Within the world of semiconductor equipment, Cascade Microtech (NASDAQ:CSCD) is a tiny player, though it has respectable market share in what management has traditionally viewed as its core markets. New product launches and improving margins have done wonders for the stock (which is up almost 90% over the past 12 months), but I think there could still be more to come.
Cascade has not only been developing new products to broaden its addressable market, but has also been acquiring technologies and products that should help the company transition to the next major developments in chip design. Cascade does not have a great record when it comes to sustainable margins or cash flows, and it does operate in a notoriously cyclical industry. Even so, I don't believe it takes particularly heroic assumptions to suggest that the shares could still have upside.
This Is Not A Test
Cascade Microtech competes in the markets for stations and cards used to test semiconductors. Cascade's equipment allows fabs to test chips at the wafer level instead of testing the final packaged product, and that is considerably more cost-effective for the customer. The company operates at both the engineering and production levels; production refers to the actual commercial runs of chips, while engineering refers to testing done during the chip design and fab optimization processes.
This is a highly competitive business, and Cascade's management lists over a half-dozen rivals in both the systems and probe card markets, but the company competes in part on product features and by focusing on particular markets and market segments. For instance, Cascade does not compete in areas of the market that require large probe areas, with memory chips being the biggest example. I believe that's an important detail, as FormFactor (NASDAQ:FORM) is the largest probe card supplier in the industry (and Micronics is quite large as well), but both of this companies have focused a great deal more of their attention on the DRAM/flash memory markets.
There are three primary parts to Cascade's business model and they are consolidated into two segments. The Systems segment is home to the company's probe systems and reliability test systems, and the company claims about 60% of its targeted engineering market and about 4% of its targeted production market. The Probes segment includes both analytical probes and the company's proprietary Pyramid probe cards - consumable cards (as in, they wear it with use) that work with equipment made by other OEMs like Agilent (NYSE:A) or Teradyne (NYSE:TER) to test a variety of circuit types.
From Engineering To Production
As I said before, Cascade has generally steered clear of the memory market, where FormFactor boasts impressive market shares (with about half of the DRAM market and more than 10% of the flash market). Instead, Cascade has focused more of its attention on advanced logic, wireless, and system on a chip (SoC) markets. With that, the company boasts most of the largest and best-known names in the semiconductor industry as customers (including fabs, fabless chip companies, integrated semiconductor companies).
What interests me most about Cascade, though, is how the company is positioning itself for the next cycles in the semiconductor industry. The company recently launched a series of new products, including the fully-automated and scalable CM300, the Smart 150 lab probe station, and the APS200Tesla Fab prober. This last one is particularly interesting to me as it not only addresses power ICs and adds tens of millions of dollars to Cascade's addressable market, but it also represents further expansion into the production test market - a large area where Cascade has historically had a more modest presence.
Likewise, the company recently acquired the reliability test products unit of Aetrium (NASDAQ:ATRM), which will improve Cascade's wafer-level reliability testing offerings. Then, a couple of weeks ago, Cascade acquired Germany's ATT Advanced Temperature Test Systems, a manufacturer of advanced thermal systems used in wafer testing. This wasn't a cheap deal (around $30 million, with about one-third up front in cash), but ATT has been seeing good revenue growth and strong margins.
Better still, these deals (particularly ATT) should advance the company's efforts to participate in the industry's migration to next-gen structures/designs like 3D and FinFET, as well as larger (450mm) wafers. While Cascade is going to have its work cut out grabbing share from FormFactor in areas like system on a chip, I do believe there will be solid growth potential on both the engineering and production side for Cascade.
The Opportunity Is There … Will Execution Follow?
I believe that there are a lot of things Cascade can do to grow the business. Acquisitions like ATT can increase the company's share-of-wallet with existing customers, as well as facilitate the development of better systems that take share from rivals like Vector and Wentworth Labs. I also believe the company's move towards a greater focus on production could unlock tens of millions, and maybe hundreds of millions, of dollars in addressable market.
Of course, there's a big difference between "can" and "will". I don't necessarily blame Cascade for its inconsistent revenue performance - that's just the nature of the industry. What does concern me more, though, is the inconsistent history with respect to margins and free cash flow. Cascade isn't alone here, FormFactor and Micronics have been just as erratic, but the real trick in valuing Cascade is in figuring out whether the company's goals of better margins (the company recently laid out a target for company-wide gross margin of 50% against a trailing 12-month margin of about 44%) will lead to sustained positive free cash flow.
I'm cautiously optimistic at this point. I'm projecting long-term revenue growth of 6%, but I do believe there could be upside to that number if Cascade gains share with the industry transition to new designs. I am expecting Cascade's inconsistent free cash flow pattern to continue (with FCF margin peaking in the teens and then dropping into the single digits), but I am expecting it to remain positive and I am looking for long-term growth of around 6% to 7%.
The Bottom Line
Discounting those cash flows back at a 12% discount rate generates a price target of $11.50, suggesting that Cascade is still priced to deliver some pretty appealing year-to-year appreciation. I also believe the shares are priced fairly attractively on the basis of other metrics - EV/EBITDA, EV/revenue, and ROE/P/BV all suggest double-digit undervaluation at today's price.
By no means is this a "widows and orphans" type of stock, and there are valid reasons to doubt whether Cascade can consistently deliver positive free cash flow (let alone fend off FormFactor if that company chooses to address more of Cascade's target markets). Even so, I think there is still a decent risk/return here, though I'd really like to see a retreat into the single digits before adding shares in my own account.
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.