Searching Through Semiconductors

The semiconductor industry, from a price per share perspective, is close to all time highs. Because of this, I was quite surprised to see a semiconductor business pop up on one of my loose stock screeners. The company is inTest Corp (INTT). Sporting a FCF Yield of 9%, growing revenues, and industry leading margins and returns on shareholder capital, INTT was worth digging into a bit more, even if the charts aren’t as constructive. 

Understanding the Business

GuruFocus presents the best synopsis of business operations by stating:

inTest Corp operates in the semiconductor industry. It designs, manufactures, and markets products that are used by semiconductor manufacturers to test their integrated circuits and wafer products. The business of the company is organized into the following product segments, Thermal, Mechanical, and Electrical Products. The Thermal Products segment includes the operations of Temptronic Corporation, Thermonics, Sigma, inTEST Thermal Solutions GmbH (Germany), and inTEST (Singapore). The Mechanical Products segment includes the operations of its Mt. Laurel, New Jersey manufacturing facility. The Electrical Products segment includes the operations of inTEST Silicon Valley Corporation. Its product includes test head manipulators, docking products, test interfaces, and thermal solutions.

During 2016, the company reorganized their business operations from three segments to two. Prior to the change, the three segments of business operations were Thermal Products, Mechanical Products and Electrical Products. Now the company consolidates their revenue operations into Thermal Products (“Thermal”) and Electromechanical Semiconductor Products (“EMS”).

Company History

inTEST was founded in 1981 and served primarily in the semiconductor industry with manipulator and docking systems to support ATE production test equipment. The company quickly grew from there and established a base of operations in Asia, quickly followed by Europe.

INTT went public in in 1997 and expanded its presence with tester interface products by acquiring TestDesign in 1998. In 2000, the company made a determinant effort to broaden their business to include thermal systems for electronics tests by acquiring Temptronic Corporation, creating ThermoStream, a brand of temperature forcing systems for characterizing ICs and devices.

During the mid 2000s, the company once again made a strategic effort to expand and diversify their business operations by acquiring Sigma Systems, a thermal chamber and plate production company in 2008. Through this acquisition, the company pole-vaulted into the role of leading supplier to optical transceiver production test customers.

Seemingly not satisfied with covering a plethora of semiconductor type businesses, INTT looked to develop business in the industrial area. To achieve this, the company acquired Ambrell Corporation, a manufacturer of induction heating systems used in a wide variety of industrial processes.

One Industry & Two Markets

inTEST operates in two main spaces within the semiconductor industry: Automated Testing Equipment and Non-ATE. In order to understand the industry, it’s important to understand the mechanics of these individual markets, how they are similar, and in what ways they are different.

The Automated Testing Equipment segment is INTT’s main driver of revenues. The company said in its latest quarterly report that ATE business, “used by semiconductor manufacturers to perform development, qualifying and final testing of integrated circuits (“ICs”) and wafers, and for other electronic test across a range of industries including the automotive, defense/aerospace, energy, industrial and telecommunications markets.” Although this is a major driver of revenue for the company, they are the first ones to admit the volatile nature of this sub-segment of the semi industry.

Expressing this concern in their 10-Q, the company admits, “The ATE market in which we operate is characterized by rapid technological change, competitive pricing pressures and cyclical as well as seasonal market patterns. This market is subject to significant economic downturns at various times.” Altera.com’s analysis of the semiconductor ATE segment confirms the company’s belief.

ATE Industry Trends

The ATE segment of the semiconductor industry has a market size of ~$4B (2014 data) and is growing at roughly 3% CAGR. According to Altera’s report, which you can find here, the ATE market is driven by semiconductor chip volumes. So, if volumes increase, demand for chip testers grows in tandem. This shouldn’t come as a surprise. The demand for chip testers should continue to grow into the future with more and more appliances incorporating “smart device” characteristics. Don’t believe me? Have you seen the kind of robot-spaceship refrigerators Samsung is rolling out?

Altera identifies the following factors that determine market trends and dynamics in the ATE space:

  1. ATE vendors are tied to a boom and bust cycle.
  2. Capital utilization rates drive capital equipment orders.
  3. Device Manufacturers’ sentiment on the future of chip volumes.
  4. ATE vendors have limited customer base.

Increased Value Through Diversification

To combat this inherent industry segment risk, inTEST made a strategic effort in 2016 to branch out into non-ATE segments of business through its acquisition of Ambrell Corporation. With the acquisition of Ambrell, the company extended its reach of markets to consumer product packaging, fiber-optics, automotive, and others. Ambrell manufactures its products in the US and conducts marketing and support activities from its facilities in the U.S>, the Netherlands and the UK.

