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, Gino Verza (27 clicks)
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This article discusses Nanometrics (NASDAQ:NANO) and Nova Measuring Instruments (NASDAQ:NVMI). It reviews their historical performance, and selected value metrics, and discusses apparent misalignment in their stock prices. The context of the analysis is free cash flow and various related value metrics.

Background

NANO and NVMI provide process control metrology systems used in the production of semiconductors. They supply semiconductor fabrication tools to chipmakers.

Both companies are exposed to the pronounced cyclicality of the semiconductor-making industry; with periods of high product demand and enhanced financial productivity leading to excess investment, over supply, and losses.

Industry risk looms large as a major driver of outsized variability in revenues and earnings, and in stock price performance. Major unevenness in revenues and recurring weakness in EBIT and in EBIT margin (see Medium-Term Performance chart below) causes financial results to fluctuate markedly.

Extreme inconsistency adds complexity to the management of the business -- in planning product demand for peaks and valleys, in the generation of sufficient cash to cover a stable base of salaries and expenses, in the optimization of investment in working capital, and in the timing of capital expenditures. Business irregularity also necessitates an adequate surplus of cash balances to meet operational and investment needs during lean periods and to ensure survival. Consistent with such industry profile is a high cost of capital relative to issuers in more stable industries.

NANO and NVMI exhibit significant operational risk due to the concentration of business (and revenues) in large clients who command strong negotiating power. Single client losses, or losses of sales to a single client, can have material impact in revenues and earnings.

Advancement in semiconductor manufacturing technology provides the impetus for new product announcements to respond to increasingly complex semiconductor production processes and to maintain competitive edge. Technological challenge also contains real risk.

Because of the relative size of both companies in the semiconductor equipment space relative to competitors with much larger resources, financial and otherwise, NANO and NVMI are particularly vulnerable to possible unfavorable outcomes. They compete in the same space, for the same business, often for the second supplier spot.

Uneven historical performance and opaque medium (and long-term) prospective view make only for very tentative and highly uncertain estimates in the industry, particularly when looking beyond the immediate future.

Medium-Term Performance

The table below compares revenues and EBIT for NANO and NVMI since FYE12/05, including FYE 12/10 (pro-forma).

EBIT (Earnings before Interest and Taxes)

Fiscal Year End

12/05

12/06

12/07

12/08

12/09

12/10(P)

NANO

Revenues ($MM)

70.54

96.37

146.29

102.10

76.71

176.00

Revenue Growth

36.62%

51.80%

-30.21%

-24.87%

129.44%

Avg. Rev. Growth

32.56%

EBIT ($MM)

1.38

-22.13

-4.02

-83.46

-13.35

37.68

Avg. EBIT ($MM)

-13.98

EBIT/Revenues

1.96%

-22.96%

-2.75%

-81.74%

-17.40%

21.41%

Avg. EBIT/Rev.

-16.92%

NVMI

Revenues ($MM)

30.14

48.29

58.08

38.97

39.32

87.05

Revenue Growth

60.22%

20.27%

-32.90%

0.90%

121.39%

Avg. Rev. Growth

33.98%

EBIT ($MM)

-9.04

-2.51

-3.15

-6.96

2.47

18.69

Avg. EBIT ($MM)

-0.08

EBIT/Revenues

-29.99%

-5.20%

-5.42%

-17.86%

6.28%

21.47%

Avg. EBIT/Rev.

-5.12%

Sharp increases in annual revenues are intermingled with severe drops, for both companies. Nonetheless, average annual revenue growth is remarkably similar; 32.56%-33.98%. Average EBIT for the period is less negative for NVMI (-$0.08 million) than for NANO (-$13.98 million). Average EBIT margin for the period is negative for both companies, but less negative for NVMI (-5.12%) than for NANO (-16.92%).

The averages in revenue growth and in EBIT margins for both companies were disproportionately increased by the inclusion of the pro-forma FYE12/10 figures, which reflect an extraordinarily auspicious performance.

Performance of Quarter Ending June 2010

The table below compares performance of quarterly results ending on 6/30/10.

  • NOPAT (Net Operating Profits after Taxes) = EBIT (1 – Tax Rate)
  • Operating Capital is the capital invested in the firm; in working capital and in fixed assets.
  • ROIC (Return on Invested Capital) = NOPAT/Operating Capital
  • FCF (Free Cash Flow) is NOPAT minus uses of cash in working capital and in fixed assets.

