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Sunday, May 6, 2018

Snap-on (NYSE: SNA)


  • This reliable cash generator has not been this cheap for a long time after posting a decline of over 17% for the year.
  • Growth drivers include a continued increase in vehicles on the road with the average age of these vehicles rising and the continued expansion into other industries besides automotive repair.
  • Snap-on serves a large market while providing much more reliable cash flow than the majority of other companies comprising the industrial sector.

Read the Full Seeking Alpha Article HERE

Tuesday, February 13, 2018

McDonald's (MCD) - The Portfolio Stabilizer


  • Investors need stocks in their portfolios that perform well in any phase of an economic cycle.
  • Few companies provide as reliable an earnings stream and cash flow as McDonald’s.
  • While the U.S. market is saturated and we are talking about a giant, there are sufficient avenues for growth for the years ahead.

In investing there are no certainties.  However, in the case of McDonald’s (MCD), we are talking about one of the most reliable investments out there.  Just think about it – how often have you seen an empty McDonald’s or one without a line of cars in the drive through.  This company has been reporting positive net income for over three decades.  The free cash flow numbers are equally impressive with positive free cash flow reported every year since 1991.  With this kind of consistency and the comfortable payout ratio of 60%, there is little risk that the dividend will be cut.  More likely the dividend will continue to increase over time from its current yield of 2.44%.  Management has shown confidence in its long term strategies by setting a $22 to $24 billion cash return target for the three year period ending in 2019.

Of course, just because we believe the dividend is safe does not mean that everything is perfect.  Revenue and income growth have stalled in recent years.  The annual revenue and income numbers for 2016 were both lower than they were in 2011.  There has not been a collapse in sales by any means but the years of impressive growth are well in the past.  There are a few reasons for this including market saturation, fierce competition, and a trend toward healthier eating. 

Despite these challenges, McDonald’s still makes sense in a diversified portfolio.  This cash cow has the financial means and the demonstrated capacity to adapt and remain relevant in the years ahead.  The company is not going to give up on its hamburgers and French fries but will continue to enhance the menu.  With the success of McCafĂ© coffee and other snack offerings, the menu is expanding to reach a wider audience while still retaining existing customers. 


Opportunities in Delivery & International Expansion

One reason for the halt in growth mentioned earlier, market saturation, actually may lead to a new growth avenue.  Because of McDonald’s footprint there is an opportunity to become the leader in food delivery which has recently become a hot area with dramatic growth in third-party delivery companies like Grubhub (GRUB).  In McDonald’s Global Growth Plan, the company mentions this opportunity stating that in its top five markets (U.S., France, the U.K., Germany, and Canada) nearly 75% of the population lives within three miles of a McDonald’s.  No other food company has this kind of reach.  The company already delivers food in China, South Korea, and Singapore with annual system-wide delivery sales of $1 billion.

There is also still room for international expansion despite the fact that McDonald’s already operates in over 100 countries.  In its most recent annual report, the company identified China, Italy, Korea, the Netherlands, Poland, Russia, Spain, and Switzerland as markets that it believes have relatively higher expansion and franchising potential.  For fiscal 2016, international markets accounted for 34% of revenues.  Overall, the company is targeting sales growth of 3 to 5% with an operating margin in the mid-40% range.  The company is targeting EPS growth in the high single digits.  While these targets are achievable they are far from certain.  Earnings grew by a more modest 3.5% on average for the trailing 5 year time period. 

High Marks for Consistency

It is doubtful that investors can find many companies as reliable as McDonald’s with its impressive cash flow and manageable debt levels.  The profit margin for the trailing twelve months was 22.75% while return on invested capital came in at a solid 20.42%.  Further evidence of McDonald’s consistency is found by looking at the financial performance metrics with five year averages for return on assets, return on equity, and return on invested capital coming in at 14.6%, 77.6%, and 19.52%, respectively.  The reason for the inflated return on equity numbers has to do with the considerable long term debt compared to equity. 

McDonald’s had $25.9 million of long term debt as of December 31, 2016.  Of course, given its track record and associated low interest requirements by its bondholders, this is a relatively cheap way for the company to finance its operations.   The graph showing the change in debt to assets provided below shows that the level of debt actually increased substantially in recent years starting in 2015.



This sudden increase in the debt level was a result of what the company calls optimization of the capital structure.  The idea of this restructuring was to leverage the access and favorable terms available for credit.  The strength and reliability in free cash flow as well as this availability of credit is what allowed McDonald’s to increase its dividend and return $30 billion in cash to shareholders in the three years ending in 2016.  While these debt levels undoubtedly increase risk, we feel that McDonald’s made a savvy decision to take advantage of the low interest rate environment to the benefit of shareholders.

