Donald Kania – CEO
FEI Company (FEIC) JP Morgan Healthcare Conference Call Transcript January 13, 2012 3:00 PM ET
All right, good afternoon. We are about to get started here. We are very happy to have FEI Company and the Company’s CEO, Don Kania to present. The breakout for this session will be in the Georgian Room.
Okay. Thanks a lot. It’s good to have everybody visit, appreciate your time and give you a view of the story of FEI. So, the usual Safe Harbor statements, don’t believe anything I say and don’t hold it against us. And then, just so, for those of you who knew the story, it was FEI. We make really fancy microscopes that see atoms basically. We can see and manipulate the atomic scale and we apply that to a lot of different markets.
So, our thesis is, new technology leader in the marketplace and then, customize those. We have three technologies that are core to this and customize those technologies for those markets. So, our R&D investment is highly leveraged overall. And you can see some – we’re all about imagery and analytics that is seeing things that are very small and then, telling you which atoms are which. So, there is a variety of industries that I will talk about that we serve.
I think overall there are two parts of the puzzle. One is the many industries and the other is that there is many geographic – there is a geographic diversity of the company and I love all these pictures. In the upper right, there is President Obama in front of an FEI microscope. That happens when Intel Corporation had Obama visit and when Intel wanted to show off what they were doing, what did they do? They put him in front of an FEI microscope and we are quite proud of that. So that’s our semiconductor business we call it electronics overall. Below that Dr. Daniel Shechtman in our research business won the Nobel Prize in chemistry this year and we are especially proud, there he is in front of the microscope.
It's really cool when people want to show off, you see our people sitting in front of our mike, we have Tim Geithner sitting in front of an FEI microscope. It's just a way to show off that you are techie. And there is just an emotional connection there too and we’ll go into that. National Protein Institute, China, our Life Sciences business selling into China. China has been our fastest growing region; it now represents 12% of our business invested in that over the last few years.
In the lower right, we have a Natural Resource business, I will talk about, we served at oil and gas segment and we did a test site in Papua New Guinea of all places. So, geographic diversity, market diversity, common technology leadership that’s FEI’s story. So growth, lots of ways to serve and I will talk about fundamentals of that strategy of growth is expanding our served available market. We think we can double that in the next three years. And at the same time, we have had a pretty good track record of improving our financial performance. We think we can continue to do that in the next few years. Just to give that kind of a snapshot of what the company looks like by market and by region.
On the left is market, you can see Electronics semiconductor business about a third, what we call research and industries, so that includes our research customers around the world. I think college professors, lots of them; they buy a lot of our stuff. And industry, it includes our Natural Resource business, that's about a third of our business. Life Sciences, which is new and fast growing in FEI is about 11% and I’ll spend more time on that given the nature of this conference. And then, servicing components that’s our legacy business there we continue to get recurring revenues from that that’s about 20% of our business overall.
If you look on the right-hand side, give or take a quarter, we are a third to third to third, third North America, third Europe to third Asia; fastest growing segment is Asia by far. And if we look long-term and near-term in terms of business order performance, the left hand chart goes from 1999 to 2010. The right-hand chart by quarter from Q1 ‘09 to Q1 ‘11 had a pretty good track record of growth. It's also good to highlight, I think that during the great recession, the company still remained relatively robust. We did flatten out, but we didn't take a deep dive overall. Again our diversities I think came to play to keep this going well.
On the far right, you see that little blip there on the order front that represents effective currency on the booked orders; I just wanted to highlight that. We do have large operations in Europe and a lot of our orders flow in from Europe, so the Euro-Dollar exchange rate is something that we pay a lot of attention to and focus on. But just to give a sense that in fact, what did was revalued the backlog at the end of each quarter, the currency shifts those orders, lose some value, but to the benefit of the company, a weak year out means we are a more profitable company overall.
