Nanometrics: A High-Growth Firm For Medium Investment Horizon

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About: Nanometrics Incorporated (NANO), Includes: BRKS, KLAC, MKSI, NVMI, RTEC
by: Abrar Hassan Saadi

Summary

Major chip manufacturers use Nano's automated systems, which account for substantial portion of its total revenues.

Sales are growing rapidly over last few years with stabilized profitability and efficient risk management.

Share repurchases worth of $23 million in last one year might indicate that the firm thinks it is undervalued.

Valuation shows that the firm is almost correctly priced in the market.

The advent of smaller and more powerful chips has placed supreme needs for advanced process control metrology and inspection systems. With more than 14 systems divided into segments such as automated, integrated, analysis and material characterization, Nanometrics (NANO) has successfully placed itself as a top performing process control metrology and inspection systems provider. Nano's flagship automated system Atlas III is adopted by all of the major 3D-NAND manufacturers and two of the largest DRAM manufacturers. Having almost all major global chip manufacturers as customers and stepped-up investments in R&D, I think Nano can touch its own revenue growth expectation of 20% yoy economically. My valuation model indicates that the current intrinsic value of Nano is $33.55 per share, which shows that the share is overvalued by roughly $3.5 a share (Nano is $37.05 at the time of writing this article). However, relative value analysis shows varied results depending on the specific multiple. While P/B and EBITDA indicate Nano is slightly undervalued, P/E indicates that it might be otherwise. To better reflect the data, I have determined the upper and lower range by using 95% confidence interval after which Nano looks fairly priced from an overall relative value perspective. Further investigation into business prospects and financial analytics indicates that the firm has a good potential for high-growth portfolios. However, because my DCF indicates that there is room for slight correction in the market, it's better to hold Nano if you are currently invested in, and do not enter new positions if it doesn't at least partially converge to its intrinsic value.

2015 2016 2017
Samsung Electronics Co. (OTC:SSNLF) 13% - 26%
SK Hynix (OTC:HXSCF) 11% 15% 13%
Micron Technology (NASDAQ:MU) 16% 20% 12%
Intel Corporation (NASDAQ:INTC) - 18% 11%
Toshiba Corporation (OTCPK:TOSBF) 10% - 11%
Taiwan Semiconductor Manufacturing Co. (NYSE:TSM) 19% 10% -

Figure: Customers who individually account for more than 10% of Nano's revenue, Source: 10-K

"…This means that our Atlas III has now been adopted by each of the five 3D-NAND manufacturers and both of the two largest DRAM manufacturers. As testament to the rapid and successful introduction of the Atlas III, we shipped our 100th system earlier this month."- Dr. Pierre-Yves Lesaicherre, President and CEO of Nanometrics.

Source: 10-K

Currently, memory manufacturers are rushing to capitalize 3D NAND technologies and indicate rising need for efficient process control and inspection systems. Because all the major NAND manufacturers have already adopted the Atlas III system, it is clear that the systems are standard systems that are widely accepted. The Atlas family was introduced first in 2004, and gradually, it developed with advanced OCD and thin films metrology through ellipsometry and reflectometry technologies. Now, Nano's systems are a widely accepted choice among giants as Samsung, SK Hynix, Micron, Intel, Toshiba, and others. This is reflected in Nano's five year CAGR of 12%+ in sales. Substantial portion of Nano's sales comes from its automated systems line, roughly 58.5% in last year, and 57.6% the year before. Under its automated system segment, Nano's offerings are Atlas III, Atlas II+/Atlas XP+ and UniFire, primary market of which is the semiconductor industry and applications of which includes film thickness, film stress, CD, Overlay, Inspection and advanced packaging applications. Integrated systems and material characterizations systems contributed roughly 16.31% and 8.23% to sales, respectively. The remaining portion is generated by its service segment.