Despite this Mc Donald’s has slightly under-performed the S&P 500 over the last 5 years, returning 69.5% compared to 72.57% for the S&P 500.  However, to see the true benefits of consistent operating results and owning McDonald’s we need to look at a time period that includes the contraction phase of an economic cycle or a recession.  Looking at the most recent 10 year time period, which includes the 2008 financial crisis, we see real out-performance by McDonald’s.  McDonald’s returned 189% over this time period compared to 96.77% for the S&P 500.  The impact of the financial crisis on the stock was negligible in comparison. 

Discounted Cash Flow Analysis
With the recent decline in the overheated markets, McDonald’s has dropped back to a slightly undervalued level.  Of course, the valuation depends on what growth estimate you use.  Our first model considers the following inputs:
  • Quote: $160.80
  • Discount rate: 10% (desired annual return)
  • Dividend: $4.04 (2.51%)
  • EPS: $6.36 (trailing twelve months)
  • EPS average annual growth rate for the next five years: 8.3% (Average analyst estimate from Reuters)
  • PE ratio in year 5: 25 (this is about equal to the current PE of 25.28)

Using these inputs shows that McDonald’s is currently trading at 96% of fair value.  Clearly, this is not much of a margin of safety.  However, we should keep in mind that we used a 10% discount rate and that we are talking about one of the most consistent companies out there.  On the other side of this argument let’s consider a change to one number in the model.  We could have used the meager average annual EPS growth rate over the last five years, 3.52%, in place of the analyst estimate.  In this case the model shows us that McDonald’s is actually trading at 118% of fair value.  Overall, we think that the average analyst growth estimate of 8.3% may be too optimistic, while the historical growth rate of 3.52% is actually reasonable.  Reuters only provides three analysts estimates.  The lowest of these three was 8%, so not much lower than the average.

The table below considers some other metrics to provide another view of the current market valuation of McDonald’s relative to the industry.


Source: Reuters & Finviz
From the table we see that McDonald’s Beta, a measure of volatility, is quite low.  This is also true for the industry in general.  This has to do with the earnings reliability discussed throughout the article.  Since we discussed the ballooning debt level we included the interest coverage.  Here we see that this level of debt is actually quite comfortable for a company like McDonald’s.  This number tells us that the company could pay its annual interest expenses about nine times with its earnings in a given year.  This gives us further confidence that McDonald’s has not increased its leverage to a level we would  consider to be overly risky.  Overall, the table seems to indicate that McDonald’s is trading at a reasonable level relative to peers given that it is arguably the most reliable and well known name in the space.

Options

Options are available for McDonald’s.  However, the current price per share is $160.80 and since selling covered calls requires 100 shares; this is likely only something an investor with a substantial portfolio balance would consider.  We will discuss how using a buy-write strategy with McDonald’s could provide a yield boost.  An investor that buys 100 shares can sell a covered call to provide some extra income.  One call of interest is the one expiring on June 15th with a strike price of $175.  This option would provide a premium of $2.88 per share or $288 per contract.  In this case the seller of this contract would only need to sell his or her shares if the price increased by almost 9% over the next 4 months.  If the call is exercised the investor would make about 10.5%.  If on the other hand, the stock does not go up by 8.83% over this time frame the investor will keep his or her shares.  The $288 premium would equate to an annualized yield of 5.17% after considering fees of $14 which may vary slightly based on your brokerage.  We think selling this option would be a reasonable thing for an investor with 100 shares to do since McDonald’s could be considered slightly overvalued at that point and the annualized return from the premium is attractive.

Final Thoughts

When the market is overvalued and volatility is finally finding its way back into the market, it’s nice to have a stock that performs well in every phase of the economic cycle.  Stable cash cows like McDonald’s are almost never trading at a large discount to fair value.  Why would they?  However, while McDonald’s is not necessarily cheap at its current level, we think the recent decline has made it a suitable opportunity for investors to initiate a position.  In the next five years, we think that McDonald’s can at least achieve its historical average annual EPS growth rate for the last five years of about 3.52%.  Anything above this would be a bonus.  Even if McDonald’s just maintains this growth rate, we think investors will receive satisfactory results by holding this stock which is fit to handle any type of market.  Therefore, investors may want to consider giving the burger giant a spot in their portfolios.

