Photo: i.say, Creative Commons, Flickr

After disappointing earnings result on April 27, it’s been a bumpy ride for shareholders of MEMC Electronic Materials (WFR – Last trade $59.15). The company reported Q1 results in line with street estimates, with Q1 EPS at $0.71 vs. $0.69 expected (EPS included a favorable tax credit of $0.02) and revenues at $440.4 million vs. $444 million expected. The share price dropped from a high of $67.48 on April 26 to a low of $52.22 on May 1. Many suggested that the sell-off was overdone, and the stock managed to make a minor recovery to a high of 59.50 on May 8.

So why did investors punish the stock for in line earnings? Due to slowing semi wafer demand, the company did not beat street estimates for the first time in over two years. Also, WFR was unable to boost guidance in a favorable environment, unlike its competitors, guiding Q2 revenues $460 million to $470 million vs. street estimate of $465 million.

Judging from the price action of the stock, it seems investors bid up WFR shares on best case scenarios. We could see a repeat of this pattern in solar stocks over the following quarters as more investors jump on the green bandwagon with greedy (unrealistic) expectations.

Is the sell-off in WFR justified? Most of the WFR bears expected the company’s gross margins to have peaked towards the end of 2006, but Q1 gross margins improved by about 220 basis points from Q4. Bulls point out that WFR is currently undertaking major additions to capacity, and that the market is underestimating the value of the current expansion. Furthermore, management met all of their targets from their Q4 conference call.

Given the improved gross margins during Q1 it might be too early to describe WFR as a commodity player nearing a peak. But some analysts would suggest capital can be better deployed elsewhere. If the current demand projections for solar turn out to be too optimistic, or if capacity expands too rapidly, silicon will move from undersupply (with inflated margins and prices) to massive oversupply (with falling margins and prices). Due to management sticking to their core business plan and not hinting at any diversification efforts, WFR is particularly vulnerable to such a scenario.

Despite the recent sell-off, the thesis on WFR does not change. WFR has already demonstrated its ability to grow its revenues and margins and earnings through the inventory correction in the semiconductor industry. The company currently trades at a discount to the semiconductor industry because it has had extreme earnings volatility through up and down cycles. Now seems to be a good time to buy, since WFR now has a lot less cyclicality than it has had historically. Citigroup has also mentioned the stock as a LBO candidate.

In summary, I think that upside and downside risks for WFR appear balanced, and we will have to wait for greater clarity in the silicon supply/demand outlook to judge future direction of the stock. The recent WFR price action offers us a glimpse of a future trend where solar stock prices are pushed higher on best case scenarios, but drop sharply if (unrealistic) high expectations are not met. Investors should be on the lookout for these irrational reactions, and WFR might just turn out to be one of those opportunities.

Disclaimer: I do not own any stocks mentioned above. I do not give investment advice. Do your own research. Do not rely on anything in this blog to make investment decisions. Consult an investment professional familiar with your specific financial situation before buying or selling any security.