MKS: A Quiet Star in Chipmaking Gear
By Richard Tortoriello
On Feb. 18, Applied Materials (AMAT ), the world's largest semiconductor-equipment maker, reported January-quarter results that were above our expectations, with orders up 32% from the prior quarter. Applied also said it expects a 30% rise in orders in the April quarter from the previous quarter. Much of this strength was driven by demand from Asia, with 71% of January-quarter orders coming from that region.
With chip-equipment shares, as tracked by the Standard & Poor's Semiconductor Equipment Index, having run up 71.8% in 2003, vs. gains of 27.4% for the S&P 1500 Index and 37.5% for the S&P 600 SmallCap Index, investors have started to wonder if the industry recovery and the stock rally are over. S&P believes a cyclical recovery in both the semiconductor and semiconductor-equipment industries is just beginning and that industry share prices will rise -- although probably not as spectacularly as in 2003 -- over the next 12 months.
One outfit that we believe will benefit from Applied's accelerating sales as well as an overall recovery in the global economy and in information-technology spending is MKS Instruments, based in Andover, Mass. MKS (MKSI ) is a leading supplier of components and subsystems to semiconductor-equipment makers, with customers such as Applied Materials, Novellus Systems (NVLS ), and Tokyo Electron.
MKS also sells products based on similar technologies to thin-film manufacturers for applications such as flat-panel displays and compact disks, and to various other markets, including medical and industrial companies. In 2003, the semiconductor-equipment market accounted for about 69% of sales, the thin-film market 9%, and other markets 22%.
We at S&P upgraded MKS shares on Feb. 4 to buy, from accumulate, after the company reported fourth-quarter results. Sales have begun to accelerate: They rose 31% from the fourth quarter of 2002. MKS generated sales of $337.3 million in all of 2003, up from $314.8 million in 2002. For the first-quarter, ending in March, MKS forecasts sales to jump almost 70% vs. the same period a year ago.
Although MKS has been in business for more than 40 years, we believe it's not well known to the average investor. It went public in 1999, and since then it has purchased more than 10 companies. MKS's largest acquisitions were Applied Science & Technology Inc. in 2001 and the ENI division of Emerson Electric (EMR ) in 2002. These two acquisitions added two large product lines to MKS's portfolio: reactive gas generators and power supplies for semiconductor and other thin-film process chambers.
MKS's original product was the Baratron pressure-management line, which still makes up a significant percentage of sales. Another large product line is materials delivery and analysis, which includes a wide range of flow-control and composition-analysis measurement and control tools.
When it comes to developing new products, MKS is increasingly targeting integrated subsystems and network-enabled sensors and feedback systems. Integrated subsystems save money and increase product quality for chipmakers and provide a higher return to MKS. Its goal is for integrated subsystems to account for 30% of sales in 2004, up from 20% in 2003 and the high teens in 2002.
With chipmaking processes becoming increasingly complex and sensitive, MKS has also increased its focus on providing network feedback and control systems, which allow fabrication-plant operators to monitor processing parameters within a given tool and make adjustments from a central location.
In the medical market, MKS counts a leading magnetic-resonance-imaging (MRI) maker as one of its top 10 customers, and it recently acquired radio-frequency technology to further expand its MRI product line.
In 2002, MKS undertook a major consolidation of recent acquisitions to streamline product development and manufacturing, and to reduce costs. It lowered selling and administrative expenses by 10% in 2003, on a 7% increase in sales.
The latest earnings report showed MKS's operating leverage, with a swing from a 3-cent loss (excluding amortization of intangibles and restructuring charges) in the third quarter of 2003 to an 11-cent profit in the fourth quarter. For the first quarter of 2004, MKS expects operating earnings per share of 20 cents to 25 cents. S&P forecasts EPS of 96 cents in 2004 and $1.35 in 2005.
We expect an improving global economy to help drive these results, and we estimate worldwide semiconductor sales will rise 25% in 2004 and semiconductor capital equipment sales to increase 30% to 40%, as both consumers and businesses buy more electronic goods. Overall chipmaking utilization rates of above 90% in the fourth quarter of 2004 have spurred a recent surge in equipment demand, thanks to chipmakers adding capacity. While we don't expect such growth to be linear in 2004, we believe the combination of high utilization rates and rising chip demand is good for equipment makers.
From a valuation standpoint, MKS shares, at roughly $25, trade at 4 times trailing 12-month sales, slightly above their historical average of 3.1 times sales. They stand at 2.2 times book value, well below the historical average of 3.3. On a price-earnings basis, the shares are at 25 times our 2004 estimate -- well below a peer average of 35 -- and are about 1.5 times our 5-year projected earnings per share growth rate of 17%. On a p-e to growth (PEG) basis, this is moderately above a PEG ratio of 1.3 for the S&P SmallCap 600 index.
Our 12-month target price is $38, which represents a multiple of 3.4 times book value, vs. a historical average of 3 for small-cap semiconductor-equipment shares. Though MKS shares are high-risk due to their volatility, we have a buy recommendation on them.
Note: Richard Tortoriello has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.
Analyst Tortoriello follows semiconductor-equipment stocks for Standard & Poor's Equity Research
Edited by Karyn McCormack