Monday, February 12, 2018

QCR Holdings (NASDAQ: QCRH)


  • QCR Holdings is undervalued based on our discounted cash flow analysis in addition to trading at a substantial discount to peers.
  • Despite the overall market getting ahead of itself, QCR Holdings has been under-followed or at least underappreciated by investors.
  • This is a bank with conservative management, solid historical performance, and attractive opportunities for growth via consolidation in the regions it serves.

See the Full Seeking Alpha Article HERE

Thursday, February 1, 2018

Global Brass And Copper Holdings (NYSE: BRSS)


  • GBC Holdings has favorable business economics with its low capital expenditures compared to other industrial companies.
  • Global Brass generates attractive cash flow while servicing many industries and providing a broad array of products.
  • This is one of the few industrials and stocks in general with solid performance that still trades at an attractive valuation in the extended run of this bull market.

Read the full Seeking Alpha article HERE

Sunday, November 12, 2017

Citi – Slightly Undervalued for a Reason

 Citigroup (C) is still slightly undervalued based on a discounted cash flow model despite currently trading only slightly off its 52 week high and having risen 36.76% over the last twelve months.  Citigroup is not unique in this regard.  The other three giant U.S. banks JPMorgan Chase (JPM), Wells Fargo (WFC), and Bank of America (BAC) have gone up 27.15%, 4.02%, and 39.38% over the last 12 months, respectively.  Wells Fargo was the notable underperformer relative to peers largely due to the impact of the fake accounts scandal. 


Valuation

None of these banks are trading at a huge discount to fair value after these impressive runs.  Our DCF model shows Citi, JPMorgan, Wells Fargo, and Bank of America trading at 92%, 95%, 98%, and 87% of fair value, respectively.  The DCF model considered a 10% discount rate, the earnings over the last 12 months, the current dividend, and the average long term growth rate from analysts covering the companies.  Specifically, the inputs for Citi are listed below:

  • Quote: $72.25
  • EPS: $5.19
  • PE: 13.93
  • Dividend: $1.28 (Yield: 1.73%)
  • Long term earnings growth rate: 9.53%
  • Discount rate: 10%
  • Target Buy Price:  $78.7 (92% of current price)
Citi is cheaper than JPMorgan and Wells Fargo and slightly more expensive than Bank of America based on the DCF evaluation.  However, there is good reason for this slight undervaluation.  Citigroup had the lowest average annual growth rate over the last five years out of the four banks.  Additionally, Citigroup ranks lowest based on various profitability metrics.  For example, Citi has the lowest return on equity and profit margin among the big four.  The trailing twelve month profit margin for Citi was 23.6% compared to 31.7%, 35%, and 46.6% for Bank of America, Wells Fargo, and JPMogan, respectively.

We should also note that the average estimate for Citi’s long term earnings growth rate of 9.53% from analysts polled by Reuters seems rather optimistic.  One should note that the average annual growth rate of the last five years was 5.7%.  On a positive note, that gives at least some credibility to the growth rate used above, quarter over quarter earnings grew by 14.5%.  The latest 10Q shows EPS of $1.42 for the three months ending September 30th compared to $1.24 for the same quarter in 2016.  While there is potential for Citi to achieve the 9%+ average annual EPS growth, especially with its operations in Latin America and Asia, there is plenty of uncertainty evidenced by the low end of the analyst estimates for the annual long term EPS growth which came in at 5%.  Using this more conservative forecast in the DCF model actually results in a target buy price that indicates that Citi is trading 15% above fair value.

Recent Results

Citigroup splits its results by three segments which include Global Consumer Banking (GCB), Institutional Clients Group (ICG), and Corporate/Other.  The GCB Group includes operations in North America, Latin America, and Asia offering local business and commercial banking, residential real estate loans, and asset management in Latin America.  It offers Citi-branded cards in all regions while offering retail services in North America.   The ICG provides Investment banking and treasury and trade solutions in addition to corporate lending.  It also offers markets and securities services in fixed income and equity markets.  This segment also generates some of its revenue from Europe, the Middle East, and Africa (EMEA).  Finally, the Corporate and Other segment covers operations and technology and global staff functions as well as other corporate expenses.  It also includes results of discontinued operations.

A review of the third quarter operating results shows that the quarter over quarter jump in EPS is largely attributable to the ICG which saw income increase by 15% quarter over quarter.  The ICG had net income increase by 24%, 15%, -2%, and 11% in North America, EMEA, Latin America, and Asia, respectively.  The bright spot in GCB was Asia.  Net Income from GCB increased by 15% in Asia while it actually declined by 16% in North America.  Latin America’s GCB segment saw modest income growth of 3% on a quarter over quarter basis.  Citigroup’s net income also got a boost by the reduced drag from discontinued operations compared to 2016.

