. The number of furnaces is only limited by how much Cap EX Apple wants to spend and the space available inside of Mesa. Your calculation included 1,000 furnaces at $300k each for sapphire build out. However, GTAT’s purchasing power is not limited to $578m, but up to Apple’s approved Cap EX plan for this project ,which has been cited as high as $1.5B by the Arizona Commerce Authority.
    5. We will find out Monday what GTAT spent in Q4 2013 Capital and how they guide for 2014 but I’m very confident Apple is doing 99.99% of the heavy capital lifting and once the furnaces and equipment are in place the money received from Apple will be used for sapphire screen build out (raw materials and inventory accumulation). Additionally, the iPhone 6 may sell 80m units in 2014 alone between September and December which indicates that your unit forecast of 40m at $12 per screen for $480m in 2014 appears to be very conservative.
  • 2014 Revenue is being evenly distributed over 2014 @ $175m a quarter there are a few problems
    1. Sapphire production in Mesa did not begin until February and if the iPhone is being released in September GTAT will not have any meaningful deliveries of sapphire screen inventory to Apple’s assembler until June at the earliest but most likely July for production ramp up yet you have revenue split evenly over the four quarters in 2014.
    2. Since deliveries will not begin until June/July at the earliest the $480m projected for 2014 will be achieved mostly over Q3/Q4 (90% or better). This indicates the 2014 exit run rate for Apple’s business will be at least $240m a quarter headed into 2015.
  • 2015 Revenue from all sources is $1.1B but there are a few problems
    1. If September iPhone release date is accurate, 2014 revenue for Apple will exit at least $240m per quarter heading into 2015. $240m per quarter is an annualized amount of $960m versus full year estimate of $1.1B, but $960m for Apple does not account for any unit growth even at the industry growth rate or any additional products such as the iWatch ( 60m units in 2015), iPod, and iPad.
    2. GTAT will be launching several key products in 2015 (Hyperion, HVPE coupled with PVD for LED, Sic and HicZ (Solar) which are not accounted for in the $1.1B revenue estimate for 2015.
    3. Solar Equipment upgrade cycle is expected to resume by 2H 2014 or early 2015 which will add $100m+ in revenue in 2015
    4. Sapphire demand is expected to outstrip supply driven by mobile applications (outside of Apple) coupled by LED’s increasing appetite for sapphire wafers by late 2014 or early 2015. A large sapphire equipment upgrade cycle will hit in 2015 for LED/Sapphire Mobile and this is not factored into the $1.1B estimate for 2015.
    5. GTAT has $658m in backlog split Poly ($301m) and ASF ($355m) and PV ($2m). OCI represents a majority of the Poly backlog and they plan to start the next phase of factory development in Q4 2014 so much of this will be realized in 2015. ASF backlog has been deferred for much of 2014 to address Apple capacity needs so much of this backlog will be realized in 2015 due to LED (sapphire) demand outstripping supply.

My bottom line

Apple deal at a minimum represents well over $1B a year in 2015 even if it’s only on one product because 2014 will only have 6-7 months of revenue months. Apple will sell 200-250m iPhones in 2015 and a large % of those will be sapphire. Apple has relaunched the iPhone 4 in India and they plan to retire the iPhone 5c. The sapphire models should represent 60-70% of 2015 units sold. The iWatch is very likely to feature sapphire laminates and estimated sales unit sales are 60m units for 2015. If Apple adds the iPod (30m annual units) or the iPad (85m) annual units the 2015 revenue number for just Apple significantly exceed $2b.

The rest of GTAT’s core businesses are entering the sweet spot as they head into 2015. GTAT’s backlog of $656m should translate into $400m+ of recognized revenue in 2015. The solar equipment upgrade cycle will restart in 2015 as global demand outstrips current capacity for new installs. Hyperion Ion Implantar technology will be ready for commercial launch in 2014. Sapphire for LED will face severe under supply issue by the start of 2015, and GTAT can grow their business by signing a large sapphire material contract for LED and/or by selling ASF equipment. GTAT will be launching their Silicon Carbide for semi-conductors in 2015 paired with their Hyperion technology, which will undercut the market’s current prices.

