Orbotech: Relishing In China's Growing Appetite For Consumer Electronics

| About: Orbotech Ltd. (ORBK)
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(Editor's note: Orbotech Ltd. is scheduled to release earnings results on Thursday October 31)

We believe Orbotech is best-positioned within a small, but rapidly evolving industry that is being overlooked by the market. We expect strong industry tailwinds and a recent restructuring to drive top-line growth and margin expansion to above normal levels, resulting in ~40% upside and a 2014E fair value target north of $16.

COMPANY BACKGROUND

Orbotech Ltd. (NASDAQ:ORBK), located in Israel, is the market share leader in the production of inspection, testing, repair, and monitoring equipment for the printed circuit board (PCB) and flat panel display (FPD) manufacturing industries. Printed circuit boards are the backbone of electronic devices and flat screens are increasingly installed alongside, which translates to nearly every branded device relying on ORBK's equipment in the manufacturing process. This equipment is installed in customers' plants to enhance yield and increase cost savings, thus resulting in a high return on investment and being viewed more as a partner than vendor. Familiar brands served by ORBK's customers would be top-notch smartphones and tablets from Apple (NASDAQ:AAPL) and Amazon (NASDAQ:AMZN), or Ford's (NYSE:F) automobiles with built-in infotainment. Orbotech's core business is currently split 70% PCB to 28% FPD, with service/license revenues accounting for 33% of that total. The more visible service revenue benefits from ORBK's largest-in-industry installed base: ~10,500 PCB systems and over 1700 FPD systems. Geographically, revenues from China were 56% of total with Asia generating well over 80%. Notable customers, primarily from the FPD market, consist of: Samsung (OTC:SSNLF), Corning (NYSE:GLW), LG Display (NYSE:LPL), Sharp (OTCPK:SHCAY), AU Optronics, (NYSE:AUO) and China's BOE and China Star.

INDUSTRY OVERVIEW

Both the printed circuit board and flat panel display equipment supplier industries are highly cyclical and dependent on global economic growth, and ultimately, the end consumer. The last half of 2011 through 2012, was a prime example as uncertainty stemming from U.S. fiscal issues and a near financial collapse in Europe, threw a wrinkle in the major PCB and FPD players' forecasts for expansion. This led to a drastic fall off in the FPD market forcing many equipment vendors to restructure operations and take massive write-downs/impairments. More recently, however, the tide has turned as the expectations for the future of Chinese consumer spending draws closer to relevancy. This has converted the PCB and FPD industries from a passive stance into aggressive expansion as new plant builds are ramping and further planning is in discussion. In the most recent conference call management cites, "The pipeline is quite healthy in terms of orders that were already closed and business discussions. Our customers are reporting that they are expecting a good H2." The country of choice for new expansion has been China, aided by government incentives for the FPD market and inclusion of greater PCB development in the next "5-year plan." An example of migration is the Samsung-Corning joint venture, SCP, building a $600 million plant in the Wuxi district to make LCD displays. A leading indicator for equipment suppliers are plant expansions where Orbotech management estimates, "a typical FPD fabrication plant, costing between $2 and $4 billion and taking about a year to construct, approximately 2.5% of the construction costs are allocated to yield-enhancement products of the type we sell." This equates to a range of $50-$100 million in revenue for the small yield-enhancement industry. Vying for these design wins on the PCB side are main competitors: Camtek (NASDAQ:CAMT), Dainippon Screen (OTC:DINRF), Fuji Film (OTCPK:FUJIY), Hitachi Group (OTCPK:HTHIY), and Electro Scientific Industries (NASDAQ:ESIO). On the FPD side notable competitors include: a subsidiary of Applied Materials (NASDAQ:AMAT) and Charm Engineering of Korea.

CATALYSTS

Industry tailwinds are blowing in the direction of Orbotech. One main driver is consumer expectations for more complex and smaller devices with high performance components that require advanced manufacturing, which in turn increases the likelihood of greater defects. Also, the more complex electronic devices become, the more costly they are to produce, hence, defects have a greater impact. Manufacturers looking for optimal efficiency and cost savings look to ORBK's end-to-end solutions to catch and repair defects on-site in real-time. Orbotech is considered to have the only end-to-end yield-enhancing solutions of its kind; which is a great differentiator and a top reason for holding the market share lead. Another driver is the emergence of 3G technology and eventual global build out of LTE (or faster) that is increasing penetration rates for high-end smartphones and tablets. Orbotech management recently laid out estimates for mobile device growth and resulting revenue per 250 million additional devices would equal $250 in company revenue by 2016. At the end 2012, management assumed it received $.50 per mobile device shipment, so by simple math at the end of 2014 each new device should equal ~$.75 in new revenue. Given management's rough estimate for the difference from 2013 to 2014 we get 500 million additional sales x $.75 = $375 million in consumer device revenue. Since this is unconfirmed, we expect the stated 2012, $120 million from new markets will reach a more conservative $150 million in 2014. Dividing $120 million by 2012 total revenue of $400 million we get 30%, and translating the $150 million would equal $500 million in total revenue for 2014. Yet another driver is the resurgence of large flat panel displays from a rise in demand for Ultra-High Definition TV's. NPD DisplaySearch stated global TV shipments grew 4% in Q1, with China growing at a whopping 28%. This has led to increased capacity utilization and we believe ORBK is best-positioned to capitalize on future growth.