Final Thoughts

While you can do a lot worse than investing in Citigroup, investors can likely find better places to put money at this point.  Citigroup is now fairly valued even if you use the more optimistic end of the long term growth estimates in your valuation calculations.  It also usually is not advisable to invest in the least efficient or least profitable company just because it seems cheaper.  There are some promising aspects of Citi’s business with its operations in Asia and Latin America providing real growth potential.  However, recent results show that Citi continues to lag its three big peers on most profitability and efficiency metrics.

Wednesday, November 1, 2017

Cirrus Logic – Seriously Cheap

  • Cirrus Logic has not kept pace with the rise of the NASDAQ this year leaving it as one of the few value plays left in the technology space.
  • The company is poised to benefit from many of the hot emerging areas in the technology space such as the smart home and connected car.
  • This company is well off its highs, has a strong balance sheet, has impressive cash flow, and we still see significant growth potential.

Cirrus Logic is one of the few technology companies with a long term positive outlook that is not hovering at a 52 week or all time high.  In fact despite the 5% jump on Friday, the company is still 20% below its 52 week high and is only up 0.85% for the year.  We think the future for Cirrus Logic is bright given the emerging opportunities for the portable audio chip maker.  Cirrus Logic has grown sales by an annual average of 29.2% over the last five years.  EPS grew by an annual average of 24.90% over the same time period.  If you believe that Cirrus can grow earnings at even half this rate for next five years, like we do, then the company is significantly undervalued at current levels.  Added to the growth potential, Cirrus has a strong balance sheet which includes no long term debt.

The Company

Cirrus Logic is a portable audio chipmaker.  They are a leader in high performance low-power integrated circuits for audio and voice signal processing applications.   The company’s products cover every aspect of audio in electronics from capture to playback.  Their components are found in smart phones, tablets, digital headsets, and as will be discussed more below smart home applications.  If you have an Apple iPhone, you are using Cirrus components.  Per the 2017 Annual Report, the company targets growing markets where it can leverage its expertise in analog and digital signal processing to solve complex problems.

The company basically operates in two segments which are portable audio products and non-portable audio products.  The portable audio products are used in mobile applications such as smart phones and tablets while the non portable audio products are used in smart home applications as well as automotive and industrial applications.

Cirrus contracts out the production of their semiconductors so they are a fables semiconductor supplier.  We view this as a positive since it reduces capital expenditures.  Additionally, the company says that the outsourced manufacturing strategy allows it to concentrate on its design strengths while minimizing fixed costs.  They use a variety of foundries including those of Taiwan Semiconductor (TSM) and MagnaChip Semiconductor. 

The company’s main competitors include Qualcomm, AAC Technologies, AKM Semiconductor Inc, and Analog Devices Inc. to name a few.  Cirrus and its competitors have more frequent opportunities to achieve wins in the portable audio device segment due to the shorter product life cycles compared to non-portable audio market which provides more reliable continued revenue streams.

Voice-as-an-interface

One driving force we want to highlight is voice-as-an-interface.  Here we are talking about human interaction with computers or other electronics through speech in order to initiate a response.  One product that already highlights this as a growth area for Cirrus is the Amazon Voice Capture Development Kit.  As stated by Jason Rhode, the Cirrus CEO, in the 2018 first quarter call, the Voice Capture Development kit “enables a wide range of consumer OEMs to bring Alexa-enabled smart home products to market faster and more efficiently.”  The Amazon Alexa Voice Service adds voice control to connected products that have a microphone or speaker.
He went on to state that he expects voice-as-an-interface to be a really huge driving force in the industry.  There are many opportunities for Cirrus in this emerging area.  This was emphasized by Jason Rhode in the conference call as he noted that where Cirrus really sees its strength is in improving performance via algorithms embedded in a device to provide audio and voice performance in ultra low power, low latency applications.

Our Answer to a Recent Underperform Rating

Customer concentration is by far the biggest concern for Cirrus with the Apple (AAPL) iPhone accounting for somewhere between 75 to 80% of revenue.  A Bank of America analyst recently issued an underperform rating on the stock with a $50 price target largely related to this concern.  The rational was that revenue from the iPhone may not increase after fiscal 2018.   We think there are sufficient opportunities aside from the iPhone to allow for continued growth.  Again keep in mind that the share price of Cirrus should increase substantially if the company can just grow earnings by less than half the annual average of the last five years.  The company already counts many other major companies as customers including Samsung, Lenovo, and Ford to name just a few. 

