MKS Instruments: A Growth Play
We believe that shares of semiconductor-equipment outfit MKS Instruments (MKSI: $24) do not appropriately reflect the company's earnings growth and competitive advantages. Trading at a discount to peers and given the company's superior growth potential, we believe the shares provide a compelling opportunity. We believe insider sales may have been a concern to some investors but we view that concern as fading and we see share buybacks as fully offsetting any residual effects.
MKS has a sustainable competitive advantage through its broad product offerings, in our view, which allows it to leverage innovation and research across products and markets and to integrate multiple products into more attractive integrated subsystems. We believe this will enable MKS to outgrow its industry peers. The stock carries S&P's highest investment recommendation of 5 STARS (strong buy).
MKS is a leading supplier of components and subsystems that measure, control, and monitor critical parameters of semiconductor and other advanced manufacturing processes. The company also offers products that power certain manufacturing processes.
Instruments and Control Products
In 2006, 70% of its revenues were attributable to the semiconductor market, 8% to manufacturers using thin film processes (e.g., flat panel displays, architectural glass, coating for eyeglasses, magnetic storage, optical storage such as CDs and DVDs, optical fibers and filters used in communication markets), and 22% to other markets (e.g., solar, medical, energy generation, chemical agent detection, industrial, research). Most sales to the semiconductor market are to equipment makers where MKS's components are part of a larger tool.
The company's products are divided into three groups. The instruments and control products group includes tools that measure and control the pressure of gases inside the process chamber, tools that measure and control the delivery and flow rate of gas/vapor/liquid materials to the process chamber, gas and thin film composition analysis tools that monitor the process in real time and alert the technicians when repairs are needed, and tools that control harmful electrostatic charges. Also part of this group are a suite of data analysis and digital control network products, which connect sensors, subsystems, the factory network, and system control computers for real-time advanced process control and computer-controlled automation.
The power and reactive gas product group includes power delivery products; products used in the etching, stripping, deposition, and cleaning stages of semiconductor fabrication; and products used to remove contaminants from the process chambers. The vacuum product group includes measurement sensors, power supplies, read-out units, and tools that measure vacuum pressure using ionization and thermal conductivity. Other components include valves, traps, and so on, that ensure leak-free connections to prevent contaminants from entering the processes.
MKS is a market leader in 10 of the 15 product markets in which it is active and among the top four in every market (with the exception of data analysis, a market it just recently entered). We regard the environment as competitive and believe that MKS's leadership is earned through superior product offerings. International sales represented 34% of 2006 sales, and integrated subsystems represented 26% of 2006 sales, up from 20% in 2003 and 11% six years ago.
MKS has a history of acquiring companies with complementary technology, which we believe is central to its differentiation strategy. It also confers a competitive advantage: a broader product offering than its peers.
In 2006, MKS completed three acquisitions. In January, 2006, it acquired Ion Systems, a provider of electrostatic management solutions, for around $73 million in cash. Also that month, MKS acquired Umetrics, a leader in multivariate data analysis for roughly $30 million in cash. In November, 2006, MKS completed the acquisition of Novx, another company with electrostatic monitoring products.
We view these businesses as offering complementary products to MKS's existing product lines and view these acquisitions favorably. We expect similar acquisitions in the future.
Cautious Spending Ahead
MKS's revenues have been volatile over the past 10 years. We believe geographic and product diversification, as well as the maturity of the semiconductor market, will lead to less volatility for MKS. Including the effects of acquisitions, revenues grew at a 16% compounded annual growth rate (CAGR) for the 10 years ending December, 2006, and we believe similar growth is possible over the next five years, driven by product innovation and stronger pricing as MKS approaches its target of 40% of sales from integrated subsystems.
We believe 2007 is likely to be a soft year for the semiconductor-equipment industry, based on our view that growth in chip demand will be a moderate 9%, and that chipmakers spent heavily on equipment in 2006. In addition, with utilization rates at chipmakers off their peaks, and elevated inventory levels at chipmakers, we see them investing cautiously in new equipment.
We believe, however, that industry fundamentals are likely to improve in the latter half of 2007, assuming continued U.S. and global economic growth. We believe the current digestion period is likely to be softer than historical cyclical downturns, given greater product and geographic diversification and a more mature industry. We believe the long-term industry growth rate for semiconductors is 9% to 10%, and the long-term growth rate for semiconductor equipment is slightly below that, around 7% to 9%.
Better Than Peers
With the continuous shift to smaller line-widths, semiconductor chips are becoming increasingly sensitive to microscopic contaminants during the manufacturing process. At the same time the increasing wafer size and increasing complexity in the manufacturing process are pushing up the costs of defects. These two forces are causing chipmakers to increase their focus and investment in process control tools that reduce defects and enhance yield. We believe MKS's products address these issues, and we see the markets for its products growing more rapidly than the equipment industry at a CAGR of 10% to 11%.
As a market leader in many of its markets with a track record of innovation, a broader product offering than peers, success in adding value through integration of multiple products into subsystems, potential to leverage innovation and R&D investments across multiple product and markets, we believe MKS offers better revenue growth potential than peers. We estimate compound annual organic revenue growth of 13% for the next five years and 16% including acquisitions, in line with the company's performance over the last 10 years. Furthermore, with 30% of 2006 revenues attributable to nonsemiconductor markets we believe MKS will experience better revenue stability than peers.
We believe extensive insider selling by the former chief executive officer and current chairman, John Bertucci (and his wife, Claire Bertucci), as well as selling by Emerson Electric, a major holder (since selling a business unit to MKS), may have been a source of concern to some investors. We believe the ongoing nature of this selling indicates sales are not motivated by a negative view of MKS's prospects. Moreover, with Emerson Electric having reduced its stake from 9 million shares to around 3 million, we see this concern fading.
MKS announced plans for a $300 million share buyback in February, 2007 (around 12 million shares at current levels), and we think any downward pressure from insider sales will be absorbed by share buybacks.
On a valuation basis, MKS shares offer a compelling opportunity for investors, in our view. On a price-to-earnings basis the shares trade at 13.3 times our 2007 EPS estimate of $1.85 and 13.5 times the 2007 consensus estimate of $1.82. This is well below peers trading at 16 to 17 times both S&P and consensus estimates, and well below the three-year historical average of 18.9 times and the three-year historical median of 15.1 times. Assuming no margin gains and applying our estimated five-year CAGR for revenues of 13% to MKS, leads to a p-e-to-growth (PEG) ratio of 1.0 times, which is below the S&P 500.
The shares trade at 1.5 times book value, 1.8 times trailing sales, and 1.7 times our 2007 sales estimate, all broadly in line with historical levels.
Applying a PEG ratio of 1.5 times to our 13% growth rate suggests a value of $36. Applying a peer-based target p-e of 16 times our 2007 EPS estimate suggests a value of $30. Blending these two metrics leads us to our 12-month target price of $33, which implies about 34% upside from current levels.
We view MKS's corporate governance policies as weaker than peers. We view unfavorably the multiple related-party transactions involving directors or offices (other than the CEO) and the fact that the company does not disclose its governance guidelines. We also view some compensation issues unfavorably, including the lack of disclosure of performance criteria and hurdle rates for performance-based equity awards.
Positive factors, in our view, include the lack of a poison pill and the fact that the audit committee is composed solely of independent directors.
Risks to our recommendation and target price, in our opinion, include a greater than expected slowdown in the global economy, a more severe than expected downturn in the semiconductor sector, and more intense competition than expected in MKS's markets. In addition, while we view recent insider selling as benign, continued or accelerated insider may be a concern to investors.