When it comes to companies tied to the semiconductor capital equipment cycle, talking about valuation often feels pretty pointless. Creating accurate long-term models is a Sisyphean task, and the realities of the market mean that the stocks often go much too low in the bad times and much too high in the good times. With that in mind, then, Edwards Group (NASDAQ:EVAC) doesn't necessarily jump out as a screaming bargain today, but I suspect that a recovering in the cyclical semiconductor, panel, and LED markets will lead to significant stock performance for a year or two.
Weak Tech Markets Sucking Away The Momentum Today
As a leading supplier of vacuum pumps and exhaust abatement systems to the semiconductor equipment, panel, solar, and LED markets, these are not times of abundance for Edwards. Revenue fell 16% in the fourth quarter (and 7% on a sequential basis), after a 20%/13% drop back in the third quarter. Declines were led by the semiconductor business (down 37% and 18%), but the Emerging Technologies business was scarcely better (down 26% and 11%). The company's General Vacuum business was better (down 7% and up 1%), but hardly strong.
All things considered, I think Edwards Group is doing okay on margins. Despite the sizable volume declines in the business (particularly in semiconductor products), gross margin fell only 150bp from last year (though more than five points from the third quarter). Operating income plunged two-thirds, despite a 10% cut in SG&A spending. Now, I'm not attempting to pull a Jedi mind trick and suggest these are good results - what I'm attempting to say is that I've seen many other companies tied to the semi capex cycle do much worse.
In Tough Times, The Tough Survive
While this downswing in semi capex has been hard to digest, the company continues to maintain or gain share across many of its markets. Moreover, the company has not backed away from innovation and product development - a relatively new product (the nXDS scroll pump for degassing in the steel industry) has sold almost 1,000 units since launch, despite a pretty unfavorable climate for steel capex.
Stepping back a bit, Edwards is a leader in advanced vacuum pumps and abatement systems. The company pioneered dry pumps over twenty years ago, and sells a range of dry pumps, turbomolecular pumps, and abatement systems into the semiconductor equipment, steel, life science, flat panel, LED, and solar markets. Edwards is also in the business of servicing its installed base - with over three-quarters of a million pumps and 10,000 abatement systems in place, that service business generates about 20% to 30% of revenue through the cycle.
In many respects, Edwards is built around the semiconductor business, where vacuum pumps have seen greater incorporation into finished equipment over time. Edwards' vacuum pumps factor significantly into the lithography and deposition steps, with other steps like etch and annealing becoming more important. Edwards does business with almost everybody - from major OEMs like ASML (NASDAQ:ASML), Applied Materials (NASDAQ:AMAT), and Lam (NASDAQ:LRCX) to customers like Intel (NASDAQ:INTC) and Samsung (OTC:SSNLF) - and holds about 38% share of the market - roughly double that of Pfeiffer Vacuum (OTC:PFFVF). Exhaust abatement is also a significant business here, as states like California are notoriously touchy about air quality issues.
Edwards Group has also been successful in taking its technology and applying it to multiple markets (and the company's history predates that of the semiconductor industry). The most significant markets at present within the General Industrial heading are steel mills where customers like ArcelorMittal (NYSE:MT) use the pumps for degassing and life sciences, where Edwards' pumps are used in various tools and analysis equipment manufactured by well-known companies like Agilent (NYSE:A), FEI Company (NASDAQ:FEIC), and Thermo Fisher (NYSE:TMO).
Last and not least, Edwards has taken a page from many semiconductor equipment companies and looked to leverage its technology into markets like flat panels, LEDs, and solar where the underlying production processes are quite similar. Here too, Edwards' customer list reads like a who's who - SunPower (NASDAQ:SPWR), Aixtron (AIXG), Veeco (NASDAQ:VECO), and AU Optronics (NYSE:AUO) all use Edwards pumps in their manufacturing process or equipment.
Waiting For The Rebound To Bring The Growth
It's hard to find a market that Edwards serves that's actually pretty healthy right now. Semiconductor equipment orders have been looking a little better, but that's relative to a pretty deep ditch (Applied Materials' trailing 12-month revenue is nearly one-quarter below peak). Likewise, the panel, solar cell, and LED equipment makers have seen a pretty steep erosion in business over the last 12-18 months. Steel and life sciences, too, aren't exactly the picture of health, as companies like Thermo Fisher and Waters (NYSE:WAT) have generally had to make do with single-digit revenue growth at best.
When it comes to cyclical markets, though, what goes down often comes up and I think that will be the case for Edwards. As mentioned, the company has strong share of the semiconductor equipment pump and exhaust markets, and I believe the company will benefit from both share growth and increasing penetration of vacuum into various chip production steps. Along similar lines, Edwards pumps are part of ASML's new EUV systems and this could be a very interesting market in a few years' time.
On the industrial side, Edwards' share is smaller (more like 10%) but the company is still an overall market leader. Rivals like Pfieffer, Agilent (both competitor and customer) and Gardner Denver (NYSE:GDI) are stronger in some particular markets, but tend to be more limited overall. Growing this business has emerged as more of a priority, with the company looking to shift more customers to dry pumps and find new end markets/applications for its technology. With Emerging Technologies, the story is similar to semiconductor equipment - the company is waiting for an uptick in markets like flat panels and LEDs, with the long-term potential of the latter looking quite significant given the energy and cost savings.
The timing of these recoveries is a big unknown, and investors have also had to digest a change in leadership. The former CEO resigned "by mutual agreement" with the board, and the board named Jim Gentilcore as the new CEO back in late February. At age 60, though, I think it's fair to ask if Mr. Gentilcore is a long-term option, and/or whether that means the company's board might see itself as a sale candidate.
As I said in the intro, long-term financial forecasting of companies that serve these markets is difficult at best and useless at worst. Nevertheless, with Edwards' markets likely to grow at long-term rates in the range of 5% to 10%, I think a long-term revenue growth target of about 7% could be manageable.
On the margin side, it really matters how the rebound shapes up - the company has the capacity in place and ready to go. Long-term, I believe the company can generate free cash flow margins in the low teens (and a free cash flow growth rate of around 10%), but I'm even less certain of that target than the revenue number - management did handle this downturn reasonably well, but free cash flow margin did slip into the single-digits.
The Bottom Line
On a cash flow basis, these shares look to be fairly valued, with a target price of around $7.50. On the basis of peer group analysis, though (looking at metrics like EV/EBITDA and EV/rev), you could argue for a target in the $10 to $12 range. Along those lines, I fully expect this stock to rise if and when the market believes in a semiconductor capital equipment recovery cycle, and these shares could well double (or more) - as I said before, these stocks tend to overshoot when business improves.
With strong share, a history of innovation, and long-established relationships with top-tier OEMs, Edwards looks like an interesting, albeit not very liquid, way to play multiple secular market rebounds over the next two to three years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.