A Turnaround Tale

Editor’s Note: ACCESS YIANNIS AND ELLIOTT’S PRELIMINARY RESEARCH. Elliott contributes regularly to Seeking Alpha, a free website that features analysis of stocks, markets and economic trends. He’s started publishing some of the initial research that he and Yiannis do for Cocktail Stocks on Seeking Alpha. Readers interested in a behind-the-scenes look at Yiannis and Elliott’s process should register with Seeking Alpha, follow Elliott’s feed and share their take on their investment ideas. Your input could help determine which investment idea becomes the stock of the month. Of course, the final pick is reserved only for loyal Cocktail Stocks subscribers. Yiannis and Elliott look forward to hearing from you.

The Stock

The Trade: AU Optronics (NYSE: AUO)–Buy < 5.

Why Now: The market for flat-panel displays has weakened in recent years because of slowing demand in developed markets and a glut of liquid crystal displays. This hard-hit display maker should benefit from a handful of demand catalysts and is in the midst of a restructuring plan that should return the company to profitability in the second half of 2012.

The Story

Yiannis calls Elliott from Athens, Greece.

Elliott: Hello?

Yiannis: Elliott, guess where I’m sitting?

Elliott: At home, in the dark? Aren’t the electric company’s workers are on strike again?

Yiannis: Ha. We have power. I’m calling from your favorite restaurant in Athens, 21 Ristorante. This chateaubriand is outstanding.

Elliott: That’s my favorite item on the menu. How are the guys there?

Yiannis: The economy is terrible here.

Elliott: That’s the understatement of the century. When are you going to bring back the drachma so that I can have a less expensive holiday there?   

Yiannis: I’ll get right on that. Anyway, Ristorante 21 has been packed every night this week. It’s probably the only restaurant in Kifisia that’s been doing this well.

Elliott: Ristorante 21 is definitely the best place to eat in Athens. And the people that eat there still have money, even if the government is broke. By the way did you see what happened to our short pick from last month’s issue of Cocktail Stocks?

Yiannis: Yeah, shares of Best Buy (NYSE: BBY) have been in freefall.

Elliott: The electronics retailer posted terrible results in its fiscal fourth quarter ended March 3, 2012. Management noted that sales shifted from the stores to its website. Online sales tend to have lower profit margins because of intense competition from Amazon.com (NSDQ: AMZN), which has stepped up its efforts to win share in the market for consumer electronics.

Best Buy also announced its third restructuring initiative in a year and will close about 50 of its 1,000 stores in 2012. Although this move will help bring costs under control, these closures won’t improve profitability right away. I also doubt that closing 50 stores will be enough, especially with Apple (NSDQ: AAPL) adding to its brick-and-mortar retail locations.

I see more downside to come for Best Buy’s stock.

Yiannis: Bad news for Best Buy is good news for us. But enough about last month’s pick–I have a turnaround story that I think would be perfect for the April issue of Cocktail Stocks.

Elliott: I’m all ears.

Yiannis: Taiwan-based AU Optronics (NYSE: AUO) manufactures and sells TFT-LCD panels, the flat-panel displays that are used on a wide variety of consumer electronics products, including televisions, laptop and desktop computers, digital cameras, mobile telephones and in-dash displays in automobiles. TVs are the company’s most important market segment and account for about half the firm’s total sales. Computer displays contribute about one-third of the firm’s revenue.

The company primarily sells its displays to manufacturers of branded consumer goods. Electronics giant Samsung Electronics (Seoul: 005930) is one of AU Optronics’ top customers and has accounted for as much of 15 percent of the flat-panel display makers’ revenue in recent years.

Elliott: AU Optronics’ stock plummeted last year. What happened?

Yiannis: The company faced two major headwinds in 2011: Weak demand amid a halting economic recovery and a glut of TFT-LCD panels on the market.

Over the past decade, AU Optronics has benefited from consumers’ shift away from traditional box-like television sets in favor of slimmer flat-panel displays. In addition, the growing popularity of consumer electronic devices such as laptop computers, digital cameras and smartphones has driven demand for TFT-LCD panels. But in the wake of the 2007-09 economic downturn, consumer demand for LCD TVs–traditionally one of AU Optonics’ most profitable product categories–has recovered slowly. Consumers in developed countries are less willing to spend on large-ticket items such as TVs than they were before the recession.

