Sunday, December 18, 2011

Smoke and Mirrors? A closer look at recent controversy in Universal Display

Stock-specific financial journalism, particularly in the blogosphere, is generally not a good place to search for Pulitzer worthy material. Most problematically, almost every stock-specific article published on a blog is one person or another “talking his or her book,” that is, trying to convince fellow traders or analysts to buy or sell the stock in a manner that benefits the author’s position. Unsurprisingly, authors who talk their book rarely present an even handed view of a situation, obfuscating or evading where the facts don’t match the story they are trying to weave. We will devote our inaugural blog to one particularly egregious example of poor stock-specific journalism by the, and, in a follow up, we will pay homage to one of the smartest and most transparent bloggers around.

In the interest of full disclosure, we are on the opposite side of the trade from as we are long Universal Display Corporation. We acknowledge there are risks to our investment, but we feel the rewards outweigh the risks. However, we do not encourage anybody to invest in UDC (ticker PANL), nor should our discussion below be interpreted as investment advice, or as advice to buy, sell or hold any securities. You may, however, interpret this blog as advice on who not to listen to, and how to spot a bad argument.

On December 13th, the published an article making several allegations against UDC. They are, in order of introduction:

*UDC’s patent portfolio, the foundation of the company’s value, may be worthless as they may not have invented OLEDs as they claim.

*The fact that Samsung signed a 7 year license agreement with UDC should not be interpreted as a validation of UDC’s patents.

*Several recent events at UDC cast doubt on their financial future, including insider sales by company executives, guidance characterized by the as “startling the market with a weak outlook for its upcoming sales,” and upside to third quarter results driven by entry into a “commodity business.”

*Entering into the host materials “commodity” business is a bad decision or sign of weakness.

Universal Display Corporation is the leader in Phosphorescent OLED (PHOLED) IP and chemicals, having funded the development of the modern PHOLED process through research at Princeton and USC, and at their headquarters in Ewing, NJ. PHOLED’s use 75% less power than standard fluorescent OLEDs, and in a 2 – color configuration (red and green phosphorescent emitters are currently commercially viable with 20k + hours to 95% luminosity compared to ~1k hours for blue) are an enabling technology for thinner, lower power consumption (-30% compared to LCD) and flexible displays. PHOLED displays also feature better contrast ratio, wider viewing angles and faster refresh rates as compared to standard LCD screens. In exchange for licensing its patented PHOLED stack, UDC has received unit royalties from display manufacturers including LG and Samsung, and has sold its patented PHOLED emitters to many other companies, including Sharp and Toshiba in Japan and AU Optronics in Taiwan.

In June, UDC suffered the invalidation of three out of their roughly 50 patents in Japan for being too broad in scope. These were not their core PHOLED patents. UDC plans to appeal the decision and prepare to refile narrower patents. In November, in Europe, UDC was forced to amend one of its core patents to limit the scope to the use of Iridium emitters, vs. their earlier claim of any phosphorescent dopant compound. Iridium is the only PHOLED emitter in commercial use at present. UDC plans to refile each individual dopant compound (the prior patent focused heavily on Iridium) it has discovered at the European patent office, and also to appeal the decision, however its claim on Iridium emitters remains solid. Additionally, due to the international nature of the consumer electronics market (where goods produced in one market are shipped elsewhere, meaning an IP violation in one market can lead to repercussions in all markets) and the fact that none of UDC’s patents have been challenged in the US, it is unlikely that UDC will suffer an adverse impact from these narrow invalidations abroad. UDC also has a litany of patents in its portfolio, boasting roughly 550 issued and 650 pending patents in the PHOLED arena.

For an IP company, UDC has not led a particularly litigious life, likely because industry players accept their strong IP position with 1200 issued and pending patents, and their dominance in supplying PHOLED emitters and now host materials in the OLED stack at higher grade than the competition. We are not a patent attorney, however, and are not in a position to comment on each or any of the individual patents that make up UDC’s portfolio – what we do find interesting is that on August 23rd, 2011, months after the Japanese court invalidated 3 of UDC’s patents and with the European decision pending, Samsung and UDC reached a 7-year license agreement during which Samsung is prohibited from challenging any UDC patents and must buy PHOLED emitters directly and exclusively from UDC.