And then, growth in developing markets, I’d tried to highlight this, it makes a little more quantitative. We look from 2005, 2010 and our view for 2014. If we identify developing regions is, parts of Asia, Eastern Europe, the Middle East, which has also been fast growing for us. Latin America, we just opened an office in Brazil. You can see that, it's grown from 36% to 42% of business and we expect it to grow beyond 50% as we go forward. So, we think that offers a lot of resiliency in terms of our ability to continue to grow the company from a geographic perspective.
So, now I'm going to talk about SAM expansion and it may look a little complicated and I will not go through the alphabet soup here. But the whole idea is, we make electron microscopes that market is about $1.5 billion around the globe, growing somewhere around 5% to 6%. And our ambitions are certainly higher than that, we’d like to grow the company more quickly. But we also note that there are a tremendous number of – if you take a technology perspective, other technologies that do similar things of looking at small scale trying to understand how things work. NMR and XRD are pretty popular in the Life Sciences areas as an example, X-Ray fluorescence, light microscopy. And if you look at that whole marketplace it's about $7.3 billion.
So, as I will try to elucidate in the next few slides, our strategy is to double that served available market, enter with zero market share, but present compelling solutions based on our technology into areas where we can go take dollars away from people that make X-Ray D and NMR. The money is there, we don't need the markets to grow, we just need the people to see that the FEI solution gives you something different, something more valuable than what's being provided to the marketplace today. And I will highlight that in a couple places.
The biggest driver is in Life Sciences and in our Natural Resources business. And if we look at how the company might evolve through that process as we look from today to 2011 numbers here to 2014 in the future, you can see that Life Sciences grows significantly as a piece of our business in Natural Resources, research kind of stays near the same and electronics, our semiconductors business as a percent of business, it will probably shrink over time, yet it is a growing business overall. So, the whole opportunity grows, but the pieces of the opportunity shift over time, more towards Life Sciences, more towards Natural Resources.
And so, we've done a couple of recent announcements, the whole string, I’ll kind of walk you through those. And we've outlined this strategy to our investors over the past three years of the actions that we need to fulfill to allow us to grow this served available market. And so, a bunch of boxes will pop up here and I’ll try to walk you through all of them.
And let’s start near 11 o'clock, which says NIH Living Lab. This morning in our Life Sciences business, we announced a co-operative research and development agreement with the National Institutes Health, the NCI, the National Cancer Institute to take our technology, which I’ll describe a little more in Life Sciences and work together with their experts in XRD, their experts in NMR to work together to help drive the value of what we do in Life Sciences further and faster into the research business of Life Sciences.
We also think there is a longer term threat to pharma, but we won’t really talk about a lot about that today. This is a near-term drive for us overall. So, we believe this is ultimately a validation and an accelerating mechanism to grow our Life Sciences business.
If we go around to, let's go counterclockwise to the bottom, to 6 o'clock. In November, we bought a small optical microscope company, as many of you know, the instrumentation in the Life Sciences business, optical microscope is a really big workhorse, a relatively large marketplace of sophisticated instrumentation.
We also bought a small company in this space to stick next to our electron microscopes. We believe that there is in the next few years, a tremendous opportunity for solutions that combine optical high-performance optical microscopy and electron microscopy. And the way to think about this Google Earth, you can do tremendous things with optical microscope, fluorescent tags, all of that sort of stuff. But ultimately there are times when you want to zoom down to the near atomic level and understand what's going on, that’s our goal is to provide both at optical capability and the electron capability in one platform.
I want to talk a lot about the other ones right now, the ones that, about the 9 o'clock position related to our Natural Resources business. We announced a small acquisition on Monday in that area as well as some more sophisticated software solutions for doing large samples, that’s what’s up at 2 o'clock.
So, Life Science market, this has been the track record of the company from the order rate, 15% compound annual growth that is 2005 for the most recent reported quarter of Q3 2011. And the way we like to think about all of our businesses, there are layers to grow that business and step one for FEI is structural biology. That is the ability to measure in three dimensions the shape of macro molecules or ultra structures of cells. Therefore, the Life Sciences play overall.
