A lot of the "yeah, but's" that I mentioned in my last piece on electron microscopy company FEI Company (NASDAQ:FEIC) have come to pass. Spending on semiconductor equipment has disappointed as major fabs like TSMC (NYSE:TSM), Intel (NASDAQ:INTC), and Samsung (OTC:SSNLF) revise their plans, oil/gas demand has dried up, life science demand has been consistently inconsistent, and the company lowered its long-term revenue growth guidance during its midyear analyst day.
None of these really surprised me, particularly the guidance revision, so the impact to my valuation wasn't too extreme. There's still ongoing risk to the quarterly results given the uncertainty in semiconductor industry spending, but the valuation is pretty interesting for a market leader with multiple growth drivers. There's still a risk that the company's margin targets prove too ambitious, but at around 15% below my fair value, it's worth a closer look.
Life Sciences In The Lead
FEI reported 3% revenue growth in the fourth quarter, or 8% in organic terms, and that was good for a small beat relative to the sell-side. The Science side of the business led the way with 12% organic growth on strength in life sciences and improving demand in material sciences. Industrial demand remains the laggard, but still up 3%, as semiconductor spending remains inconsistent and generally disappointing.
Management at FEI has been talking more seriously about margin improvements and they seem to be delivering. Gross margin improved two points from last year, and operating income rose 14% to more or less preserve that margin leverage. Given that R&D spending was flat in the fourth quarter and down around 7% for the year, I wonder if the company has approached a point where incremental R&D spending growth will trail revenue growth.
Although reported bookings growth declined 4% as reported, the book-to-bill ratio was 1.08x and the constant currency organic figure was up 11%. Whether or not currency effects should be excluded is an interesting (if academic) debate, given that currencies don't necessarily zero out over time and FEI does a significant amount of business out of the United States. Either way, orders were stronger in the Science business, with reported bookings up 6% and organic bookings up 14%, while Industrial books were down 11% as reported and up 4% in organic terms.
Industrial - Waiting For The Next Ramp
There's a long line of companies waiting (and hoping) for spending on next-gen (10nm and below) chip equipment. FEI has historically generated around 40% of its revenue from the semiconductor space, where the company's systems (scanning electron microscopes, transmission electron microscopes, and dual beam systems) are used in the design of new circuits and in inspection/quality control as fabs begin production at new nodes.
This is a significant market and a significant opportunity for FEI. While FEI is quite strong at the high end of the market, both JEOL and Hitachi High-Tech are meaningful competitors in the semiconductor space. FEI enjoys strong market share, but more and more of the industry's spending is concentrated on the biggest players like TSMC, Intel, and Samsung, and that makes the market dynamics less predictable.
Right now, the question is when the spending on the 10nm ramp really shows up. FEI should be well placed, though, as the company's systems are not only able to handle the new 3D architectures, but do so quickly. FEI is also expanding its offerings, as the company acquired DCG in 2015 and will look to eventually pair this company's electrical fault isolation capabilities with its physical fault isolation.
Life Sciences Coming Around To EM
Structural biology has long relied on X-ray crystallography to determine molecular structures and the relationship of those structures, but FEI's high-resolution cryo-electron microscopy is seeing steady growth in adoption. While cryo-EM is not a flawless approach, it has an advantage over X-ray crystallography in that structures can be evaluated in their normal in situ state - an important consideration when understanding a disease (like Alzheimer's) relies upon a proper understanding and characterization of protein structures.
I'm not looking for a transformative "ah hah!" moment, but rather steady penetration of FEI's systems into structural biology at the academic and corporate (biopharma) levels. JEOL, Hitachi High-Tech, and Carl Zeiss will be there along the way, but I believe FEI has an edge at the high end of the market. That, though, is a mixed blessing, as the high cost of these systems (over $1 million) can lead to a great deal more oversight in the budgeting process. I'd also note that companies like Bruker (NASDAQ:BRKR) aren't going to just surrender their existing business in life science; there are still valid applications for nuclear magnetic resonance spectroscopy and X-ray crystallography.
More Realistic On Revenue, But What About Margins?
I never thought management's prior goal of double-digit organic revenue growth was realistic or attainable, and I don't think the market really believed it either. The revised expectations for mid-to-high single-digit growth do seem more reasonable, though I don't see the high end coming into play unless/until the mining and oil/gas sectors recover to a point where companies are willing to spend again on high-value equipment for exploration activities.
I'm still looking for around 6% long-term revenue growth, with the timing and magnitude of the 10nm-related spend a key unknown for the next couple of years. Life sciences and material sciences can generate a "keep the lights on" level of revenue growth, but getting to 6% is going to require ongoing growth in semiconductors over the long term and it's well worth noting that the company hasn't delivered 6%-plus revenue growth in several years.
Management is also looking to improve margins over time, and like its guidance with revenue, I look at this as ambitious but achievable. Getting over the $1 billion to $1.1 billion mark should open up a level of operating leverage that makes double-digit FCF margins possible, but there are obviously no guarantees. I think FEI can get to the mid-to-high teens with FCF margins over time, but the fair value in my model falls into the $50s if they can never get past 10%. With my expectations as they are, I'm looking for mid-teens FCF growth over the long term, supporting a fair value of around $84 today.
The Bottom Line
The market has definitely soured on its former favorites, and FEI would seem to fit that group even though the long-term growth assumptions baked into the price still aren't what I'd call "conservative." While the life sciences business is growing nicely, it's going to take semiconductor spending to get the market excited again, and that could still take a couple of quarters to show up in FEI's results.
Disclosure: I/we 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.