Zygo: Overlooked, Cash-Heavy, And Ready To Rebound

| About: Zygo Corporation (ZIGO)
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Summary

Tailwinds in key markets and a positive shift in product mix benefit bottom line results.

Hedge fund MAK Capital One (holding ~23% of ZIGO shares) recently took over as Board chairman; an unlocking/creation of shareholder value expected soon.

Zero sell-side coverage of ZIGO shares has aided an inefficiency gap; any uptick in investor awareness could narrow the gap.

Limited downside, with 30% of MV in cash and consistent institutional support at ~1.1-1.2 tangible BV.

Our estimated CY2014 price target of $22 represents potential upside of 40%.

COMPANY OVERVIEW

Zygo Corporation (NASDAQ:ZIGO) offers Metrology solutions and Optical systems/components for OEMs in the semiconductor, medical, defense, and automotive industries. The higher-margin Metrology segment (~65% of revenue) provides yield-enhancing, measurement, and test solutions, such as: 3-D optical profilers, precision positioning systems, and interferometers. The lower-margin Optical segment (~35% of revenue) provides optical components and subsystems, including: aspheric lenses, mirrors, and machined glass windows for applications in EUV lithography, ophthalmic surgery devices, and aerial reconnaissance. Zygo's competitive advantage relies on the ability to leverage the company's leading technology and broad patent portfolio to consistently introduce value-added/custom-engineered products. Large competitors consist of Agilent (NYSE:A), Ametek (NYSE:AME), KLA-Tencor (NASDAQ:KLAC), L-3 Communications (NYSE:LLL), and smaller peers include II-VI Inc. (NASDAQ:IIVI), Newport (NASDAQ:NEWP), and Rudolph Tech (NASDAQ:RTEC).

INVESTMENT SUMMARY

Positioned in several key markets with tailwinds. Against the backdrop of a weak semiconductor capital equipment sector and a depressed defense industry in 2013, Zygo's operating results held fairly steady. Management credits product/end market diversity and customization capabilities, not to mention a culture of consistently introducing next-generation prototypes. As revenues began fading from customer push-outs in late 2012, bookings and backlog began hitting near record levels, indicating a continued presence of demand. This has recently come to fruition (Q2 revenue growth of 39%), and set Zygo up to capitalize on future opportunities. SEMI expects Zygo's largest addressable market, the test and assembly/package portion of the semiconductor capital equipment space, to grow at a combined rate of 9.6% for 2014. Management sees record shipments of precision positioning systems and strong interest for the new Nexview family and Mini Interferometer as leading the Metrology segment higher. Couple this with Zygo's leverage (~20% of revenue) to Japan's semiconductor equipment market that is expected to double in 2014, and we are comfortable in conservatively modeling Metrology to grow 8%. On the Optical side, areas of increasing activity are in Ophthalmic surgery devices and unmanned aerial vehicles (drones), expected to grow 12.5% and ~14% in 2014, respectively. We believe these two niche industries will lead Zygo's Optical revenues higher, resulting in a conservative model of growth of 1.6%.

(thousands)

CY2012

CY2013

CY2014E

Metrology revenue

98,043

106,814

115,300

Optical revenue

59,603

56,019

56,900

Total revenue

157,646

162,833

172,200

Shift in mix to higher-margin products. Zygo surpassed target gross margins of 50%, reaching 51.5% in the most recent quarter, primarily driven by a larger portion of revenues from Metrology shipments and higher-margin Optical products. Management cited Q2 shipments of high-margin precision positioning systems were at a record pace, and sees the trend continuing through Q3. This resulted in Metrology segment gross margins jumping to 61% from 54% a year ago. We believe Zygo can maintain a 60% profile for Metrology, mostly due to new products entering a growing semiconductor capital equipment space and an expansion of footprint. As additions to the sales force begin to tackle a larger potential base, we see Metrology adjusted EBITDA margins in the range of 22%-25%.

The increasing popularity of drones is boosting demand for Zygo's aerial reconnaissance lenses, which in turn, is incrementally impacting Optical's gross margins. This is one reason the last two quarters have seen sequential moves higher, now at 30%. Outside of the defense industry, we foresee the growing ophthalmic surgery devices market (laser eye surgery) and an uptick in the nascent EUV lithography space absorbing overheads at a higher rate. Plus, management believes the vertical integration of the new Tucson facility could benefit gross margins by 200 basis points. All in, this leads us to believe Optical's gross margin is capable of returning to historical norms of 33%-35%, with adjusted EBITDA margins of 10%-15%.

As for percentage of revenue, based on previous quarters' bookings and cited quoting activity, we expect the Metrology segment to continue to outgrow the Optical segment, resulting in higher consolidated margins:

CY2013

CY2014E

Metrology % of rev.

