Diversification Pays For AEIS

By Stephen D. Simpson, CFA | November 01, 2012 AAA

Although there are exceptions here and there, this is, by and large, a miserable time for companies in the semiconductor equipment and solar energy markets. So it would stand to reason that if companies such as Applied Materials (Nasdaq:AMAT) and First Solar (Nasdaq:FSLR) are having difficulties, Advanced Energy Industries (Nasdaq:AEIS) should be in trouble too. And yet, while these are not exactly banner days for this small component and subsystems company, business is holding up reasonably well, which gives me even more confidence for when the eventual recoveries take hold.

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Getting Through a Tough Period
The third quarter report for AEIS was not great, but the company is muddling through better than peers such as MKS Instruments (Nasdaq:MKSI) and SMA Solar (OTC:SMTGF). What's more, the company continues to recruit customers in industries that should help offset the fundamental cyclicality of the semiconductor market.

Revenue fell almost 9% from last year's third quarter, but did rise about 2% on a sequential basis (missing estimates by a trivial margin). Thin film sales were down about 12% from the second quarter and now look to be nearly 50% off of prior peak levels. Inverters, however, were strong and the company's solar business rose about 20% sequentially.

Profit performance was more mixed, but still surprisingly positive given the overall environment. Gross margin actually improved by nearly a point from last year, and by a similar amount on a sequential basis. Even still, the operating performance wasn't great - operating income fell about 7% from last year on an adjusted basis, but did improve about 15% sequentially (also on an adjusted basis). Segment profitability was directionally similar (negative annually, positive sequentially), but the magnitude of the year-on-year decline was greater on a big decline in thin film profitability.

SEE: Understanding The Income Statement

Guidance Suggests No Quick Turnaround
With analyst estimates recently heading lower for a host of semiconductor capital equipment companies (including ASML (Nasdaq:ASML), Applied Materials, and KLA Tencor (Nasdaq:KLAC)), it's perhaps no great surprise that AEIS management also lowered guidance for the fourth quarter. Simply put, the expected second half flat panel recovery never took place and memory chip markets remain weak on soft sales of consumer electronics (at least outside those sold by Apple (Nasdaq:AAPL) and Samsung).

At the same time, the solar business is likely to slow. The company expects a shift from utility customers to commercial customers (AEIS has minimal residential business), and the expiration of various grant and tax credit programs, to say nothing of ongoing overcapacity, is likely to slow the industry further.

Can Better Days Be Ahead?
This is a tough period for AEIS, but I continue to believe that there are solid reasons to think the long-term outlook could be better. For starters, the semiconductor and panel markets are quite likely to eventually recover, though admittedly that timeline to recovery keeps slipping. At the same time, the company continues to diversify its customer mix - recently adding customers in markets such as gas abatement, ophthalmic lens coating and automobile headlights.

On the solar side, I continue to believe it's a "when, not if" market. The efficiency and cost effectiveness of solar panels continue to improve, and the industry is moving towards a point where panels can make sense for utilities, businesses, and even residential buyers absent heavy subsidies and incentives. As a leading company in the inverter space (more than one-third share in utility and commercial installations), AEIS should be able to benefit from long-term installation growth.

The Bottom Line
All of that said, investors should not expect a quick turnaround, nor an easy path. Any business worth doing is worth copying, and AEIS will not be immune to tech- or price-based competition. Likewise, as Applied Materials has so amply demonstrated over the past year or two, serving unpredictably cyclical markets makes for a lot of volatility and stretches of significant underperformance.

SEE: A Primer On Investing In The Tech Industry

I do believe that AEIS has a credible shot at mid-teens free cash flow growth, and such a growth rate would support a fair value in the mid- to high-teens. At the same time, the stock's current multiples (price/book, EV/EBITDA, EV/revenue) suggest a potentially attractive entry point. While I do believe AEIS will be bought out in the next few years, investors considering these shares need to also be aware of the substantially above-average risks; AEIS has navigated this slowdown better than most, but cyclical industries such as semiconductor equipment have long proved that conditions can quickly get much worse with little warning.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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