2013

2014

2015

2016

2017

EBIT Margin

-15.88%

-6.75%

3.13%

13.30%

16.78%

Profit Margin

-9.80%

-18.70%

1.60%

19.90%

11.70%

FCF Margin

-5.63%

-3.86%

-0.15%

18.85%

5.95%

ROIC

-11.21%

-7.21%

2.90%

15.70%

18.01%

Source: Stockrow

Nano operates in a high growth but volatile industry, and I expect this nature to continue in coming years. Nano's volatility can be attributed more to capital layouts and tax issues than sales, which is a positive factor nonetheless. Sales have featured double-digit growth over last five years, but profitability fluctuated greatly in the first half of those years and then stabilized to a more narrow range in last two years. In last one year, Nano has repurchased more than $23 million of common stock under its share repurchase plan. This could signal that the firm thinks that they are undervalued in the market, and some of its impact can attributed to its rising stock price for last five months. However, technological aspects and new customer wins remain critical factor for Nano. President and CEO of Nano Pierre-Yves Lesaicherre said in its latest earnings call that capex in DRAM, NAND, foundry and logic is expected to continue through 2019, which I feel will strengthen their market position by solidifying technological advancement. Current technological factors for process control manufacturers include improvement across optical critical dimension metrology, 3D transistor architecture and high density 3D-NAND. Improvement in these areas will contribute to more accurate device dimensions, density and performance, making the overall process control more efficient and powerful. As I wrote earlier, beside technological factors, new customer wins remain a major factor for Nano. Last year, a major shift in memory spending in Korea drove the region's contribution substantially in Nano's sales. Sales in South Korea contributed 36% last year compared to 20% the year before. Lesaicherre told analyst that the firm has a growing pipeline of new products and new customers that are incremental to its current level of business. He also added they see opportunities for additional market share gains and further growth in our software and services businesses.

Revenue by Region

2015

2016

2017

United States

20%

14%

13%

China

9%

20%

12%

South Korea

16%

20%

36%

Singapore

9%

17%

8%

Japan

17%

12%

16%

Taiwan

25%

12%

8%

All other countries

4%

5%

7%

Source: 10-K

Let's now come to valuation. I have used a DCF model and relative value model to assess Nano shares. In order to arrive at $33.55 as its intrinsic price, I have assumed 11.50% in weighted average cost of capital for the firm and 3% perpetual growth rate for terminal year cash flow, which is five years from now on. This indicates that Nano is overvalued by $3.5 per share. Relative value ranges show that Nanometrics, Nova (NVMI) and Rudolph (RTEC) reflects greater conformance than KLA Tencor (KLAC), MKS Instruments (MKSI) and Brooks Automation (BRKS) by being inside the range. As the table shows, marked with red are the firms that exhibit values outside the range. Combining the results from both the DCF and relative value table, it's safe to say that Nano is very slightly tilted towards overvalued, but not quiet. As a result, investors who already have a position should hold it, while interested ones should wait for some time to see if they can get slightly better place. Nonetheless, the mispricing is only $3.5 per share and might not be large enough to discourage growth investors with medium investment horizon.

DCF Model (full table posted at the end of the article in the notes section).

2017

2018F

2019F

2020F

2021F

2022F

Unlevered Free Cash Flow

53,092,000

54,870,437

58,895,055

63,228,903

67,566,231

72,148,175

WACC

11.50%

Discount Factor

0.8969

0.8044

0.7214

0.6470

0.5803

Present Value of Free Cash Flow

49,211,154

47,372,804

45,613,253

43,714,974

41,864,992

Total PV of FCF

227,777,178

Terminal year perpetual rate

3.00%

Terminal Value

874,266,118.29

PV of terminal value

507,305,196.48

Implied Enterprise value

735,082,374.06

Less: Total Debt

47,000,000.00

plus: cash and cash equiv

117,003,000.00

Implied Equity Value

805,085,374.06

weighted avg shares

24,000,000.00

Implied Share Price

USD 33.55

market price

USD 37.05

mispricing

USD 3.50

Relative value table

Company Name

Market Cap

PE Ratio

Price/Book

EV/EBITDA

Nanometrics Incorporated

$1.03B

21.10

3.70

9.60

Nova Measuring Instruments Ltd.

$810.58M

17.82

3.06

9.76

Rudolph Technologies, Inc.

$864.52M

18.95

2.36

11.97

KLA-Tencor Corporation

$18.45B

23.22

11.38

9.66

MKS Instruments, Inc.

$5.08B

13.43

2.82

8.23

Brooks Automation, Inc.