We think there is a tremendous both complementarity and places where we can add value to Life Sciences research is to the understanding of the machinery of life that’s different than NMR and XRD do today. And that's about a $600 million marketplace, so I’ll come back to the SAM expansion, there is money being spent there, we want some of that money. We will have some new competitors as a result, but we think we can bring tremendous value.
How do we want to accelerate that? Partnership with NIH we just announced, where we have world experts in all three technologies working together at one site with state-of-the-art equipment to map that halfway forward.
Next, as I described, we bought an optical microscope company, we think cellular biology is the next layer of growth, so we are starting this year moving over the next few years where we link optical and electron microscopy together that Google Earth kind of solution. That's how we think about continuing this growth trajectory into the future. Make those key investments, be strategic, partner with the right people that leverages growth in the future.
So for us, in structural biology, we do think in terms of workflows, total solutions, so in this case when people want to measure something in an electron microscope, they freeze the samples in a special way, so that you don’t form ice crystals, but you form amorphous ice, so you freeze life at a particular point, so you can look at virtually any kind of sample, but it is frozen, so you don't have to do exotic crystal preparations, all you have to do dunk it into some cryogenic fluids and I won’t go into that.
It goes into a relatively sophisticated, very expensive electron microscope that has a lot of automation on it. It can do multiple samples, repeat them over and over. ASPs around $4 million to $5 million to give you a sense.
And then, software that we have analogous to what CT does, you take the multiple images of an object of interest, say it’s a ribosome, say it’s a virus and then you can determine three dimensional images at resolution for things like viruses, near atomic, a few angstroms and for arbitrarily complicated structures like ribosomes, it's about six or eight angstroms. So, in the regime that’s very interesting to Life Sciences today.
And so, here is a sample, a little bit more of the data. You can read the quote at the top, but the whole idea is, you get a bunch of images, you process those images in FEI software. And in this case, one of our customers who researches HIV, determined that the protein structures that are used in the docking mechanism of HIV that were determined by X-Ray crystallography were in fact in error.
The process of producing crystals had changed their shape and Sriram at the National Institutes of Health actually determined. So certain viral, certain anti-viral approaches to preventing HIV or creating vaccines were flawed. And in fact, this research then showed that in fact there are alternative approaches. And so, we see this as sort of the poster trial for, how do we provide value, we can image in a different way, it doesn’t require the same kind of specialized sample prep that X-rays do and can provide new and different insights into how things work.
And we are really in that game, again partnerships build this business over time, but we think this story is really quite compelling. And here is another one where in fact in conjunction with NMR, NMR is particularly good at looking at certain regions of a complicated structure, but in conjunction with cryo-electron microscopy, the data on the left, one is able to put the two pieces together and learn more about functionality than the two, than one or the other separately. So, again the NIH seem here, trying to get things to work together in our structural biology world overall.
And then, this is the kind of the summary, the announcement with the NCI and National Institutes for Diabetes, digestive and kidney diseases that was announced literally went out this morning. We have all the tools there, we have all the world’s experts there and we expect it to bear fruit over the next year or so.
So, part two of Life Sciences. First part was that structural biology thread, it's a good business for us, they were running about 100 million in this space, so to give you a sense of scale. And we think that that’s an area we can grow, but at the same time, we are moving forward in cellular biology that linkage of light microscopy and electron microscopy together.
The second box over, which says image acquisition iMIC, that’s the acquisition we made back in November, it's a high-performance optical microscope company they do live-cell imaging if you know, the jargon and super resolution, small niche company in Munich, Germany, but has what we need to be successful.
Our goal is not to be a competitor in the broad optical microscope space. Our intention is to produce a correlative workflow solution, so that life scientists who traditionally use optical microscopes can take advantage of the high resolution capability of electron microscopy. And that's in both in two and three dimensions. And I won't go into more details, there is a couple of different approaches after that for linkages, which you can look again, frozen samples or plastic embedded samples turn out to be classic in this case. A whole new opportunity for us, this space represents we believe a few hundred million dollars in served available market.
