Newsletter Value Investor Insight carried an interview July 28th with D3 Family Funds manager David Nierenberg (pictured left), whose $500 million fund focuses on small and microcap stocks and has generated an average net return of 16.8% per year since its launch in 1996, versus a 9.3% for the Russell 2000, according to Value Investor Insight. Here's the segment of the interview in which Mr Nierenberg discusses his position in Electro Scientific Industries (ESIO), which was trading at $17.54 at the time of the interview (chart here):
Where do you see opportunity in Electro Scientific Industries (ESIO), another semiconductor- equipment company?
CD: The company’s core competency is in lasers and laser-material interaction. Their largest business is selling memory-yieldimprovement equipment to end-user manufacturers like Samung, Hynix and Infineon. Basically, when you make dynamic random access memory [DRAM], many of the links on the wafers at the start of the manufacturing process will be defective. ESIO’s laser technology blasts out the defective link to allow the wafer to work with redundant links made into each chip. The lasers are small and very precise, using machine vision to find the places on the wafer that are defective and to remove them. This increases the yield for the semiconductor manufacturer so much that the equipment pays off almost immediately.
The DRAM business should see significant growth in demand, primarily from the launch of Microsoft’s Vista operating system, which will require roughly double the amount of memory in every PC. Given that ESIO has a 65% market share in their primary business and very close relationships with their customers, we expect it to get the full benefit of that industry growth.
The company’s other main business is the testing and terminating of multi-layer ceramic capacitors. These capacitors are in every cell phone, every digital camera, every MP3 player. ESIO’s equipment, again using lasers and machine vision, is primarily used to test and eliminate defects in the capacitors.
Historically, capacitor manufacturers have bought additional equipment when their factories get to 85% utilization. That hasn’t happened in this cycle, because they’ve been reluctant to buy after having built too much capacity in the last investment cycle that ended in 2001. But the manufacturers have been running at greater than 90% utilization rates for multiple quarters now and this piece of the business is starting to turn up sharply because of pent-up demand.
The stock currently trades around $17.50, but they have $8 per share in cash. What do they plan to do with it?
DN: They have far more cash than they need to grow and prosper. As technology businesses mature, you’re starting to see companies like Microsoft and Applied Materials paying dividends, a trend I think will proliferate. Unless ESIO makes one or two strategic acquisitions, which they may well do, I would seek substantial dividends from them.
CD: ESIO is one of the companies that has managed to be profitable throughout an entire cycle, and typically companies that do that are rewarded with premium multiples. But due to some of the same macro negativity that’s affecting Brooks, they trade, net of cash, at only 10x the $1 per share we expect them to earn next year.
With positive industry trends and smart cost management, we think they can grow sales 15% per year over the next five years and earnings considerably faster. With no increase in multiple, that’s a double from today’s price. But if they grow at that rate, you could easily see a market multiple of 15x or more. If they pay a one-time or regular dividend, that just piles on the upside.