Of this license, The writes “UDC has begun pointing to a renewed contract with Samsung (the true powerhouse of the OLED industry) as clear validation of its fundamental patents. Yet other companies have paid hefty fees for patents that proved worthless on down the road, history shows, with RIMM…forking over 600 million for allegedly infringing on patents that later failed to hold up in court.”

We are amused at the RIMM reference and we are somehow not surprised that the Canadian Blackberry manufacturer would make a $600 million mistake, in light of the nearly $70 billion of market cap the company has also given away by virtue of being slow to react in the unforgivingly iterative mobile device market. Samsung, however, has never been so generous with IP claims. Both Rambus and Sandisk put up with several rounds of courtroom battles before winning concessionary license fees from Samsung in the 100m/yr range for Rambus and $180m/yr range for Sandisk (we back into the Sandisk assumption by taking 50% of their 360m annual royalty revenue stream, as Samsung is roughly half the non -Toshiba/Sandisk NAND flash market). In fact, as Samsung’s renewal on a 7 - year license with Sandisk drew near in 2002, Samsung actually had the gall to sue Sandisk for infringing four flash patents of its own. Tessera, the licensor of semiconductor packaging processes also underwent a legal duel with Samsung before winning a term license in 2004 and extending it through 2017. And finally, Samsung has not shied away from very public legal battles against Apple which included brief injunctions against Samsung’s Galaxy products due to alleged infringement on AAPL’s operating system patents.

Nor did Samsung agree to a license with UDC because, as suggests in its article, it was simply cheaper to do so than to go to court. While the 2011 payment Samsung makes to UDC is modest (roughly 11 million for the year), UDC’s CFO Sidney Rosenblatt has stated publically that the payment should scale at or close to the same rate as Samsung’s OLED revenues, as Samsung capacity plans and market forecasts were used to establish the agreement. With Displaysearch noting that global OLED capacity will likely increase by 200% in 2012, and by a further 100% in 2013 and 50% in 2014, an upside scenario for Samsung’s license payments could be above 100 million by 2015, and would continue to grow into 2017 when the agreement expires. To use a more conservative scenario, if UDC won the proxy of a 70bps royalty (well below what UDC has received from other customers, in the 2 – 3% range, due to Samsung’s size) on 6 – 7.5bn of Samsung panel revenue in 2015 (assuming they have 50% of a 12 – 15bn market, in line with IDC ), licensing revenue from Samsung could come in between 45 and 55 million per year, which is still far more than it would cost Samsung to contest the patents if it really believed it was worth doing.

Additionally, the 7 year term license compelled Samsung to purchase emissive materials from UDC exclusively – an opportunity which equates to .18/per color per handset and could be worth upwards of 100 million of business annually at Samsung in smartphones alone (assuming $.36/per handset with red and green, and 300m Samsung OLED phone displays), but more importantly an opportunity worth dollars of incremental revenue/per chemical on tablet computers and especially large flat panel televisions, which are expected to scale to commercial production in 2013 – 2014. The commitment to purchase emissive materials from UDC could therefore be worth hundreds of millions per year of revenue over time, even without the commercialization of blue PHOLED emitters, which if history is good precedent, will probably be scaled by UDC at some point in the next 10 years and would represent an additional 50% of upside from these assumptions to $.54 per handset with red, green and blue.