TILL Photonics, they are a small company, they make cool microscopes and it’s really neat, but they were such a niche player, they really didn’t have much of a footprint. We were more focused on technology than we were on market presence. This is about using their technology into our workflows overall. We spent about $20 million for it.
So, Life Science is now the structural biology, we have got a good business in place, we think we can make it a great business over time. We are doing the right kinds of investments there. Next is cell biology, creating those workflows that allow us to do optical to electron in a seamless way and be able to sell that to our customers.
In that area, we actually have a collaboration with the Knight Cancer Institute at Oregon Health Sciences University. Philip Knight, the Founder of Nike was generous enough to give a few hundred million dollars to the University there to set up a cancer institute that was specifically focused on understanding the spatial and temporal dynamics of life that are relative to cancer and the science of cancer. And so, we are actually founding members of that and have a strong relationship with them and all and they have been hiring some tremendous people.
Again it’s that same model of let's find the world’s experts, get them to use FEI’s equipment show that value and that allow us to leverage it in the marketplace. I will talk a little bit about the other business segments, because I know this isn’t a Natural Resources business conference. We have a small business today, this is one of our, this is our fastest growing business in Natural Resources. You might ask, what do electron microscopes have to do with Natural Resources? Well, it turns in things like oil and gas and in minerals extraction, people want to know, what minerals are where and how they are distributed in space.
Well, it turns out, we can do that. It’s analogous to what we do for Life Sciences; we can do two or three dimensional imaging of the distribution of minerals in this case. We can do that in an automated way. And so, if you're drilling an oil well, you really want to know if the drill head is in an oil bearing layer. If you are doing a mine, you want to know how much of the material of interest and how it’s distributed. These both become economic arguments with the customer, how do they get more yield out for effort put in.
And we are early in this game, it’s a small business, we don't report it out as a small segment, but it's been growing 50% or greater clip over the past year. So we feel good about it, it's our highest grossed margin business and a little bit about that. We did announce an acquisition this week, but the whole point is, can we do this at a well site. Can we make a rugged microscope? Can we make a rugged system? We have had three joint development projects with major players in the oil and gas business.
We did test in Papua and New Guinea, we did test in the Persian Gulf, we did test at an undisclosed location with Geolog, they won’t tell us who the partner is. But the idea is, we validated in 2011, 2012 is a year of commercialization and we hope to continue that aggressive growth rate in the business through 2012 and beyond.
So, we bought a small company, this was announced 1/9, which was Monday, just outside of Pittsburgh, these are the guys that make the rugged microscope. So, we decided that we wanted to own the whole tool set rather than subcontract it and bought for $30 million.
So electronics, this is our semiconductor market and it is really interesting in the instrumentation world and this world there is a lot of concern about the cyclicality of this business. Electronics is a tremendous business for FEI. We are very comfortable with it being about a third of our business and that is our strategic intent, not to let it to be too big, but it’s widely profitable for us and it is a growing cyclical business, so it’s cyclical growth for us.
And what we show here are the order rates and you can see we went through the great recession, yep, things went down, but they didn’t go down drastically. And I’ll remind you that the company stayed flat through that period, but what’s I think most interesting to note is that peak-to-peak we have grown.
Capital equipment spending overall was flat between those two periods. The share of spend in that industry for what FEI does is increasing. And what we do is enable the creation of these smaller and smaller devices over time.
We are closer to the research side of this business, so we are not so capacity driven. As I said, great business, high margin and it has a long tail of service, which is really important. These customers paid well for service business that’s about 20 some percent of FEI.
Finally, the research market, think material scientist here, this is college professors, institutions around the world, people that want to understand the fundamentals of materials. Good business for us overall, advancing discovery, the global reach of this business is compelling, you will find FEI microscopes from Saudi Arabia to Russia to South Africa to Zimbabwe to you name it, you will find them there. And it gives us some resiliency in the market place, even though there is concern about government spending, which ultimately funds a lot of this both in the U.S. and in Europe, but China is relentless in its pursuit of growth and this is a very fast growing segment for us.