This diversion from the standard ATE segment of the semiconductor industry will play a role in the valuation and competitive advantage of INTT further on.

On the whole, the macroeconomic environment is still positive, which would signal a strong growth in the semiconductor industry.

Business Deep Dive

The company derives most of its revenues from its Thermals segment of its operating business. For the nine months ended of the most recent quarter, Thermals accounted for 60% of revenues, with EMS bringing in the remaining 40%. Earnings after taxes paint a different picture, with EMS net earnings representing 63% of net earnings.

Within the two segments of the business, the majority of the business’ net revenues are generated outside of the United States. For the nine months ended most recent quarter, the company recognized 74% of its net revenue from outside of the United States. The company generates larger revenues outside of the US all the while having less than half of the property and equipment in regions outside the US.

Competitive Business Advantage

This percentage of revenues from overseas is a large competitive advantage for the company. How so? If the United States faces a slow down in the amount of semiconductor chips demanded, it won’t have as much of an impact on net sales as it would if 74% of its revenues came from inside the states. Another competitive advantage the company has is its determined effort to diversify its revenues between the ATE and Non – ATE segments of semiconductors. An example of this determination is in the most recent quarterly statements in which the company derived 47% of its net revenues from non-ATE segments, compared to only 26% a year ago.

This expansion through diversification effort served to broaden the company’s customer diversification and has increased the company’s footprint in several growth markets. Through the acquisition of Ambrell, the company now has induction heating technology which complements their thermal technologies while simultaneously establishing their position in the industrial market space. The company claims they are well positioned to capture market share in the markets they serve, while expanding inTEST’s footprint in additional thermal test and industrial markets.

The Jockey & The Team

The company is led by James Perlin In January 2018 James took over the leadership position after serving as Executive Vice President since November 2015. Before taking over corporate leadership roles, Perlin served as General Manager of Temperature Management Production Segment of inTEST. Before joining the inTEST team, Perlin served as VP and General Manager of Accusonic Technologies, a privately held company that designs and manufactures hydro-acoustic measurement systems. Perlin’s total calculated compensation according to Bloomberg is $492,791, which includes $41,952 of restricted stock awards and $1,656 in total value of Options.

Following Perlin is Hugh T. Regan, Jr, secretary-treasurer and CFO. From 1985 to 1996, Regan served in various financial capacities for Value Property Trust, a publicly traded real estate investment trust. Regan Jr’s calculated compensation as of fiscal year 2016 was $416,547, which includes $31,464 of restricted stock awards and $1,242 of total value of options.

Insider ownership is relatively high at 17%, not great considering some of the companies I’ve been able to find with ownership north of 40%, but in a high-tech business like semiconductors, 17% is mighty fine by me. Along with strong insider ownership, the company has a 3YR Average Share Buyback Ratio of 0.60, which isn’t great on a standalone basis, but one has to view this metric in the scope of the semiconductor industry. As an industry, the 3YR average share buyback ratio is -3.80, meaning it issues nearly 4x more shares than it buys back. INTT is leading the pack in this category.

Valuation, Foundation, & Growth

Metrics

The company trades 1.4x sales, 11.2x FCF, sports an EV to EBITDA of 6.25, and an EV to Revenue of 1.22. These ratios make INTT cheaper than more than 60%  – 80% of its competitors (on a ratio basis, remember). The company trades about 12.5x earnings, making it cheaper than 77% of its competitors.

Another No Debt Company

From a balance sheet perspective, the company is extremely solid. No debt, steady increase in assets with a simultaneous decrease in liabilities. As of the last quarter, the company has $60MM in Assets and $16MM in total liabilities. In fact, the company’s cash position of $11MM is almost enough to cover all of its liabilities. Not bad! One thing to note is the company’s cash position decrease of around $15MM from $26MM to $11MM. This shouldn’t concern the intelligent investor because the company used that cash to purchase Ambrell, a deal which should pay off handsomely for the company over the next 3 – 5 years.

Growth Figures

Not only is the company far cheaper than the majority of its competitors, it also has some of the best margins in the industry. Operating Margin of 16.93%, Net margin of 11.34%, ROE of 16.35%, ROA of 13.18%, and an ROC of 120%. Each metric is better than 82%, 72%, 78%, 86%, and 96% of its competitors respectively. The company has a weighted average cost of capital (WACC) of 5.12%, and a ROIC of 32.52%. Earnings Yield of 14% is better than 91% of the industry, and a forward rate of return of 12% is better than 58%.

