Background
In a market where margin of safety is scarce, it's worthwhile to explore some of the more overheated and valuation-disconnected stocks. One such name is Universal Display Corporation, a provider of OLED materials (and really the only public OLED pure-play publicly traded). Universal Display researches, licenses, and develops OLED technologies for display/lighting manufacturers for use in screens for smartphones, tablets, laptops, TVs, and other specialty/general lighting products. Unfortunately, between starting to write this post 4 days ago and now, we’ve already missed out on a 15% drop, but I believe the risk-reward still looks good here. For a bit more context, the stock is still up 119% since January 2019. It is now trading at 43x forward earnings and 17x forward sales. Sell side reports cling to "jelly-bean counter" revenue models estimating handset/TV shipments into 2025 and utilize DCF models with perpetuity growth rates well above GDP growth in order to justify current value.
Company
To be clear, the business is not engaging in shady business tactics nor is it a going concern. At a cursory glance, the bull case is convincing. In fact, the balance sheet is robust and margins are stable with secular tech tailwinds contributing to strong growth forecasts. Apple has transitioned close to its entire iPhone lineup to OLED displays and Chinese manufacturers are only just beginning to ramp up OLED capacity for both handsets and TVs. First, economies of scale at Universal's customers act as diseconomies of scale for Universal itself. Universal's volume pricing discounts have been called out in the past as reasons for missing revenue guidance. More importantly, though, efficiency gains and yield improvements at an OLED panel manufacturer will translate into smaller OLED materials revenue for Universal. The next step function in efficiency at some of Universal’s customers could come with new deposition technique to greatly reduce the amount of material needed to create an OLED display. The current deposition technique involves spraying materials against a screen where most of the material is scrapped (and cannot be re-used). Ink-jet printing could increase materials utilization by a factor of 2-3x, effectively reducing Universal’s customers need for materials by the same amount. All of Universal Display’s manufacturing is outsourced to PPG Industries. As a result, the company is highly reliant on the moat it has created with its intellectual property. Core patents roll off in the next 2-3 years and the materials themselves can quickly become commoditized as this IP rolls off. Inquiries to Samsung and LGD indicate they are working on developing in-house materials for their production processes. Samsung has already disintermediated Universal Display with their host materials and will likely plan to do the same with emitter materials next. Universal mitigates concerns by signing long-term licensing agreements with the manufacturers themselves. However, Samsung's current agreement expires at the end of 2022 (concurrently with the expiration of Universal's patents) and it remains to be seen how a new agreement might look—the market appears to be pricing in a guaranteed deal renewal.
Industry I don’t dispute the compelling market potential of OLED technology (TVs, handsets, VR headsets, lighting, auto, etc.) and I build significant growth into the model--however, valuations still don't make sense. Unfortunately, some technical knowledge is necessary to understand the trends that may negatively impact Universal in the coming years, and, in my opinion, is partly why the market may be mispricing the stock. With quickly changing trends, I believe management has not appropriately responded to changes in display technology. The company’s singular and narrow mindset isn’t only evidenced by its novelty ticker, OLED, but by management’s inability to discuss new, competing technology. MicroLED tech grants the same benefits as OLED with higher brightness and lower power. It is highly likely that microLED tech will supplant OLED displays (but possibly not lighting) in the next 5-10 years. MicroLED will begin production at smaller device sizes where yields are higher before improvements can be made for TV device sizes. In the meantime, Chinese display manufacturers (e.g. BOE) along with Samsung and LG have been building OLED fabs or converting LCD lines over to OLED.
Stock
History lends a few indicators for why now is starting to look like a good time for a short of the company’s stock. The LED market has seen two analogous cycles in lighting and display where the entire value chain sold off during a multi-year capex cycle. The sell-offs were due to rapid ASP erosion and oversupply due Chinese subsidies. It’s no surprise that Chinese panel manufacturers have received government grants to do the very same with OLED as has been done with LEDs. The LED cycle sell-offs also occurred as the rate of growth for downstream shipments inflected downwards. Just as Apple has transitioned almost entirely to OLED technology in its handsets and premium OLED TVs have been cost competitive in the market for ~4 years , we are now reaching the slowing of the growth rate of downstream shipments for OLED tech as well. The technology, despite the continued hype, is now mainstream.
A generous two-year price target is $159 with a floor closer to $111 if customers see large efficiency gains and growth rates slow. Assume:
- Sales grow 22-30% annually in the next two years (at consensus) resulting in revenues of $610M through 2021
- Operating and net margins continue to grow (EBIT margin from 40% today to 55% in 2021)
- Market assigns the stock of 27x P/E multiple while growth rate peaks and aligns with past 5 year average fwd P/E multiple.
- Add in $13 of cash per share currently on balance sheet
- $5.44 2021 EPS * 27x P/E multiple + $13 = $159 base case