Quarter End

6/30/09

6/30/10

6/30/09

6/30/10

NANO

NVMI

Revenues ($MM)

14.52

50.83

6.94

19.44

Revenue Growth

250.07%

180.12%

EBIT ($MM)

-6.48

12.89

-0.14

4.68

EBIT/Revenues

44.63%

25.36%

-2.02%

24.07%

NOPAT ($MM)

11.73

4.68

Operating Capital ($MM)

83.25

89.05

10.54

8.16

ROIC (Annualized)

52.69%

229.41%

Both companies reported strong revenue and EBIT results for Q 6/10. EBIT margins were remarkably close, 25.36% (NANO) and 24.07% (NVMI). Annualized ROIC was substantially higher for NVMI (229.41%) than for NANO (52.69%).

ROIC measures efficiency in the use of Operating Capital. NVMI generates $2.29 in NOPAT per Dollar of capital invested, while NANO generates $0.53. The permanency of the amounts invested in Operating Capital in both companies suggests that the significant difference in their ROICs reflects a rather permanent condition.

Implied Growth

The table shown below shows the FCF growth rates implied in the current stock prices of NANO and NVMI. They have been computed with the following formula:

  • Current stock price = [Enterprise Value + Cash – Debt] / # Shares
  • Current stock price = [(Present Value of FYE12/10 FCF x implied FCF Growth rates discounted at WACC) + Cash – Debt] / # Shares

Knowing the current stock price, FYE12/10 FCF, WACC, Cash, Debt, number of Shares, we compute the implied FCF Growth rates (in bold).

8/10

12/10

12/11

12/12

12/13

12/14+

NANO

Stock Price

13.91

FCF ($MM)

33.44

WACC

13.00%

13.00%

13.00%

13.00%

13.00%

Cash ($MM)

54.90

Debt ($MM)

12.69

# Shares (MM)

22.85

FCF Growth

8.00%

-16.00%

-16.00%

4.00%

NVMI

Stock Price

5.23

FCF ($MM)

16.22

WACC

13.00%

13.00%

13.00%

13.00%

13.00%

Cash ($MM)

46.69

Debt ($MM)

0

# Shares (MM)

26.41

FCF Growth

8.00%

-36.00%

-36.00%

4.00%

The implied FCF growth rates, computed for NANO --- 8% (expected industry growth) in FYE12/11, minus16% in FYE12/12 and FYE12/13, and 4% for FYE12/14 and in perpetuity; and for NVMI, are in bold in the table.

As a corollary, when the FCF base ($33.44 million) grows at the FCF growth rates of 8% in FYE12/11, minus16% in FYE12/12 and FYE12/13, and 4% for FYE12/14 and in perpetuity; and they are discounted at WACC; cash balances are added, debt is subtracted, and the result divided by the number of shares, the result is the current price of the NANO stock ($13.91/Share). A similar computation is done for NVMI.

The table shows the difference in the rates of implied FCF growth rates between NANO and NVMI. For each of FYE12/12 and FYE12/13 the implied FCF growth for NANO (highlighted in red) is minus 16% vs. minus 36% for NVMI. This means that embedded in the price of the NANO stock are higher rates of FCF growth for FYE12/12 and FYE12/13 than for NVMI.

The expectation of a faster grown in NANO than NVMI runs against the findings in the comparative analysis described earlier. The FCF growth implied in the price of the NVMI stock should be greater, but in no case lower than NANO’s. Accordingly computing the price of the NVMI stock, applying NANO’s FCF growth (8% in FYE12/11, -16% in each of FYE12/12 and FYE12/13, and 4% beginning in FYE12/14 and in perpetuity) to the NVMI’s 12/10 FCF base ($16.22 million) results in a price of NVMI stock of $6.82, instead of the current market price of $5.23.

Summary

If you own shares of NANO, you have implicitly accepted industry risk and the operational risks inherent in the stock. In such case, you might consider examining NVMI. Underpricing in the NVMI stock relative to NANO’s is not explained by their comparative historical performance:the Medium-Term Performance and the Performance of Quarter Ending June 2010, discussed earlier.

In other words, the higher FCF growth embedded in NANO’s price relative to NVMI’s is not warranted by the comparative historical comparison between the two companies.

Conversely, the case could be made for NVMI’s stock price to command higher implied FCF growth rates than NANO’s. Applying NANO’s growth expectations to NVMI’s FYE12/31 FCF, under the proposition that NVMI’s FCF growth rates should, at least be equal to NANO’s, results in $6.82 as the price of the NVMI, instead of $5.23, current market price.

In summary, no compelling evidence seems to support the 30% discount in the current price of the NVMI stock, relative to NANO’s.

Disclosure: Author long NVMI

Source: If You Like Nanometrics, You Ought to Take Closer Look at Nova