I believe Apple deal is worth $2B+ in 2015 and GTAT’s other businesses combined with the revenue backlog that will be recognized in 2015 will yield an additional $1B+ in revenue. I’m expecting total revenue to be at or north of $3B in 2015 and EPS of nearly $3.00.

Contract language on ownership of Equipment

I included some of the key exhibits from the complicated contract between GTAT and Apple (bolded below). Apple is giving $578m to GTAT to acquire equipment, but they are also reimbursing GTAT every 2 weeks for purchases and acquiring exclusive rights to the equipment (furnaces). Apple ultimately will own every bit of capital equipment inside Mesa but GTAT will operate, inspect and maintain the furnaces, fabrication equipment, diamond saws, etc. The $578m Apple gave GTAT is a line of credit and after GTAT spends the first $100m on equipment (furnaces) Apple will pay them back and GTAT will still have $578m available to buy more equipment (furnaces). The amount of furnaces GTAT can buy for Apple is not bound by the $578m dollar limit but it only limited to the amount of space available for equipment inside Mesa. GTAT’s Salem, MA facility is 25,000 square feet and has well over 100 furnaces inside (perhaps you can fact check me!), the Mesa facility is 1,300,000 square feet, which means it could hold over 5,200 furnaces. Once the furnaces have been installed and producing sapphire boules GTAT will need to use the $578m to fund the build out of it’s inventory for Apple’s sapphire displays. The process for building sapphire screens as you know is a long one and will require GTAT to hold significant amounts of inventory both in terms of finished goods but raw materials including aluminum oxide and graphite which will easily tie up $300-500m of GTAT’s cash. The additional money GTAT raised in December was to improve their liquidity to limit’s Apples legal rights to obtain a secured interest in GTAT’s IP should something happen. The lions share of the money will be used to fund GTAT’s LED expansion. Step 1 was the Kyma Technologies PVD exclusive licensing deal and step 2 may be announced as soon as Monday in the form of a large sapphire (LED) materials contract or an acquisition of another Sapphire Equipment supplier. I bolded the key components of the contract in below

STATEMENT OF WORK #1

to

MASTER DEVELOPMENT AND SUPPLY AGREEMENT

# C56-13-02947

 

Apple and GTAT are entering into this SOW and the rest of the Collateral Agreements (as defined below) pursuant to which: (i) Apple will design and build the Mesa Facility that it will lease to GTAT; (ii) GTAT will grow and process sapphire boules into Goods which it will sell to Apple; (iii) Apple will make a prepayment to GTAT to fund the purchase of Furnaces (as defined in Section 1.6 below) and Equipment used to make the Goods and (iv) GTAT will grant Apple a security interest and provide Apple with other protective rights in recognition of Apple’s investment in the Mesa Facility and Apple’s prepayment to GTAT.  In connection with the foregoing, Apple and GTAT, or Apple’s or GTAT’s Related Entities, as applicable, are entering or will enter into the following agreements (collectively, the “Collateral Agreements”):

5.Apple-Owned Equipment.

5.1 GTAT will purchase the Equipment listed in Attachment 7hereto (collectively, “Apple Equipment”) and subject to the terms of this SOW, including Sections 5.2 and 5.4, Apple will purchase such Apple Equipment from GTAT and subsequently the Apple Equipment will be held by GTAT as a bailee for purposes of producing Goods for Apple.

5.2 GTAT will place purchase orders for the Apple Equipment only upon prior written approval by Apple with respect to the quantity, specifications and price of each item of Apple Equipment.  Upon request, GTAT will provide Apple up to three competitive quotes for each item.  Apple reserves the right to contact each vendor directly to validate and/or negotiate the terms of any order (and GTAT agrees to waive any confidentiality restrictions to facilitate such discussions). GTAT will promptly provide documentation of each such order to Apple.  The value of any direct or indirect benefit received by GTAT from any vendor that sells Apple Equipment to GTAT in connection with this SOW must be applied exclusively to reducing the cost of the Apple Equipment listed in Attachment 7.