Growth in global TFT-LCD manufacturing capacity has outpaced demand, driving down average selling prices (ASP) and cutting into profit margins. Consumers have become accustomed to watching the prices of flat panel TVs decline every year, making it difficult to halt the decline in ASPs.

Elliott: How did AU Optronics do in its most recent quarter? I’m trying to figure out where the turnaround story is here.

Yiannis: The company reported weaker-than-expected fourth-quarter results, with ASPs declining by roughly 6 percent sequentially. To worsen matters, a US court convicted AU Optronics of price fixing, a judgment that will force the company to pay a hefty fine. LG Display (Seoul: 034220, NYSE: LPL) already pleaded guilty to similar charges, while Samsung Electronics settled outside the court system. The maximum fine of USD1 billion won’t bankrupt AU Optronics. Nevertheless, the judgment is an unwelcome headwind for a company that already faces challenging business conditions.

Elliott: Ok, I understand why the stock has been beaten down, but you still haven’t talked about AU Optronics’ turnaround story.

Yiannis: Although the company continues to face a challenging business environment, all the bad news is already priced into the stock. Even when the company reported weak fourth quarter results, the stock pulled back only slightly.

Meanwhile, business conditions should improve somewhat in 2012. AU Optronics’ management team expects demand growth to outpace capacity growth in 2012, with global demand for flat panel-displays rising 14 percent. The supply of displays is expected to increase by only 8 percent.

In addition, demand for LCDs could surprise to the upside because of several potential catalysts. A few years ago, Apple created a new class of laptop when it introduced the ultra-thin MacBook Air. Other manufacturers have latched onto this trend and are scrambling to launch their own lines of lightweight but powerful laptop computers. Hewlett-Packard (NYSE: HPQ), for example, will launch several “ultrabooks” in the next two quarters and will support these new products with an aggressive marketing campaign. A surge in sales of ultrabooks could bolster demand for AU Optronics’ advanced flat-panel displays.

The anticipated launch of Microsoft Corp’s (NSDQ: MSFT) Windows 8 operating system toward the end of 2012 could also be a boon for LCD makers. Although Apple is the darling of the technology sector, many businesses and individuals still rely on PCs that run the Windows operating system. When Microsoft releases new versions of Windows and other core products such as MS Office, a PC upgrade cycle usually ensues because the new software requires a more powerful computer. This tailwind could come into play at the end of 2012 and extend into early 2013.

Elliott: Does AU Optronics have any content in Apple’s products? As you just mentioned, Apple is the darling of the tech sector right now.

Yiannis: The South Korean company supplies displays for some Apple products. Persistent but uncomfirmed rumors also indicate that Apple plans to launch a smaller version of its popular iPad tablet computer and that AU Optronics has been selected as one of the exclusive suppliers of LCDs for the device. Confirmation of this rumor would definitely send AU Optronics’ stock price higher.

Elliott: Readers might find it strange that we shorted an electronics retailer in the last issue and are picking a beaten-down display manufacturer only a month later.

Yiannis: The key difference is that Best Buy lacks exposure to emerging markets. Although consumer spending has moderated in the US and other developed markets, domestic demand in Brazil, India and China continues to strengthen. As household incomes increase in these nations, sales of LCD TVs and other consumer electronics have grown at a healthy pace.

AU Optronics will also benefit from the introduction of several new products this year. The company plans to start mass-producing its active matrix organic light emitting diode (AMOLED) displays for a major smartphone manufacturer this quarter. AMOLED displays offer a sharper picture and a faster refresh rate making them more responsive to users’ touch. AMOLED displays also consume considerably less power than other LCD technologies, which is essential to extending battery life.

AMOLEDs are currently only being used for small displays. However, AU Optronics is developing a larger-format AMOLED display that could be available as soon as late 2012.

In addition, AU Optronics is ramping up production of 3D television display technologies. Management expects the company to grow its share of this booming market segment to as much as 20 percent from only 6 percent in 2011.

Elliott: New product launches are always good because innovative technologies often have higher ASPs than LCDs, which have been commoditized at this point.

