A Rising Tide Lifts All Ships (But Especially Those Without Debt That Have Growing Margins)

I like finding fifty-cent dollars, that’s not a surprise. What I like more is finding a fifty-cent dollar that’s an exceptional business, maybe even an industry leading business. Advanced Energy Industries (AEIS) is an industry leader in power supplies and power conversion solutions within the semiconductor space. They lead through having the best technologies, leading products, as well as enhanced servicing operations to create even more value for their customers by reducing customers’ overall cost of ownership. The company also has one of the highest Returns on Capital in their space, a tremendous competitive advantage. Each dollar spent on their business generates more dollars of value than the leading competitor.

Trading at 11x forward earnings and 15x FCF, AEIS has a crystal clean balance sheet, no debt, and industry leading margins (all above 20%). The company converts a large percentage of its revenues into FCF which provides them the ability to fund operations and growth internally without the need of outside capital. To go along with sustainable FCF growth, the company actively buys back its shares when it sees fit, as well as engages in M&A to strengthen its operations. It also doesn’t hurt that the industry is set to explode with increased demand. AEIS might be a dollar trading at $0.70.

Company Background

Advanced Energy was founded in 1981 with the goal of being one of the leaders in delivering advanced power and control technologies to its customers. Over three decades have passed and the company can thoroughly claim victory to its goal. The business has footprints all throughout the world: North America, Europe, and Asia. providing technical expertise and responsive power solutions for thin film and industrial manufacturing is its bread and butter, and it achieves industry leading recognition through acquiring or developing the latest technology in the space.

More specifically, the business’ products provide leading, field-proven power control and arc management capabilities that enable complex semiconductor processes and other high-tech applications to do their job. If that sounded like mumbo-jumbo, here’s the takeaway: AEIS sells products that are a crucial step in making sure semiconductor chips perform their jobs well. The company has a pretty bad-ass slogan that sums it up even better: At Advanced Energy, we provide the breakthrough that enables the breakthrough.

Business Deep Dive

The company directs its efforts into a few main areas: Process Power, High & Low Voltage Power, Thermal Products, and Global Services. By breaking down the applications of each area of business, we can get a better understanding of how their products interact with their markets.

  • Process Power: Semiconductors, solar panels, data storage, and advanced thin-film applications.
  • High & Low Voltage Power: Semiconductor implantation and inspection, mass spectrometry, scientific, industrial, and medical.
  • Thermal Products: Semiconductors, solar panels and advanced packaging applications.
  • Global Services: Comprehensive repair, enhancement and used equipment programs for the complete life-cycle of the product.

Revenue Breakdown

The company’s main source of revenue comes from its semiconductor industry sales. Over the last three years, semi sales have ranged from 64.2% – 68.8% of total revenues. Industrial Power Capital Equipment provided anywhere from 17% – 20% of the company’s revenue. Finally, Global Support services provide the remaining 13% – 15%. The company gives light in their latest 10-K that their top 10 customers account for an average of 65% of their sales over the last three years, and they expect that concentration to continue into the future. Applied Materials (AMAT) accounted for roughly 33.5% of their sales while Lam Research accounted for 20% of sales; that’s dependence. This will come into play later when discussing risks. Over the last year, backlogs increased 89.7% primarily due to increased demand in the semiconductor space and specifically the industrial thin film markets.

Over the last year, semiconductor equipment revenues increased 41.5%, industrial capital equipment increased 38.8%, and Global Support service revenue increased 26.3%. Within the semiconductor market, sales were driven by increased demand for etch applications related to advanced memory and transition into 3DNAND (think Big Data and Machine Learning). For their industrial capital equipment, the company achieved increased sales due to the accelerated demand of advanced coating applications (for solar panels, flat panels, and architectural glass).

Research and Development / Operating Expenses

In the semiconductor space, R&D is the lifeblood of innovation and a key driver in sustaining a competitive advantage. AEIS spends roughly 9.0% of their sales on R&D, but that percentage has declined over the last few years to where it currently stands at 8.6%. Over the last year, the company invested an additional $13.6MM into R&D. As a whole, the company is reducing its operating expense margin, going from 26.5% to 23%. This signifies that the company isn’t pursuant on increasing expenditures for the sake of increasing expenditures, but expenses where they see fit, and saves where they can.