66%

67%

Optical % of rev.

34%

33%

Metrology gross margin

56%

60%

Optical gross margin

29%

34%

Consolidated adjusted EBITDA margin

15.5%

19.9%

Board and C-Suite upgrades could indicate a change in allocation. One of the most attractive pieces of Zygo is $91 million in cash with zero debt (30% of market value). Combine this with Zygo's largest investor (~23% of shares), MAK Capital One's founder, Michael Kaufman recently taking over as Board chairman, and we have a recipe for increasing shareholder value. Zygo has $5 million of availability from a 2007 repurchase program, and we believe the Board can increase this back to a $25 million program with ease, accounting for >8% of shares at current levels. At the same time Mr. Kaufman took chair, the Board announced a new interim CEO, Gary Willis (former Zygo chair and CEO), with focus on "achieving Zygo's full potential… and enhancing Zygo's leadership position in its markets." A fellow shareholder asked Mr. Willis to discuss cash allocation plans on the last Q2 call, to which the CEO replied, "…So we are, on a continuing basis, looking to utilize the cash to lever that for continued revenue and profit growth. And you can count on that continuing going forward." Mr. Willis was a Board director during Zygo's last acquisition, entering the EUV lithography space, which resulted in a rare gain on acquisition, with operations immediately accretive. Thus, the duo of Kaufman and interim Willis give us comfort in Zygo realizing future value, whether unlocked through cash distribution or created inorganically. With around four months on the job, we are expecting a strategic signal soon.

Zero sell-side coverage, though strong institutional support. Zygo's stock has been left to float in the wind, as the last analyst coverage dates back to 2010. This is an obvious area of potential improvement, if the company could attract an analyst to properly create investor awareness, and hence, aid in narrowing the inefficiency gap. This is most likely due to Zygo's small size and inherently boring nature. Though, despite the Wall Street snub, we take comfort in certain institutions adding shares, from MAK Capital One (now an insider), Royce & Associates, Dimensional Advisors, and especially, T. Rowe Price's small-cap value fund headed by Preston Athey. Mr. Athey's fund has added shares to its near-9% stake (2nd-largest Zygo investor) throughout 2013. A quote from the fund manager during a recent interview, "if I don't think I can theoretically get a double in 12-18 months, in most cases I probably won't buy it," suggests that by adding shares, he sees potential upside. This is no reason to make an investment decision, but our takeaway is that smart money is consistently supporting shares at ~1.1-1.2 tangible book value, representing a lowered-risk scenario from current price levels. Given the expectation for Zygo's margin improvement and a sizeable cash balance, we envision this support level at least maintaining for the foreseeable future.

VALUATION

Our estimation for CY2014 is based on the mid-point of our margin estimates stated above. (Note: Zygo's FY ends June 30th)

(thousands)

CY2013

CY2014E

Metrology revenue

106,814

115,300

Optical revenue

56,019

56,900

Total revenue

162,833

172,200

Metrology gross profit

59,900

69,180

Optical gross profit

16,300

19,346

Total gross profit

76,200

88,526

Consolidated adj. EBITDA

23,870

34,200

Our chosen method of valuation is relative to peers separated by segment due to revenue and margin differential. The Metrology segment peers have a higher-margin profile than the Optical segment peers, and thus, the forward EV/EBITDA multiples are significantly higher (source: Thomson I/B/E/S):

Metrology peers

EV/EBITDA mult.

Optical peers

EV/EBITDA mult.

Agilent

12x

L-3 Com.

8.5x

Ametek

16x

II-VI

9x

KLA-Tencor

8.5x

Newport

9x

Rudolph Tech

18x

Average

12.7x

Average

8.8x

To account for company size difference and remain conservative given embedded risks, we assign lower forward EV multiples of 11x for Metrology and 6x for Optical:

(thousands)

Adj. EBITDA

EV mult.

EV

Zygo Metrology

27,100

11x

298,100

Zygo Optical

7,100

6x

42,600

Total EV

340,700

Add cash

91,000

Market Cap

431,700

Diluted shares

19,500

Share price

$22

Our CY2014 fair value estimate of $22 represents potential upside of 40%.

RISKS

The cyclicality of Zygo's end-markets may affect order activity and timing, resulting in a negative impact to operations. The recoveries in the semiconductor and defense markets may be less beneficial, or take longer than expected, which may negatively affect our estimates. Increased competition from larger, more resourceful players may impede Zygo's ability to reach stated potential. Shares are thinly traded, and price volatility may be severe. However, this is somewhat mitigated by the long-term investment horizons of the majority of Zygo's investor base.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in ZIGO over 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.