Advanced Energy Industries' (NASDAQ:AEIS) first-quarter results reflect at least some of the reasons why I wasn't too eager to overpay for the stock back in early February. While AEIS has good technology and products for both the semiconductor equipment and solar industries, these are volatile businesses, and demand/orders for semi equipment in particular has proven to be quite volatile this year. The company has a lot of work left to do in bringing the solar inverter business to profitability, but the nearly 50% haircut since late February does have this stock at a more interesting level.
Results Weren't Great...
AEIS reported 26% yoy revenue growth in the first quarter, just missing sell-side expectations. Overall Precision Power revenue rose 34%, with semiconductor market sales up 72% yoy, but down about 5% sequentially. Non-semiconductor thin film sales were close to flat, though with multiple moving parts. The solar inverter business saw sales grow 16% over last year, but fall 16% sequentially. Keep in mind that this quarter saw the company come in a little light of expectations that had been lowered after the fourth quarter.
AEIS also came in a little light on margins, primarily due to ongoing weakness in inverter margins. Gross margin slipped a point from last year (and 120bp sequentially). Reported segment operating income rose almost 120% as thin-film profits more than tripled. Due in part to higher costs associated with transferring products to the new Shenzhen facility, inverter profits slipped back into the red this quarter.
… Guidance Was Worse
Like MKS Instruments (NASDAQ:MKSI), one of the company's prime rivals in semi equipment, AEIS had a decent enough reported first quarter, but the guidance was very disappointing. The midpoint of management's revenue guidance was 10% below the prior average estimate, in line with MKSI's 12% negative revision. Not surprisingly, both companies also reported weaker expected profits for the quarter ahead.
Soft demand is an issue in both sides of the business. Semiconductor equipment orders should pick up later this year, but the solar inverter business is still stuck in a phase of "predictable unpredictability", particularly as the company does not have exposure to the better growth right now in residential.
Semi Demand Looks Like An Industry Problem
The semi equipment space is still a mess right now. Investors and analysts continue to expect healthy equipment demand this year as fabs like TSMC, Samsung, and Intel ramp up next-gen architectures, but recent guidance has not only pointed to less yoy spending growth, but spending shifted later in the year, as these companies still need to work out some issues.
Complicating matters for AEIS is that the company sells primarily to other equipment OEMs. Applied Materials (NASDAQ:AMAT) and Lam Research (NASDAQ:LRCX) appear to be working down component inventories, and that is likely what is leading to lower sales expectations for Advanced Energy Industries. Once again, I don't see a meaningful share shift or signs that AEIS is losing ground to MKS Instruments, but knowing that others are suffering too really doesn't make the situation better for the company.
Solar Still A Work In Progress
I continue to have some reservations about Advanced Energy Industries' strategy in the solar inverter business. In particular, I am worried that the company's lack of exposure to the residential market is going to limit its growth potential. Other major inverter companies, including SMA Solar (OTC:SMTGY), ABB Ltd. (NYSE:ABB), Siemens (SI), and Eaton Corp. (NYSE:ETN), have residential inverter businesses, and it seems like a natural part of a broad product portfolio.
I am also worried about the profitability of this business. Solar is still in its early days in terms of installations, but high market share didn't save Satcon, and SMA Solar has racked up losses as well. Most industry journals seem to be on board with the idea that pricing will continue to drop at a fairly aggressive rate, and that's going to make it challenging to establish strong margins anytime soon. Moving production to China will help AEIS, particularly as cheaper labor is a significant part of the cost advantage of Chinese inverters, but the market is not likely to have indefinite patience on the margin progression of this business.
Plenty Of Uncertainty In The Growth Outlook
The basic premise underlying the AEIS model is that the semiconductor business will continue to generate boom/bust profit cycles, with expansion into other end-markets (like industrial) perhaps softening the cyclicality a bit. While the semi cycle goes through its paces, the idea is that the growing inverter business will eventually start making a more meaningful contribution to profits and cash flow.
I'm still looking for long-term revenue growth in the neighborhood of 7%, with double-digit FCF growth fueled by double-digit FCF margins. Actual results are likely to be more volatile year-to-year, but I do believe that AEIS can generate long-term FCF growth in the mid-teens on a "full cycle" basis.
The Bottom Line
I don't expect AEIS to retest its prior P/TBV lows, but there would be about 50% risk to the stock price if it did. Instead, I believe that my model supports a fair value around $24 today, with similar upside from EV/EBITDA and EV/revenue approaches. Clearly, a lot of this is predicated on a second-half recovery in chip equipment orders; if orders continue to slide, the inverter business is clearly not going to be able to fill the profit gap this year.
Although I don't love all aspects of management's strategy at AEIS, value is value, and I think these shares are back to an interesting level. I expect a lot of investors will move to a wait-and-see attitude after getting burned on chip equipment names, but that can often mean opportunity for more daring investors willing to risk losses in the pursuit of rebound gains.
Disclosure: I am long ABB. 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.