Good companies have a knack for going further than you might otherwise think, and FEI Company (FEIC) is a good case in point. This leading electron microscopy company has continued to impress investors with both its market share and growth potential as electron microscopy becomes increasing relevant to a larger group of end markets. Not exactly cheap back in September, these shares have nevertheless beaten the market in the last five months while rising more than 10%.
It is going to take a pretty ugly set of circumstances for FEI Company to ever look cheap on conventional metrics. I'm not going to argue against strong growth in markets like natural resources and life sciences, nor the growing potential of selling into key emerging markets like China. Instead, I will simply observe that I would be nervous about holding shares when the music stops and the market suddenly reconsiders just how much it is willing to pay for growth and market share, but that may not occur for many years.
Another Quarter Of Double-Digit Growth
Reading the reports of the sell-side analysts who cover FEI Company, it is interesting to see how the same set of results is viewed by bullish and less bullish analysts. Nobody is calling the fiscal fourth quarter a bad performance (nor should they), but there is a "what, me worry?" aspect to some of the more bullish write-ups.
Revenue rose 15% from the year-ago period as reported, with 21% sequential growth and nearly 16% organic sequential growth. Sales were driven by strong demand in the chip space, as "Industry" revenue rose 34% on an organic basis, while "Science" revenue was up a more modest 4%. Gross margin was soft, down 90bp sequentially and below expectation. Operating income was up strongly on both an annual and sequential comparison, though, as SG&A spending rose slower than revenue and R&D spending was up only 5% from last year.
Bookings were up 11% from last year and while the most bullish analysts played up the record level of orders, the book-to-bill did slip below 1.0. Bookings were up modestly in Science, but Industry remains strong on very good orders from the semiconductor industry, as orders are now more than a third higher than in the 2006/07 peak.
Will Lithicon Open Up More Potential In Oil/Gas?
Along with the quarterly results, FEI Company announced the acquisition of Lithicon for $68 million (which the company is paying with offshore cash). Lithicon is a provider of digital rock technology services and pore-scale microCT equipment.
Lithicon helps oil and gas companies evaluate the porosity and permeability of oil and gas reservoirs. With this information, oil and gas companies can better evaluate the economics of drilling locations and determine the optimal approach for exploiting reservoirs in terms of well design (the number of frac stages, the type of proppant, etc.). With wells in unconventional shales like the Niobrara and Bakken running from $4 million to $10 million each, getting these decisions right is important.
FEI Company was already looking to oil and gas as a significant growth market, and Lithicon will add to that effort. FEI Company will now have a complete portfolio of solutions for oil/gas customers and can now integrate microCT in with its existing electron microscopy technology and 3D visualization. Down the line I would also expect FEI to look for additional markets where it could apply this acquired microCT technology.
Uncommon Share In A Real Market
Between the company's share in scanning electron microscopes, transmission electron microscopes, and dual beam systems (which combine a scanning electron microscope and a fixed ion beam), FEI's market share in the electron microscopy space is close to 40%.
With new semiconductor products coming out and Carl Zeiss pulling back on the TEM market, FEI Company is an uncommonly good position. Normally a scientific equipment company like Waters (WAT), Thermo Fisher (TMO), or Mettler Toledo (MTD) is doing well if it can capture 20% of a $1 billion-plus market. Not only has FEI done better than that, the company has been making investments in expanding its addressable market that I haven't seen from rivals like JEOL or Hitachi High-Tech (including this recent deal for Lithicon). FEI not only has the chance to reap the benefits of having superior tools for this shift to sub-20nm in the semiconductor space, but is also in better position to benefit from the growth of new applications for electron microscopy in oil/gas and life sciences - markets that could be worth as much as existing markets like semiconductors and material sciences in a few years.
A Lot Is Already Expected
The biggest downside that I see to the FEI Company story is the extent to which the Street is already on board with the bullish side of the story. The company's current addressable market is somewhere in the vicinity of $3 billion and could grow to around $7 billion by decade's end if potential applications in fields like life science, forensics, and quality control materialize. If FEI Company can "hold serve" and get 40% of that market, it would post long-term revenue growth of close to 12% (against a trailing growth rate of 8%). Couple that with mid-teens FCF margins (strong for a company like this, but not implausible) and you can generate a fair value of $102 per share.
With the shares already above $98, I worry that my bullish case is pretty much the Street's base case. Maybe FEI Company will secure even more market share in these growth/expansion markets (particularly as they're directly targeting and investing in them), but it still would seem that a lot of optimism is already in the equity.
The Bottom Line
Companies like Illumina do show that the Street will pay handsomely for business models that combine strong market share with underlying market growth. It is also true that the Street likes innovators, and FEI Company has consistently moved the ball forward in terms of product capabilities and value-for-performance.
Talking about FEI Company as a stock to buy on a pullback is all well and good, but it could be a long wait. In the meantime, it will be important for the company to continue delivering healthy order growth and margin leverage, as these multiples don't leave much room for underperformance.