5.3 GTAT will install and qualify the Apple Equipment at the Mesa Facility in accordance with the timelines set forth in Attachment 7.

5.4With respect to Apple Equipment purchased by GTAT, upon presentation of proof of delivery and proof that GTAT has paid for line items of Apple Equipment, and subject to the terms of this SOW, no more frequently than once every 2 weeks, GTAT may invoice Apple for such line items of Apple Equipment.  Apple will purchase the applicable Apple Equipment by payment to GTAT of the amount set forth in the actual Equipment vendor’s invoice and actually paid by GTAT to the Equipment vendor for the applicable Apple Equipment.  Upon such payment, Apple will become the owner of such Apple Equipment and GTAT hereby agrees to sell, assign, transfer and convey to Apple all of GTAT’s right, title and interest in and to such Apple Equipment.  GTAT hereby agrees that it will, at any time following Apple’s payment to GTAT for Apple Equipment, upon the request of Apple, execute, acknowledge, deliver or file, or cause to be done, executed, acknowledged, delivered or filed, any further acts, deeds, transfers, conveyances or assignments as may be reasonably requested by Apple to transfer, convey or assign to Apple any of the Apple Equipment. Apple will not be responsible for any other costs associated with the Apple Equipment.

5.5 Subject to Section 5.4, Apple owns all Apple Equipment.  The Apple Equipment is and will be held by GTAT as bailee on the terms and conditions set forth in this SOW.  Apple will at all times maintain full and exclusive ownership of and title to the Apple Equipment as bailor.  The term of this bailment arrangement will expire on the earlier of (i) such date as Apple

[***] Portions of this exhibit have been redacted pursuant to a confidential treatment request.  An unredacted version of this exhibit has been filed separately with the Commission

removes all of the Apple Equipment from GTAT’s premises and (ii) such other date on which Apple and GTAT may mutually agree in writing.

5.6 Apple is hereby authorized to file financing statements or other similar documents or notices in any filing office or other location that Apple deems necessary or desirable, including for purposes of confirming its status as bailor, for purposes of giving actual public or constructive notice of the existence of the bailment created under this Agreement or for any other purposes. Apple is also authorized to contact and, if necessary in Apple’s discretion, negotiate with GTAT’s secured lenders to waive or subordinate any such lender’s potential claimed interest in the Apple Equipment to the rights of Apple.

5.7 GTAT will not attempt to sell, lease or loan any of the Apple Equipment, nor assign, transfer, pledge or hypothecate the Apple Equipment in any manner, without the prior written consent of Apple, which Apple may withhold in its sole discretion.  GTAT will not cause or suffer to exist any lien, security interest or encumbrance to be placed on any of the Apple Equipment, except in favor of Apple and any attempt by GTAT to create any such lien, security interest or encumbrance (other than the security interest in favor of Apple) will be void ab initio.  GTAT hereby waives, and subordinates to the prior rights and interests of Apple in the Apple Equipment, in each case, to the maximum extent permitted under applicable law, any and all rights, interests or encumbrances, including, without limitation, any lien that GTAT has or may have or otherwise acquire in the Apple Equipment at any time during the term of this SOW.

5.8 GTAT will use best efforts to ensure that Apple has the benefit of all manufacturer’s warranties and indemnities for the Apple Equipment.

5.9GTAT will apply Apple asset tags provided by Apple to all Apple Equipment in accordance with the requirements, if any, provided by Apple.  Under no circumstances will GTAT move Apple Equipment from the location designated by Apple, without Apple’s prior written consent, or deny Apple, its agents or contractors access to the Equipment.

5.10 Immediately upon Apple’s request or termination of this SOW, GTAT will deliver the Apple Equipment to Apple Ex Works (GTAT’s facility), provided Apple has paid for any Apple Equipment purchased by GTAT.  GTAT agrees to return the Apple Equipment to Apple in the same condition as it was provided to GTAT, except for normal wear and tear.  GTAT will be responsible for physical loss of or damage to the Apple Equipment while in the possession or control of GTAT.