The real reason Samsung may have foregone its usual combativeness regarding UDC’s PHOLED patents is that it views UDC as an ally as well as an adversary. In fact, in the most recent quarter Samsung began sampling larger quantities of UDC’s green phosphorescent emitter for inclusion in its handset and tablet products. Adding the green emitters to the red emitters improves picture quality and simultaneously reduces power consumption to (30%) versus conventional LCD compared to (15%) using just red. In conjunction with the commercialization of green emitters, UDC also increased sales of host chemicals to Samsung, which had previously been provided by local Korean suppliers. Unlike the emissive materials, which Samsung is required to purchase exclusively from UDC under the terms of its 7 year license, the host materials were ordered voluntarily and represented ~30% of revenues to Samsung during the third quarter. Thus, while claims that “Samsung[‘s license agreement with UDC] expressed only a lukewarm commitment to UDC and the technology it holds,” the voluntary purchase by Samsung of several million in host chemicals not mandated by that license indicates a closer relationship than StreetSweeper would have us believe.

Additionally, since the host layer of the OLED stack is ten to fifteen times larger in size than the emissive layer, the incremental opportunity from selling complementary host materials which enhance device performance is very beneficial to UDC. While characterizes the host sales as “commodity business,” UDC disclosed that they sold these host chemicals at a 50 – 60% gross margin and virtually no incremental operating expenses, which is not indicative of a commodity product. In fact, UDC insists that due to their expertise in patenting and exploring different PHOLED structures in conjunction with their patented emissive materials, their host materials are a complementary part of the stack. If the host materials truly are able to scale as UDC’s executives and scientists believe they will, then host chemical sales could represent an incremental $.27 - $.45 per mobile phone in revenue (compared to the ~$.18 per color they currently receive on a handset), assuming approximately 10x the area sold at 15% - 25% of the ASP as the emitters, and would drive dollars of incremental revenue per unit on PHOLED tablets and Televisions, which are expected to hit the market in large volume in 2012 and 2013, respectively. Assuming ~200m of PHOLED smartphone unit sales in 2012, this is an incremental addressable opportunity of 54 – 90 million in revenue for UDC in 2012, which would flow through to an incremental $.60 - $1.00 in EPS for 2012 alone.

It is also worth noting that while characterizes the host business as the sole driver for UDC’s upside in Q3, the core business in Q3 did 14.7m (total rev 21.7m with 7m of host materials), which was still significantly above Wall Street estimates of 11.6m for the quarter.

Finally, StreetSweeper makes reference to insider selling at UDC and states that “the company recently startled the market with a weak outlook for its upcoming sales,” as they “warned of a sequential decline in its own revenue during the busy holiday season.” Regarding the insider selling, CEO Steve Abramson and CFO Sidney Rosenblatt owned 400,000 and 477,000 vested shares as of 12/17, and had sold 23k and 40k shares respectively on the back of the Samsung deal (both sales of exercised options), at the price of $59 per share. CTO Julie Brown sold more as a percentage of her holdings, exercising and selling 40k shares and leaving herself with 170k, at the price of $44. In light of the volatility in the stock and the appreciation in the shares from the low $20s per share to $60 per share in the matter of two weeks, it is not particularly concerning that the C level executives liquidated only ~8% of their holdings on the move up. Further insider selling at these prices (now $35 per share) would be cause for concern, to us.

As for the StreetSweeper, “TheStreetSweeper covered 42,679 shares of PANL on Dec. 13 at $37 a share. It covered the remaining 12,521 shares of PANL on Dec. 14 at $34.73 a share and no longer has a position in the stock at this time.” The fact that StreetSweeper covered its short position the day of and immediately following their article says a lot about the level of journalistic ethics in the financial blogosphere, and potentially as much about its level of conviction in its own bearish thesis.

As for the startling Q4 guidance given by UDC of ~16 – 20m for Q4 (with street at 15.2m), it was significantly above Wall Street consensus and the stock traded up the next day, indicating investors were not disappointed with the outlook. It is particularly worth noting that it was the first financial guidance ever given by UDC and is thus likely a conservative view for the very reasons mentioned on the – holiday sales of the PHOLED products UDC supplies should drive some incremental chemical demand into Q4. In particular, sales of the Galaxy S2 accelerated through the start of Q4, particularly in the US where it launched at AT&T and T-Mobile in late Q3/early Q (and is definitely the standout phone at TMOB). The Galaxy Nexus, another PHOLED smartphone launched across most of Europe early in December and on last Friday in the US. Therefore, while the host materials business may drive lumpiness to the downside in Q4, the core business is clearly ramping and accelerating into 2012, and emissive material sales should be up in Q4.

