My Favorite Game-Changing Tech Stock Has 50% Upside
dsterman
There's a reason why some investors focus only on tech stocks.
It's the only sector that creates winners and losers every year -- thanks to rapid technology change -- creating an opening for investors in search of the next breakout stock. Last year's laggard can be this year's leader.
Case in point: Cisco Systems (Nasdaq: CSCO), which had lagged behind the broader tech sector for several years, but has now rallied 20% since mid-March (against the Nasdaq's 7% gain in that time). The key catalyst for Cisco: a looming set of new product launches that are expected to help invigorate growth. Analysts at Cantor Fitzgerald just boosted their target price to $31, noting that the company's "bottom in the profit cycle dovetails with a ramp in the product cycle."
Indeed, the best time to catch a tech stock when it is on the cusp of new product releases, or is on the cusp of greater adoption for its technology. And it's best to find such companies when they still represent solid value, as was the case with Cisco this past winter.
That setup is now in place for one of my favorite tech stocks for the next few years: Universal Display (Nasdaq: OLED).
The company's ticker symbol is an acronym for its core technology: organic light-emitting diodes. These aren't another flavor of LEDs that are increasingly used in light bulbs. Think of them as a better version of LCDs (liquid crystal displays). They are thinner, lighter and offer richer colors and deeper black levels.
You may have heard about OLED TV sets, but because they're still quite expensive, you might not have considered buying them. For the technology to move down the cost curve and become more competitive, a higher level of demand is needed.
But you will soon be seeing more OLEDs pop up in smartphones, smartwatches and (the unfortunately named) phablets. The use of OLEDs will open the door to curved screens and images that appear in 3-D.
Still, Universal Display can be seen as a disappointing investment for anyone following this stock, as its shares have badly lagged the Nasdaq over the past two years. Blames goes to an unrealistic set of adoption timeframes for OLED TV sets.
Yet disappointment is relative: Universal Display has still delivered solid growth in its short history.
Equally impressive, the company's costs are fairly low (thanks to a licensing model), leading to stunning earnings before interest, taxes, depreciation, and amortization (EBITDA) margins. Such margins are also now leading to solid free cash flow.
Universal Display generated a company-record $40 million in free cash flow in 2013, which should steadily rise to $125 million by 2016, according to Goldman Sachs. (That equates to a nearly 10% free cash flow yield, based on those 2016 forecasts.) Management has surely proven its mettle on the profit front. Universal Display has greatly exceeded consensus profit forecasts in three of the past four quarters.
To be sure, the advent of OLED TV sets is not yet here. Samsung (SSNLF), a key Universal Display licensee, announced in May that a new manufacturing facility will be delayed until the company can work out some final kinks in mass production techniques. The displays are easier to make for smaller products, but large-panel TVs are proving to be trickier.
Yet manufacturing costs are coming down, and OLED TVs are still expected to move into the mainstream. Goldman Sachs predicts 1 million OLED TVs will ship next year, increasing to 5 million in 2016, (which underpins much of their 2016 sales growth assumptions).
Universal Display won't capture all of that growth. Samsung is both a customer and a rival, and intends to use Universal Display's OLED materials as well as its own (thanks to an acquisition of OLED supplier Cheil Industries).
Even with all of the current market dynamics, Universal Display plans on maintaining technology leadership in this segment. Spending on research and development (R&D) has risen for seven straight years and approached $35 million last year. Look for the next generation of OLED technologies to roll out over the next 12 to 18 months.
Engineers at major consumer electronics firms are surely keeping a close eye on the company's technology roadmap. For example, Apple (Nasdaq: AAPL) is expected to use OLEDs in its much-rumored smartwatch. If Universal Display snags that contract, it could provide a quick lift to shares.
Meanwhile, as shares remain out of favor while investors remain doubtful about the prospects for OLED TVs, management is pursuing a $50 million share buyback. And they have suggested that more buyback programs may follow (as long as shares are cheap). After all, the company already has $250 million in net cash, and as noted, is puffing up that cash balance through solid free cash flow.
Back in 2011, when this company was seen to be on the cusp of a TV revolution, shares traded in the $50 to $60 range. Even a move back to $45, as OLED demand rises in coming years, sets the stage for 50% upside from here.
Risks to Consider: OLED TVs will still be priced higher than regular TVs, even when mass adoption takes place. A pullback in the global economy could crimp demand for this discretionary purchase.
Action to Take --> Game-changing stocks are often too pricey to justify. Yet in rare instances, they fall out of favor for a while, giving investors a second chance. Considering that OLEDs are set to find their way into a range of consumer products, and that Universal Display has technology leadership and offers an impressive projected free cash flow yield, the two-year underperformance relative to the Nasdaq is the opening investors have been waiting for.