5.11GTAT agrees to use Apple Equipment solely for Apple’s benefit.  GTAT will not use Apple Equipment for any other purpose or permit a third party to use the Apple Equipment except as set forth in this SOW.

5.12 The Apple Equipment provided by Apple is provided to GTAT “as is” and Apple disclaims all warranties, express or implied, including the implied warranties of merchantability and fitness for a particular purpose.

5.13 GTAT is solely responsible for installing, testing, and maintaining Apple Equipment in its control in good working condition in compliance with applicable manufacturing specifications, for purchasing and maintaining spare parts to repair such Apple Equipment with a minimum of downtime, and for any risk of loss in connection with the Apple Equipment.

[***] Portions of this exhibit have been redacted pursuant to a confidential treatment request.  An unredacted version of this exhibit has been filed separately with the Commission


5.14 Apple reserves the right to inspect any Apple Equipment in GTAT’s control at any time.  Apple reserves all its rights and remedies under MDSA, this SOW, the Uniform Commercial Code and all other applicable laws, including, but not limited to, the right to lawfully enter the premises of GTAT and take possession as bailor of any and all Apple Equipment at any time without breach of the peace.

8.1GTAT will offer to sell additional Furnaces and Similar Furnaces to Apple at the [***]:

Upon Apple’s request, GTAT promptly will provide to Apple invoices and other documentation supporting such actual costs.  [***].

8.2 [***].

8.3Apple’s purchase of additional Furnaces and Similar Furnaces will be made under the terms of Apple’s Master Equipment Purchase Agreement (the “MEPA”).  Apple and GTAT will negotiate in good faith to execute the MEPA as soon as possible following the Effective Date, but in any event prior to the second Milestone Payment made under the Prepayment Agreement.

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Comments
  1. Clint says:

    From a materials scientist’s point of view, it amazes me that everyone reporting on Sapphire is SPECULATING that it will be used for cover glass. No one has officially claimed that as the intent for Sapphire. Perhaps Corning knows something analysts do’t……A more reasonable application for large wafers of Sapphire in cell phones may be as a substrate for making the LCD screens in lieu of silicon.

    Cost is not the only negative factor. As a large optical device, such as 4+” cover screens, Sapphire would have to be thicker (heavy) compared to Gorilla glass because it is so brittle. Gorilla glass is very tough and thus can be thin (has to bend a lot to break)[Willow glass – another version of Gorilla]. Think about the pockets where you put your phone when not using it – leaning or bumping against something stresses that cover glass. Wouldn’t toughness make better sense for this application?

    Buried deeper in the phone underneath the LED or LCD screen, toughness isn’t as critical and a sapphire substrate can be very thin. Sapphire can also hold a much tighter flatness during processing than silicon making it suitable for significantly better screen displays. The evolutionary momentum for display devices is always towards improved resolution, contrast, color and decreased power consumption.

    Like

    • When you say ” no one has officially claimed it (screens) as the intent” of sapphire – what kind of official announcement would you need? Officially we know Apple will put in $2b+ into this facility. We know GTAT only has experience making sapphire cover screens. We know the GTAT CEO referenced apple last May regarding a potential deal with a “very very very big player”. We know Apple has been interested in sapphire for cover screens since 2006. We know Apple has filed several sapphire parents which all relate to sapphire screens but with different applications and forms (screens, laminate, as a thermal conductor). We know the amount of equipment and sapphire being produced by the plant is at least 10x more sapphire than the iWatch will need. If you still need more information on an official intent to use sapphire as a cover material perhaps you should see if you can get invited to the Apple event in June or September when they display it.

      Like

      • pkdecville says:

        Nicely put! (And I hope all your conclusions are correct.)

        “…perhaps you should see if you can get invited to the Apple event in June or September when they display it.”

        Like

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