On Aug. 1, 2012, inTEST Corp. (INTT), an independent designer, manufacturer and marketer of semiconductor automatic test equipment interface solutions and temperature management products, reported financial results for its fiscal 2012 second quarter. It was a strong quarter overall, but on Aug. 2 the market seemed to punish the firm for its conservative guidance in a difficult semiconductor environment. (The company reported guidance of $9.5 million to $10.5 million and an EPS range of $0.00 to $0.04 per diluted share.)
Investors should look at inTEST again, because some good things happened in the quarter and appear sustainable.
- The electrical division has emerged as the most profitable division and has the ability to become a long-term trend due to its long qualifying periods.
- Thermal continues to grow in India, Korea, and China and holds the key to diversifying the firm's non-semiconductor business.
Electrical (the smallest division) was for the June quarter, as well as on a year-to-date basis, the most profitable segment. Electrical had a very strong Q2 with sales of $4.0 million, substantially increasing 89% over Q1 electrical sales. These sales were substantially driven by both an end-user customer and an OEM customer. (Click here for Form 8-K regarding the earnings call.)
CEO Robert Matthiessen reminded us that "the electrical business is a little different in that it's a long-term sale and the product is very engineering intensive, and so you work with the customer for several months before you ship the first product. Once you ship that product and if they're ramping, you get that business no matter what because it's very difficult for another supplier to break in since it wasn't part of that development cycle. There tends to be an overall disconnect between the general economy of the semiconductor world and the way those sales go."
Responding to questions regarding sustainability, Senior Vice President and General Manager of inTEST's Electrical and Mechanical Products Segment Dan Graham, was positive and is currently seeing reasonably strong bookings at this point still for electrical -- and it's across several fronts. The firm is capitalizing on strength in smartphones, laptops, and the automotive electronics segment.
The takeaway in electrical is if you have very long development times with customers, it is very difficult for your competitors to make any headway after these contacts are established.
In the thermal segment, second-quarter bookings were $6.4 million, a 19% increase over first-quarter thermal bookings of $5.3 million. In addition, Q2 thermal sales were $6.5 million, a nearly 7% increase over Q1 thermal sales.
In some countries, inTEST has been ahead of its full-year 2011 bookings in one quarter alone. For example, in India, 2011 total bookings for the year were $178,000, while in Q2 2012 alone India booked a total of $264,000. The Indian bookings came mainly from several orders from Cypress Semiconductor in India.
In addition, the firm had a strong quarter in Korea, with Q2 2012 booking more orders than it did in all of 2011. Bookings in China continue to outpace 2011, and the firm booked its first Sigma Chamber product in Singapore, which is to be used in a reliability test application.
Recall that in thermal, the firm has built a diversified portfolio that includes non-semiconductor markets. This revenue should be a bit more inelastic and run on a different cyclical time frame than the semiconductor business. Non-semi revenue grew from 19% of total revenue ($9 million) in 2010 to 29% of total revenue ($13 million) in 2011. The firm's goal is to grow non-semi revenue to 50% of revenue. The potential for non-semi is enormous because it incorporates any market that uses thermal.
Focus on Thermal
inTEST is benefiting from the increasing need for temperature testing of circuit boards and specialized components. The firm competes mainly on two levels: wafer level and discrete product level.
Wafer level is a solid business for the firm but will never be a significant growth engine. Standards in this area are not stringent, and in the past 10 years prober manufacturers have taken over. inTEST serves smaller OEMs in this area with its Thermochuck product, which tests semiconductor wafers at high and low (-65 to +400 C) temperatures at the wafer probing station.
The discrete product level is where inTEST will experience growth over the next several years. These products provide the ability to characterize and stress test a variety of materials over extreme and variable temperature conditions that can occur in actual use.
The focus is on four main areas solving unique and challenging temperature problems:
- Sensor Technology
- Fiber Optics
- Defense and Aerospace
inTEST Solves Unique and Challenging Temperature Problems
Many of the thermal businesses the firm competes with are large companies that have standard products. The only model out there that has been in an industrial thermal test to date is one where a customer must modify its test. inTEST's business model is quite the opposite. The company asks the question, "What do you have to do to test?" and builds the equipment to fit the product. This is a model that's not generally been used out there because most of the companies it competes with are very large. Being small and able to move quickly allows inTEST to win these custom jobs.
Solid Balance Sheet
The current ratio can give a sense of the efficiency of a company. Since business operations differ in each industry, it is always more useful to compare firms within the same industry. inTEST's current ratio is well above the industry average (4.23 vs 1.34) and the firm has been building working capital since 2009. Working capital was $6.3 million in 2009 and has returned to pre-recession levels, or $19.8 million at the end of 2011.
Here's how I view the valuation of inTEST. (Source for background info: Investment Valuation, Aswath Damodaran.)
Two-Stage Free Cash Flow to Equity Model
FCFE = Net Income - Net Capital Expenditure - Change in Net Working Capital + New Debt - Debt Repayment
- The firm is expected to grow at a higher growth rate in the first period.
- The growth rate will drop at the end of the first period to the stable growth rate.
Rationale for Using the Model
As the non-semiconductor business ramps up to 50% of total revenues, we expect the firm to grow at a higher overall rate than the industry. As these products mature and the firm faces more competition, we expect the growth rate to level off.
Weakness of the Model
As you add more layers to the model it becomes more sensitive to the assumptions you make. The growth may look more "lumpy" than we have it in the model.
We used the following inputs:
- A five-year period with an earnings growth rate of 8.0% and a discount rate of 13.77%.
- A continuing period assumed to go on forever, with earnings growing at 5% and a discount rate of 13.05%.
With these inputs we arrive at a target price of $7.23.
Our price target of $7.00 per share is the average of 9.9 times our 2013 EPS estimate and our two-stage model. We would add shares at these levels.