Electro Scientific Industries, ticker ESIO, first came on my radar in August of 2016. At this time, they had just named Michael Burger their new CEO. Mr. Burger was previously CEO of Cascade Microtech and I had followed his work as he led Cascade to a successful exit. FormFactor acquired Cascade in 2016 at a premium. While investors that bought into ESIO right at Mr. Burger's hiring have already been handsomely rewarded, where does the stock go from here? I will make the case that today's pullback provides the perfect entry point.
For this article, I will refer to Electro Scientific Industries as "ESIO"
Over the past 12 months, ESIO's operating model has been restructured. This most recent reported quarter is the first clean look at the new operating model. They removed 10 to 12 million in annual expenses which took the quarterly adjusted EBITDA breaken down from approximately 50 million in revenue to 35 million. Now, even in seasonally (or cyclically) weak periods there should be no deterioration of the balance sheet.
In the quarter announced yesterday, they reported revenue of 110.8 million and diluted EPS of 0.94 a share. They have guided that the next two quarters should should look approximately the same from a revenue perspective. This explosive growth is either seasonal or cyclical and the market does not expect it to be repeated in the second half of the year. Fortunately, based on today's share price and valuation, you are more than compensated for this expectation.
I like to look at the trend of Shareholder's Equity (assets minus liabilities) when first looking at an investment. ESIO's Shareholder Equity went from 153 million to 190 million this quarter alone. This phenomenal growth will continue over the next two quarters using management's revenue guidance. By the end of the June quarter, they should have close to 250 million in Shareholder's Equity. For a company that has a fully diluted marketcap of 700 million, it means you will get the future earnings of the company at a 450 million valuation.
My guess for the move down today is that many believe ESIO has hit the top of the cycle and after June revenue will trend down. This is really nothing new as management has been saying the same. Let's look at just how far revenue would have to drop for certain things to happen. As mentioned earlier, revenue will have to go below 35 million in a quarter for them to not be at least adjusted EBITDA breakeven. Also, they could still earn 45 million in a year on only 260 million in revenue (much less than the analyst estimates of 358 million and 323 million for the next two years). Even this would be an acceptable earnings number since you are getting the company at a 450 million valuation when stripping out the tangible assets at the end of June.
Before I move on from the financials, I should point out that Gross Margins can expand over the coming years as ESIO begins to manufacture more of its own lasers. They plan to manufacture more than 50% of their lasers internally, up from approximately 30% today.
ESIO defines itself as follows, "ESI's integrated solutions allow industrial designers and process engineers to control the power of laser light to transform materials in ways that differentiate their consumer electronics, wearable devices, semiconductor circuits and high-precision components for market advantage. ESI's laser-based manufacturing solutions feature the micro-machining industry's highest precision and speed, and target the lowest total cost of ownership."
Numerous research organizations have pegged the Flexible Printed Circuit Board market that ESIO leads in to grow at an 11% CAGR through 2025. If this is true, while ESIO will always be somewhat seasonal/cyclical, it should experience higher lows and higher highs. This alone should support a much higher valuation.
ESIO also has what the CEO likes to refer to as "call options" embedded in its growth plan. ESIO's expertise in using lasers to alter materials is ideally suited to the High Density Interconnect Market. This market is at least twice the size of ESIO's existing market. Many of these HDI customers are companies that ESIO already sells products to so there is a big opportunity to build upon existing relationships. Additionally, Industrial Machining for sectors such as Aerospace and Automotive should start boosting revenue in about two years. There is a long qualification process for these sectors but ESIO is already one year through what is expected to be a two or three year journey to get established at these customers. This should provide a very sticky source of revenue when they do eventually get approved.
In summary, with ESIO you get exposure to some of the most exciting trends in technology at what is still a very cheap valuation. The balance sheet gives the company tremendous flexibility and the new operating model allows it to keep generating cash at even very low revenue levels. The business will always be somewhat seasonal/cyclical but the general trend should be up as the underlying markets they participate in grow. If they could more precisely predict annual revenue then it would command a substantially higher valuation but that is what creates the opportunity for you as an investor to get in at an attractive price.
Disclosure: I am/we are long esio.