Assessing Income & Cash Flow

The company had a tremendous latest quarter, growing revenue 60% YoY, increasing bookings 56% YoY. When you back out the acquisition of Ambrell, third quarter revenue increased 15% YoY, and bookings increased 1% YoY. The company ended the quarter with a backlog of $11.3MM. Fourth Quarter expectations for the company are net revenues of around $17.5 and $18.5MM, with net earnings ranging from $0.11 to $0.15/share. The company’s EPS growth is very cyclical, fluctuating from -47% to 45%. This goes back to the ATE industry being extremely cyclical in nature. Taking more of a historical look, the company’s Revenue 7Yr CAGR is 8%, Gross Profit Margin 7YR CAGR comes in at 14.7%. The company also acknowledges that with the release of the most recent quarter, it marks 32 straight quarters of profitability. That is not something all semiconductors can tout.

Looking at Cash Flows, the company is trending upwards with its last three quarters of increased operating and FCF. Over the last three years, the company increased FCF from $3MM in 2015 to $8MM in 2017. During that same time frame operating cash flow increased from $3.5MM to $8MM.

Estimating Intrinsic Value

In order to get an idea of a range of intrinsic value, I’m going to use a 10YR DCF EBITDA Exit model. We will assume a discount rate of 9%, a terminal EBITDA multiple of 6x – 8x (which is the company’s average multiple), Revenue 10YR CAGR of 8.4%, 16.3% 10YR EBITDA Margin, and a 10.6% Unlevered FCF 10Yr CAGR.

Using a low multiple of 6, we figure that into our enterprise value equation to get an enterprise value of $92MM ($53MM in discrete cash flows + PV of Terminal Value). If you bump the EBITDA multiple up to 8x you get an enterprise value of $111MM.

These multiple Enterprise Values gives us a fair value range of $10.02 – $11.91. This presents an upside of 27%  – 50%.

Market Perception

The market has been nice to INTT so far in 2017, with the share price appreciating 66%. It makes one wonder why I am even interested in this company if shares have risen nearly 70%. The market seems to have priced in the growth in revenues and margins YoY, as well as the increase in bookings. Also, like a high tide that raises the level of all buoys in the ocean, the incredible rise in the semiconductor industry as a whole has been a tailwind for the company’s share price.

Variant Perception

I don’t think the market is wrong right now on this stock. At the same time, I don’t think the current prices are a reflection of its intrinsic business value. This analysis is different for me, because this is a company I wouldn’t consider buying right now. In a perfect world I would wait for share price to drop handsomely for reasons not related to the operating efficiency of the business, and then accumulate a position on the lows. Will I get this chance? Who knows, it’s impossible to tell right now. Below are my three pillars of this long thesis:

  1. The company sports a FCF Yield of 9% with zero debt, industry leading margins, and a cheap valuation on several metrics compared to its industry.
  2. The company is making a determined effort to diversify its business operations, branching into areas of semiconductor industries that are less volatile, and provide a chance to capture more market share.
  3. Recent share buybacks (which the company then retired the shares) coupled with high insider ownership show me that management’s interests are aligned with that of its shareholders.

Getting Technical

Technically, the company isn’t at those signature lows that I usually like to enter in. However, there is support from both the 50MA and the $7.50 price level. The upper line of resistance goes back to 2004 price levels. To be honest, I’m going back and forth on when I would enter this trade. If price holds this support level I might enter a starter position, a small one of 25bps. If price were to break the upper resistance line, the path of least resistance would clearly be in the favor of the bulls.

However, price could break below the bottom of the symmetrical triangle, sending shares down even lower. In a perfect work I would see price head back down to $6.50 before buying. We will see.

Where is My Fallibility?

This company is an interesting play, and to be honest, I’m not sure what to make of the charts right now in terms of an entry. I will be patient to wait for the right opportunity. Who knows, for all intents and purposes, this could end up being a simple analysis post where I don’t end up buying any shares of the company. Would it prove worthless? I say no. Any chance I have to analyze a company and be given critical feedback will turn me into a better intelligent investor, even if I don’t become a part owner. Below are a few ways in which headwinds could pull shares south:

  1. Demand for semiconductor chips falls, resulting in substantial loss of product sold.
  2. INTT extents itself too much with its acquisition of Ambrell, thereby overreaching its capital allowances, forcing it to issue new stock or take on debt to finance operations.
  3. Revenues from emerging markets slow, putting headwind pressure on sales volumes given the 74% of total sales from emerging markets.
  4. Management fails to continue to buyback stock.
  5. Cash levels become so low it eats away at the intrinsic value quickly and violently.
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