Capital Allocation

The company has massive amounts of cash available, around $417MM and has a strategy in place for a 70/30 model of allocation in which 30% of FCF gets allocated to share buybacks, with the remaining 70% used for M&A. When it comes to M&A, president Yuval Wasserman exclaimed that the company, “applies opportunistic decisions when we need to, and we do have a very active pipeline of acquisitions … but are cognizant of the changes in the market.” In other words, they’re not going out and buying up companies for the sake of M&A. Since 2015, the company has bought back nearly 3 million of its own shares.

By The Numbers

Now that we’ve got the business operations laid out, let’s take a dive into the numbers, metrics, and growth guidance going into the future. I already mentioned that AEIS sports leading margins in the industry, but what does that look like? The company has an operating margin of 29.78% compared to the industry average of 4.55%. Net margins come in at 20.47% compared to industry average of 3.47%. Gross Margin of 53.14% is better than 92% of its competitors with an industry average of 23.73%. This is the definition of a competitive advantage. Finally, FCF margin comes in at 22.87%, with the next highest competitor sporting 11.23% (Rogers Corp).

The company sports revenue growth of 35%, asset growth of 31.98%, ROA of 20%, ROE of 27.60, and ROIC of 49.54%. All of these metrics and the company trades at a mere 11x forward earnings.

Projected Guidance

For the second quarter, the company is estimating revenues between $193MM – $207MM, operating margins around 30%, and EPS of $1.30 – $1.40. This would signify a $0.20 increase from last quarters earnings.

Finding Fair Value

Using a 5YR DCF model we can find what Bill Miller calls a “Roughly Right” range of fair value. Assuming revenue grows at an average annual rate of 6% over the next five years, we reach revenue of $894MM. From this we can find our EBITDA by taking roughly 35% of revenues (which has been their historic EBITDA Margin %), which gives us $322MM. From this $322MM we can get to our Free Cash flow projection by backing out taxes, CapEx, and NWC Investment. After this we are left with $244MM in FCF in 2022, or a 6.5% average FCF growth rate.

Now we can set a low – high terminal discount rate of 11% – 10%. From this we can calculate our Enterprise Value by taking the PV of the cash flows from a range of $815MM – $831MM (as a total of the 5 years). If we use perpetuity growth rates of 1.50% – 2.50%, add in the terminal FCF and add our discount factor, we get the PV of our terminal cash value which comes out to $1,627 – $2,168MM. Combine the PV of Terminal Value to the PV of our cash flows and you end up with an enterprise value range of $2.4B – $3.0B.

Now the fun part begins, figuring out fair value ranges on a per share basis. By taking our enterprise value, adding cash / investments, subtracting debt & minority interests, we are left with Value of Common Equity with a range between $2.9B – $3.45B. Divide that number by the amount of shares outstanding (which currently sits at 39MM) and you get an average fair price range of 73.76 – 87.93. This gives us a potential upside range between 20.9 – 44.1% based on the current market price of $61.

Reading the Tape

Price seems to be stabilizing on the $61 level, but before deploying capital I want to make sure this isn’t a falling knife (as much as I can be). I am looking for consolidation with an entry level of around $65 -$68, and a confirmation of a breakout anything higher than $68. Depending on how aggressive or how large of a position you want to put on, you could set a stop loss at the $55 range, or below the 200MA at $40.

Where is My Fallibility?

  1. The company could lose its revenues from AMAT and Lam Research. This would be catastrophic as the company recognizes more than half of its revenues from the combination of these companies.
  2. Demand in the semiconductor industry could slow or even dry up. This isn’t the most likely model in the latticework of potential mishaps, but it is possible. Semiconductor demand is cyclical in nature, and its possible to buy a company right before the trough of demand.
  3. The company veers away from its effective and efficient capital allocation strategy and pursues costly M&A for no reason, or even worse, uses debt to finance its M&A or buybacks.

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