So, while there are clearly risks to investing in Universal Display, the picture is not the one-sided, despairing view as cast by Competitive challenges to UDC will certainly mount in the coming months and years, but the reason they are beginning to manifest now is that the market participants have recognized that PHOLED is entering a phase of explosive growth. Samsung and LG are set to spend upwards of 10 billion in capex on PHOLED over the next two years, each, as they prepare for volume production of TVs in 2013. As we have noted, the opportunity for the handset market is $.54 per device on the emissive materials alone, and up to $1.00 per device including host materials. This represents 400 – 800 million of annual market in handsets alone by the 2014 / 2015 timeframe, depending on your assumptions surrounding penetration. The opportunity in tablets and televisions could push the TAM for UDC into the billions per year on chemical sales alone, just several years out. Since UDC is likely to scale to operating margins in the 60% + range by virtue of their model, which has little to no incremental operating expenses and gross margins upwards of 80% even accounting for mix shift to host chemicals, it is not difficult to envision a scenario of UDC earning north of 400 million in operating income on ~550 million of revenue at some point in the next 5 years, which would work out to roughly $5.00 in fully taxed EPS. Given the growth levers beyond even this relatively rosy scenario (in a long term TAM of billions), UDC would likely trade at 20x or more this EPS figure. Universal Display is admittedly a risky investment that could end poorly for investors, but there is also significant upside to be realized if they effectively monetize their competitive position in PHOLED technology. Finally, while it is not worth spending too much time on UDC’s cash position since they are a growth company and the stock is trading well above cash value, arguments that the stock is destined for penny stock status seem to overlook UDC’s ~340m in cash on the balance sheet, which works out to roughly $7.00 in net cash per share.

While StreetSweeper accuses UDC of using “smoke and mirrors” with investors, it is really The, who appears to have used this tactic in their article. We encourage nobody to invest on the basis of our advice; however we even more strongly discourage our readers from investing on the basis of the

Findings: The Minotaur (patent claims, guidance weakness, commodity host materials) on some level exists but several of his constituent parts (guidance commentary, host materials commentary, and the weakness of the Samsung/UDC relationship) are strongly overstated versus Theseus's (UDC) potential opportunity in the multi-billion dollar PHOLED chemicals market. The growling from the labyrinth does not scare us, and we have increased our long position dramatically since the StreetSweeper's article was published.

Happy Holidays to all our readers, and good luck navigating the labyrinth.

Welcome to the Minotaur


Two things motivated me to start this blog. The first is my belief that there are too many financial bloggers out there seeking to muddy rather than clear the waters (with apologies to the generally high quality financial blog named Muddy Waters) for their readers, pushing them deeper into a confusing labyrinth and generally doing a disservice to the public.

The second was the sterling example of John Hempton's blog at BronteCapital (, who provides a truly enlightening read and has served to educate me and thousands of others in how to conduct differentiated securities analysis. He is truly amazing at spotting frauds, in particular.

It will take some time for me to get the hang of things at The Minotaur. But I promise to be fair and open minded and I won't be afraid to admit I am wrong. As a hedge fund analyst, I know that having the courage to admit your mistakes is a crucial part of surviving and succeeding -- stubborness in the face of evidence contrary to your positions is what blows most people up.

The Minotaur in the labyrinth is the other side of our position. He is the strongest argument against owning a stock, or if we are short it, the most wildly optimistic scenario that could send the stock skyrocketing. We are separated from him by the labyrinth, and it may be tempting, and for a time easy, to ignore him. This blog is about facing the Minotaur rather than fearing him, and, if he is too strong, beating a retreat. Otherwise, if the Minotaur turns out to be a fearsome bit of trickery (a Trojan Minotaur? not to mix our metaphors), then our conviction will be stronger for having faced him.

Above all, my aim is to help my readers escape the fate of all those poor virgins the Minotaur devoured.