Doing Your Due Diligence

Carl Johnson, INFRASTRUCTURE -- Semiconductor International, 8/1/2001

Positive news is hard to find. We are coming into a seasonal bottoming period and a bounce is to be expected, but that does not alleviate some of the longer-term problems facing the industry.

With a sick economy weighing heavily on the chip business, we are expecting a slow grind back to health. In assessing the situation today, about all I can say is that demand is weak, inventories are slowly correcting and utilization rates are at all-time lows. A fundamental recovery will require inventory burn-off (or scrap due to obsolescence), an economic recovery to reestablish strong unit demand, a filling of factories that increases utilization levels, and ultimately an expansion of capacity with more new tools. This serial recovery along the food chain makes me cautious about the timing of a recovery. It could take a while.

In the meantime, I made the decision to ride out this downturn by doing some intense due diligence on the companies I own and want to own. This is an ongoing process, but right now it seems as though an extra effort is worth pursuing. Prices for individual stocks in the semiconductor equipment world are starting to get right. If the current market correction continues, we might even see some trough valuations before it is all over.

So what does due diligence entail? In addition to the study of a company's financial state, I find it helpful to jump in the trench to talk with those who are out in the field selling and using equipment. Trade shows like SEMICON West bring about a great opportunity to kick the tires at many companies. It should be easy this year to get to talk to key executives and engineers since attendance is likely down significantly over last year, so there tends to be plenty of space on the showroom floor. In the past I have found it advantageous to attend and do research when attendance is down. The correlation makes sense: Attendance is down because business is down. Because business is down, the stocks are going down. As the stocks are going down, I get more interested because valuations become attractive. See? There is a method to the madness.

What am I looking for? This may seem elusive, but I am looking for those companies that have adjusted their business model to fit the industry's condition. Players that know how to do this quickly and efficiently should now, at the very least, be cash-flow neutral. To me, this is the hallmark of good management — the ability to overcome, the ability to adapt.

If that first point is met, I want to see a focus on new design wins and research and development. I want to hear management discuss the possibility of adding — through merger, acquisition or partnership — ingredients that enhance and enable future growth. I want to hear about strategies that will allow them to penetrate a larger portion of the market.

Some of this may sound like the status quo. You're probably right, it does. But it is this process that helps successful investors find those diamonds in the rough. As a shareholder in many capital equipment companies, these points are essential to the return I expect from my investment. If a company is failing on any one of these fronts, should I be investing in them today?

Carl Johnson is president and co-founder of INFRASTRUCTURE (www.infras.com ). He can be reached by phone at 1-972-492-7208.