$2.75B

22.28

3.87

17.76

Average

19.47

4.53

11.16

St dev

3.58

3.40

3.45

Upper Range

22.33

7.25

13.92

Lower Range

16.60

1.81

8.40

Source: Seeking Alpha

A substantial part of Nano's sales is made to customers outside United States: 87%, 86%, and 80% of sales in 2017, 2016, and 2015, respectively. Also, portions of its costs are incurred by its international operations and denominated in local currencies. Nano enters into forward exchange rate contracts to hedge the risk. For 2017, 2016, and 2015, foreign currency transactions resulted in a loss of $0.6 million, loss of $0.4 million, and a gain of $0.5 million, respectively. The net intercompany balance that is exposed to foreign currency risk in December 2017 was approximately $0.4 million. Nano in its 10-K wrote that a hypothetical change of 10% in the relative value of the US dollar versus local functional currencies could result in an increase or decrease of approximately $44,000 in transaction gains or losses which would be included in its statement of operations. Because losses from foreign currency transactions are very small compared to Net Income, I am confident that Nano manages FX risk efficiently. Another risk factor besides FX risk is interest rate risk for Nano. At December 30, 2017, Nano held $82.1 million in marketable securities. Nano estimates that a hypothetical immediate and consistent increase in interest rates by 100 basis points from levels as of December 30, 2017, the fair value of its marketable securities would have declined by $0.5 million. But Nano's portfolio has an average duration of nine months, which is moderate in my opinion, and, as portfolios with long duration have a greater exposure to interest rate risk, Nano can manage its interest rate risk with comparatively less hassle.

Although Nano operates in a volatile industry, it has high potential for long-term growth. Its automated systems are widely used by major semiconductor firms, and it has earned itself a certain position on which it can build on. In fact, the firm has recently delivered its 100th Atlas III system, which is the third generation of the Atlas family. Risks are so far well-managed, both in terms of business and financials, as reflected in the fact that bottom-line volatility was attributed more towards capex and tax issues rather than sales while financial risk was well managed as reflected in its small losses in FX and moderate duration of its investment portfolio in a stable interest rate climate. In last one year, Nano has repurchased more than $23 million worth of common stock under its share repurchase plan, which could signal that the firm thinks that it is undervalued in the market. The valuation models show the market mispricing is not large enough to demotivate growth investors with medium horizon but can be large enough for active investors with shorter horizon. However, absence of anticipation of any significant catalyst or event might indicate that the slight mispricing is not enough for active investors. If you are already long on Nano, hold it. If you are interested to get in, you might wait for some time to see if it converges at least partially to its intrinsic value.

Notes

*DCF table

2017

2018F

2019F

2020F

2021F

2022F

EBIT

42,806,000

48,370,780

54,538,054

61,218,966

67,953,052

74,748,358

Taxes

13,096,000

16,929,773

19,088,319

21,426,638

23,783,568

26,161,925

EBIAT

29,710,000

31,441,007

35,449,735

39,792,328

44,169,484

48,586,432

Plus: Depreciation & Amortization

6,920,000

6,989,200

7,069,576

7,157,945

7,250,999

7,352,513

Less: Capital Expenditures

5,204,000

5,334,100

5,507,458

5,713,988

5,956,832

6,224,890

Less: Increase in Net Working Capital

-21,666,000

-21,774,330

-21,883,202

-21,992,618

-22,102,581

-22,434,119

Unlevered Free Cash Flow

53,092,000

54,870,437

58,895,055

63,228,903

67,566,231

72,148,175

WACC

11.50%

Discount Factor

0.8969

0.8044

0.7214

0.6470

0.5803

Present Value of Free Cash Flow

49,211,154

47,372,804

45,613,253

43,714,974

41,864,992

Total PV of FCF

227,777,178

Terminal year perpetual rate

3.00%

Terminal Value

874,266,118.29

PV of terminal value

507,305,196.48

Implied Enterprise value

735,082,374.06

Less: Total Debt

47,000,000.00

plus: cash and cash equiv

117,003,000.00

Implied Equity Value

805,085,374.06

weighted avg shares

24,000,000.00

Implied Share Price

USD 33.55

Market price

USD 37.05

Mispricing

USD 3.50

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in NANO 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.