In four out of the last six quarters in this segment, China outspent the United States on FEI product. And that’s a two-edged sword, I mean, being American I think it’s going to be a bad idea, but being the Head of FEI, it’s a wonderful thing for us overall.
China has 12% of our business is a wonderful thing. This is the big driver in that part of the world. So, to kind of walk through all the pieces of FEI, the takeaway should be Life Sciences. I think we have compelling offerings that we have the right strategy to build that to grow and there is a couple of layers to that. I have got some other businesses, they all use electron microscopes, they all use the same core R&D, we just reconfigure for each of the market places, so we are pretty efficient there.
I will run through the financials, I won’t spend way too much time I mentioned we are stable in the downturn. We will grow, we grew in 2010 with 25% bookings growth, 2011 we will be up over 30% on revenues year-on-year. We have been focusing on improving gross margins and you can see the trend that we have had over the past few years in terms are expanding that performance.
So, earnings doubled between ‘09 and ‘10, earnings doubled pretty much again in ‘10 to ‘11 and 22 consecutive quarters of GAAP profitability, which just happens to overlap with my tenure as CEO in FEI, so by magic.
And then, our charted recent quarters in terms of margin performance and both from the operating margin and the gross margin perspective kind of improvements that we have had. And then, the balance sheet, even though we bought a few things, the balance sheet is really strong maybe to a fault, but I think not.
We are starting to do some getting – we have seen a lot of prospects in the M&A area overall, which we have a lot of experience in as a management team, but also, I think it’s really important yet, EPS is a good thing, but focusing on the cash generation, particularly free cash flow.
And we show here the acceleration of free cash flow per share over the past few years and that bottom line is only through three-quarters so to give you a sense of where we are at, though we did consume some cash here for buying a couple of little companies recently, but I think this is really a measure of the improving quality of the earnings and the quality of the company over time.
And with uses of cash we bought TILL that’s the optical microscope company, ASPEX that’s the rugged microscope company. We have bought some software companies, which created our Natural Resources business in ‘09, but we have also been focusing on where the shares are. We have a convertible out there, we buy that back when we can, when it’s traced below par, but it does exercise at $29 or somewhere around that.
We are trading about $44 right now, so that’s probably not going to be happening, it will just convert. It’s not callable or anything, so in mid ‘13. And then, we have done some share buybacks of late. Pretty much the short stories, we bought 5% of the company back in about the past 15 months and that has been favorably received as well. And yet, we have still been able to continue to expand the cash balance of the company.
And then, our business model over time focused to the right hand side, you can see 2011 year-to-date. What we used to call, what we call our long-term target, obviously we are pretty much on that. Our present long-term target, which is really Q4 of 2012, is to achieve 47.5% gross margins and get operating margins up a few points.
One thing I do like to highlight to people is because we grew so fast in ‘11, our R&D as percentage of revenue lagged and that’s going to get back up; 11% is our target spend and so, one should expect to see in FEI a little bit higher level of spending at R&D in the next few quarters up to that 11% level. So, Fletcher our IR person likes to highlight, we beat our timing on achieving our goals.
So, growth and margin expansion, I mean, that’s kind of what you get with FEI. It’s secular growth, it has a cyclical growth component, but we love it, it’s a good thing. I think we have the right strategies to grow our newer businesses, which are Life Sciences and Natural Resources.
We are doing the right strategic things and being enough patient with those businesses, so they get real traction. And overall, margins are expanding, we have got a good track record for that in the past few years and we think we can achieve the targets that we have outlined for us in the future. We got a strong balance sheet, so we can do what we need to do to be successful overall.
So, with that, I would just like to thank you all. And I think we go to a breakout room for questions somewhere out there. So, thanks for your attention. I appreciate you all coming.
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