Orbotech's strong foothold in China is a key determinate of design wins from expanding customers. Over 40% of employees work in China providing a strong support network, sales, and engineering infrastructure, which creates deeper relationships with locals. This close proximity to the greatest proportion of its install base allows ORBK to better understand each customer and be first-to-market with desired solutions. The world's fifth largest LCD maker, BOE, raised $7.5 billion in July for three new production lines in China and decided to receive vacuum pumps from Edwards Group (NASDAQ:EVAC), citing the reasons as, "the company's strong presence in Asia, with multiple local manufacturing and service facilities in the region, including a new factory being built in Qingdao." That sounds very similar to ORBK's China operations and we expect an increased presence in China to lead to even more design wins. The Chinese PCB industry is expected to grow from 42% of global output last year to 2016 global output of 49.4%; and China's FPD industry is forecasted to rise to 23.6% of 2016 LCD output.

Shareholder friendly management and a strong balance sheet should boost the appeal of ORBK. A new CEO, Asher Levy, took over in Q4 of last year as the company announced restructuring and buyback plans to increase shareholder value. The buyback plan was $30 million in stock by the end of 2013 with $17 spent as of the latest quarter. The restructure was implemented to reduce workforce and facility size resulting in a ~$50 charge for 2012, and future operating expense savings of $10-$12 million going forward. This is expanding gross margins back towards the mid-40s and operating margins to the mid-teens. Mr. Levy also reorganized the company into two new categories (Strategy and Business Development and Global Product Organization) to align the company's strengths with growth opportunities, which includes possible acquisitions. The balance sheet is significantly strong with $200+ million in cash/s-t investments and debt paid down to a low $16 million. Overall, we believe the recent developments and quality of the balance should benefit shareholders as the story plays out.

Service/License revenue should increase visibility and lower operational risk. Given the cyclicality of the industry, revenues can be lumpy leading to volatility within operations and also, ORBK's stock price. An example is 2012 total revenue down 29% as FPD sales cratered 56%, meanwhile attached services revenue benefiting from the existing installed systems rose ~11%. The growth of installed systems flattened in 2012, but we expect resumed growth in light of previously mentioned new plant expansion:

PCB systems

FPD systems

2010

9000

1400

2011

10000

1700

2012

10500

1700

2013E

11300

1800

2014E

12100

1900

The rise in installed systems should further grow services revenue and enhance visibility leading to a smoother operational environment.

VALUATION

We believe valuing ORBK shares is quite challenging due to an inherently volatile industry creating a highly uncertain long-term outlook. Also, there is not an appropriate group of relative peers for comparison analysis, as ORBK is the more advanced market leader and the only one-stop shop in its niche area. That said, we do believe in the evidence presented above that industry leading catalysts should drive growth and recent internal improvements should lower risk. With a long-term view difficult to predict we focus on the developing trends of plant expansion and increased consumer device penetration to forecast 2014 results:

(Thousands)

2010

2011

2012

2013E

2014E

REVENUES:

Sale of products

$409,532

$423,968

$246,497

$304,500

$334,000

Services rendered

119,823

141,345

154,234

$147,800

157,000

Total Revenues

529,355

565,313

400,731

$452,300

491,000

Gross Profit

216,454

229,128

151,253

194,489

213,585

operating income

57,687

60,061

-40,816

non-GAAP op. inc.

54,000

73650

Taxes

7,397

7,677

456

9180

13700

Net Income

34,145

47,339

-45,579

44820

59950

Outstanding Shares

35,778

40,816

43,501

43,000

44,000

EPS

0.95

1.16

-1.05

1.04

1.36

The 2014E for EPS is $1.36 based on 8.6% top-line growth, 43.5% gross margins and 15% Non-GAAP operating income. This correlates to management's top-line growth 8.2% compounded through 2016, with GMs of 44.5% and Non-GAAP operating of 16.5%. We believe management has the best ability to accurately predict future results and, therefore, we stay conservatively below stated estimates. Also, we choose to stay conservative due to the amount of industry risk and challenges surrounding future predictability by applying a forward P/E of only 12x. This results in a PT north of $16 and upside from currents levels of ~40%.

RISKS

We view the most relevant risks as: dependent upon strength in the global economy, an ongoing criminal liability suit in Korea, a large portion of operational revenue coming from China with lax regulatory/patent protection rules, pricing pressure, and Israel Political conditions. The global economy is in a slow growth mode, but over the near term we expect the ORBK's target markets to expand at an above average rate. The company has stated the liability suit could result in a somewhat meaningless $1.38 million charge. The more important factor at risk is reputation, which ORBK has taken steps to sustain. The lax patent protection rules in China is a price of doing business in the country. We expect ORBK's constant innovation to mitigate this risk as 90% of revenue comes from products introduced within the last 3 years. The Israeli political conditions are out of the control of Orbotech and we believe we reflected such risk in the below average multiple.

CONCLUSION

Overall, we believe ORBK's favorable industry dynamics, expanding margins, greater revenue visibility, and a shareholder friendly management team with a strong balance sheet offers an attractive risk/reward opportunity from current price levels. Our conservative forward P/E multiple of 12x is applied to our 2014 EPS estimate of $1.36, resulting in ~40% upside.

Disclosure: I am long ORBK. 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.