We believe CVD Equipment Corporation (CVV) is a compelling short and faces an imminent and substantial collapse. Long on promises and short on delivery, CVD's share price has been supported by unsubstantiated graphene hype and large (and now completed) one-time orders for a failed thin film solar application. The promise of graphene developments by CVD is a mirage and years away. Not only is it too far in the future for CVD to benefit, but other more substantial companies are competing in the space. Furthermore, now that CVD has delivered its large solar orders, current orders and backlog have fallen to dangerously low levels. At $14.65/share, we believe CVD is a compelling short and believe true underlying value is only $5 per share based on its historic earnings, which is a generous valuation for a company that has since turned unprofitable and is now shrinking.
Overview of CVD Equipment
CVD Equipment Corporation (CVD or "the Company"), per its own website, designs, develops and manufactures customized equipment and process solutions used to develop and manufacture solar, nano and advanced electronic components, materials and coatings for research and industrial applications. While it sounds complex and sophisticated, CVD basically acts as an outsourced manufacturing company for R&D departments. Clients are typically universities and government and industrial laboratories that order research and testing equipment that is manufactured by CVD. These clients can choose to build this equipment themselves or outsource it to CVD. There is little know-how that is inherent to CVD's capabilities.
Low Tech Margins
While the equipment that CVD makes is customized, it is not highly specialized. With gross margins of just 31% in H1 and 36% in 2012, it's apparent that CVD's products are not very highly value-add. For comparison, KLA-Tencor Corporation (KLAC) makes equipment for technology companies, such as semiconductors and nanoelectronics, and supports companies from research and development to final volume production. KLAC's gross margin and operating margin averages were 55% and 27% during the last 2 quarters, far surpassing CVD's 31% and negative 9% operating margins.
Insignificant R&D Spending
CVD's low tech margin profile is not surprising if you consider that CVD spends virtually nothing on R&D. Per the 2012 Annual Report (here), in 2012, CVD spent just $1.33 million in total R&D, of which $389 thousand was to build internal R&D capabilities. The less than $400 thousand spent on internal R&D capabilities is not indicative to us of substantial know-how. The vast majority of the R&D, or $955 thousand worth, was spent on behalf of customers for customer orders. This further corroborates CVD's outsourced manufacturing status.
Weak IP Portfolio
Not surprisingly, with so little spent on R&D, CVD does not have a substantial patent portfolio. CVD's 2012 Annual Report does not publish how many patents CVD owns, but it is clear that it is not significant. In fact, in Note 6 of the 2012 Annual Report, CVD values its patent portfolio at just $18 thousand. Furthermore, CVD states it only has $23 thousand in Intellectual Property value.
This is indicative of weak IP and a minimal patent portfolio.
Graphene - Don't Believe The Hype
With miniscule resources and capabilities, the notion that CVV is on the cutting edge of graphene technology development is laughable.
First, what is graphene? It is a crystalline form of carbon (Wikipedia entry here) that is interesting because it is two-dimensional and has high conductivity, as explained here. It has exciting potential in nanotechnologies. But it is years away from any real-life application.
What does this have to do with CVD?
The hype around graphene and CVD started with a Bloomberg article in 2011 that mentioned CVD as a company that sells 4-square-inch wafers of graphene. The article can be found here. Notice that the article doesn't state that CVD is developing graphene applications, or that CVD possesses any know-how. The article simply states that CVD sells wafers of graphene so that others can develop it. We don't believe that CVD has developed any capabilities with regard to graphene development. It certainly has not resulted in any orders that have contributed to backlog.
In addition, a recent WSJ article (here) states that large multi-billion dollar companies like Apple (AAPL), Lockheed Martin (LMT), and BASF (OTCQX:BASFY) are investing heavy resources into developing graphene applications and filing thousands of patents all related to graphene. The notion that CVD can compete with companies like these is preposterous. As we noted above, CVD spends roughly a million dollars a year in total R&D for all of its applications, and has no significant intellectual property to speak of.
Business Has Fallen Off a Cliff
In the meantime, CVD investors blindly believe the hype on graphene and ignore the alarming deterioration in the base business. In late 2010 and early 2011, CVD enjoyed some large one-time orders that boosted backlog from $2 million dollars at the start of 2010 to over $22 million by the middle of 2011. This fooled investors into thinking CVD was growing rapidly.
However, those large orders were tied to a thin film solar customer and have since dried up. Thin film solar is a dying technology, and CVD has said that orders are unlikely to be repeated from this customer. Since mid-2011, orders have declined year over year for 8 straight quarters and averaged under 0.7x Book-to-Bill.
Lies Behind The Deterioration In Orders
CVD blames the slow orders on the disruption from their move into a larger facility, but we believe this is incorrect. First, CVD has been saying for over a year that quotation activity remains strong and orders are imminent. If quotation levels remain so high, then why are orders declining?
Second, if a manufacturing company is moving into a new facility that has double the previous capacity, the company's main priority should be to fill backlog so that the new facility's utilization is maximized as quickly as possible. Otherwise, margins will suffer. Filling backlog for CVD is even more important since according to its 2012 Annual Report, "the timing for completion of the backlog varies depending on the product mix and can be as long as two years." If orders take up to 2 years to fulfill, then CVD should have been aggressively filling its backlog as it was opening the facility, not depleting its backlog.
To us, CVD's promises don't ring true.
Most alarmingly, while CVV has promised new orders over and over again, their backlog has fallen to desperate levels. Orders in the last quarter were just $2.6 million for a book to bill of 0.5x, and CVD finished the quarter with just $5.5 million in backlog, or less than 2 quarter of sales. In the meantime, CVD is barely breakeven and cash flow from operations has been negative for 3 straight quarters. So far this year CVD has earned $434 thousand or $0.07 per share in net income, which includes a one-time $887 thousand gain from a sale of property that should probably be excluded from earnings because it will not be repeated. Excluding the one-time gain, CVD would have lost money. We believe more losses are on the way.
At $14.65 per share, we believe fair value of CVD is $5 per share or far less than half the current share price. Over the past 6 years, which includes the large one-time solar orders, CVV earned a total of $6.1 million. That's just over $1 million per year, or just under $0.20 per share in annual EPS. Being generous and putting a 20x multiple on that gets us to $4 per share. Adding the $1 per share of net cash gets us to our target price of $5 per share. Don't fall into the trap of believing false promises. Value CVD on its fundamentals and you will profit from your short position.