Yiannis: AU Optronics also announced a major restructuring initiative aimed at cutting costs and improving profitability. The firm has reduced the cost of its glass supply, a key material used in the production of LCD displays. As the company ramps up output of new products at its fabrication plants, utilization rates will improve and the cost per unit will drop.

By cutting costs and introducing new, higher-priced products AU Optronics expects to return to profitability by the second half of 2012. If the company successfully engineers a turnaround, the stock could easily double from current prices.

The LCD display business has been brutal in recent years, and AU Optronics has suffered more than some of its competitors. AU Optronics is an aggressive pick but it won’t take much good news to send the stock sharply higher. Buy AU Optronics’ American depositary receipt under 5. 

Updates on Open Positions

August 2010: Vale (NYSE: VALE)–Buy < 30

Vale’s long-term growth story remains intact, though iron ore prices will drive the stock in the near term. That being said, the company also faces some short-term issues, including China’s ban on Vale’s giant “Valemax” ships from docking at its ports. An ongoing disputer between the company and the Brazilian authorities regarding unpaid income taxes on profits from overseas subsidiaries is another headwind.

September 2010: Teekay Tankers (NYSE: TNK)–Buy < 10

A 12 percent yield is Teekay Tankers’ only saving grace. We have been in this trade long enough that all the bad news has been priced into the stock–including lower day-rates on the spot market in 2012. The stock has surged 72 percent thus far in 2012 but has a ways to go for us to break even.

February 2011: ProShares UltraShort 20+ Year Treasury (NYSE: TBT)–Buy < 30

Betting against US Treasury notes has been a losing proposition. This position could recover some lost ground when investors rotate funds from safe havens to equities, a process that has yielded a 16 percent since the new year began.

May 2011: TAL International (NYSE: TAL)–Hold

The stock has rallied significantly and should have more upside. Investors who are already in the trade should hold their positions.

June 2011: iShares MSCI Italy Index (NYSE: EWI)–Buy < 15

This play on Europe’s turnaround is less risky than our Greece-related bet. The Italians are progressing well under the leadership of their technocratic government. The exchange-traded fund also offers a 4.4 percent dividend yield.

July 2011: TransGlobe Energy Corp (NSDQ: TGA)–Buy < 15

Shares of this small-cap oil producer have rallied 60 percent thus far in 2012 and should continue to climb. This speculative stock will outperform bull markets and underperform in bear markets. 

July 2011: Market Vectors Gulf States Index (NYSE: MES)–Buy < 23.50

This exchange-traded fund (ETF) has held its own since we featured it in July 2011. That being said, the ETF has returned only 8 percent in the new year. We’re holding out for a powerful upsurge.

August 2011: National Bank of Greece (NYSE: NBG)–Buy < USD6

This stock is our most speculative play to date and is only appropriate for aggressive investors who can stomach a bet that’s based solely on a turnaround in Greece. Any orderly resolution to Greece’s sovereign-debt crisis could send the stock price higher.

September 2011: China Cord Blood Corp (NYSE: CO)–Buy < 4

Don’t let near-term volatility shake you out of this stock. Shares of China Cord Blood Corp have gained 5 percent this year despite some volatility. Expect more upside as the industry’s fundamentals turn.

October 2011: Infosys (NSDQ: INFY)–Buy < 55

A slower mover than other technology stocks, shares of Infosys should keep pace with India’s stock market. The stock took a hit at the end of February and early March, as the Indian market went through a rough patch. Investors should adhere to our buy target and only add to their positions when the stock dips below 55.

December 2011: Symantec Corp (NSDQ: SYMC)–Buy < 18

Internet security is a major growth market, and Symantec should continue to benefit. The stock has gained 18 percent this year, but investors should adhere to our buy target and only add to their positions when the stock dips below 18.

February 2012: Greenbrier Companies (NYSE: GBX)–Buy < 27

This stock has pulled back since we profiled it in February, but the company’s underlying growth story remains intact. The company’s quarterly results on April 9 could serve as an upside catalyst.

March 2012: Best Buy (NYSE: BBY)–Sell Short > 23

Disappointing fourth-quarter results send shares of this electronics retailer lower. We expect further downside.


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