With emerging opportunities for their components to be used in more products such as those related to biometrics and in applications using voice as an interface, the company should be able to reduce the share of revenue coming from Apple.  At the very least, we expect to see revenue from other companies increase going forward even if Apple remains by far the largest customer.  One other example of this was highlighted on the 2018 Q1 call.  The company mentioned ramped production of a recently introduced hi-fi DAC and a boosted amplifier with a customer in China for a flagship smart phone that was introduced in the summer.

In order to justify the underperform rating mentioned a very short term outlook is required.  The rating analysis mentions that significant revenue won’t be generated from emerging opportunities such as Android smart phones and wearables for at least two to three years.  We do not view this guidance as overly helpful to investors given that it rarely makes sense to judge potential investments by placing emphasis on what is happening in the twelve months or the next couple of quarters.  If you do not think a company has a positive long term outlook, you would likely never consider investing in it to begin with.  Similarly, if you think a company has a bright long term future, how much emphasis would you place on the next quarter?  Trying to time the market generally costs more in missed opportunity than it saves.  We believe that companies as well as investors that focus more on narrow short term results rather than long term value underperform. 

Add to this that Cirrus is currently significantly undervalued based on a discounted cash flow model as well as relative to its peers.  It seems that any temporary slowdown in growth is already priced in.  This just makes it even more likely that the company can surprise to the upside.  Keep in mind that we are talking about a company with a current P/E ratio of 13.33, a forward PE ratio of 11.88, and an average long term EPS growth estimate of 20%.  Finding overvalued technology companies priced to perfection is actually very easy in the current elevated market making a sell rating on a company with Cirrus’ valuation even more illogical.

Research and Development

The company spends a significant amount on R&D which is required to keep up with the fast changing technology and continue to provide innovative solutions to its clients.  Per the annual report, for fiscal 2017, 2016, and 2015 research and development expenses totaled $303.7 million, $269.2 million, and $197.9 million, respectively.  The 2017 increase in spending was largely attributed to the 16% increase in R&D headcount.  The company now employs over 1,000 engineers. 
 
When an analyst asked about the lack of debt and potential uses for the generated cash, the first part of the CEO’s reply was focused on the continued investment in R&D as well as adding small technology acquisitions over time.  We think that this approach makes sense given the number of growth opportunities that should present themselves in the near term and coming years.  Buybacks were also briefly mentioned as a possibility as something that will be looked at on an opportunistic basis. 

A big part of staying on the cutting edge and driving innovation for technology companies is the ability to retain top engineering talent.  On this front, Cirrus was ranked 14th in the Forbes list of best places to work for small and medium-sized technology companies.  The company has a 3.8 out of 5 rating on Glassdoor.  Overall, at a high level based on reviews and ratings, it appears that Cirrus Logic provides an environment that allows it to retain and hire the engineering talent required to drive innovation and grow the business.

Valuation

We will consider a discounted cash flow model with the inputs provided below.  For the long term EPS growth rate, we will not use the average annual growth rate of the last five years, 24.9%, or the overly optimistic average analyst estimate of 20%.  Instead we will use half of the average analyst estimate, 10% in addition to applying a 10% discount rate.  The model will also not assume any share buybacks even though a share repurchase program has been authorized.  In the last few years the share count has actually increased slightly every year. A future P/E of 15 is used in the model which is higher than the current P/E of 13.33 but is lower than the average P/E of the sector, 16.31.  The model inputs are summarized below:
  • Discount rate or desired annual return:  10%
  • EPS (ttm): $4.28
  • Average annual EPS growth rate estimate for the next five years:  10%
  • Expected future P/E:  15
Using the inputs provided above, the DCF model tells us that Cirrus is trading at 89% of fair value when using a 10% discount rate.

Another model we considered was even more conservative and used a 10 year time period.  In this model we used the same 10% growth rate for the first five years and then assumed that the growth rate would decline by one percent each year for the remaining five years.  Under this ultra conservative scenario, the model finds that Cirrus is trading at 102% of fair value.  Given that this overly pessimistic model still shows Cirrus Logic as fairly valued, we think the DCF models confirm that Cirrus is a buy at current levels.

Financial Highlights

We mentioned previously that Cirrus Logic operates under a model that is light on capital expenditures.  This has allowed for impressive cash flow.  The table below shows that cash flow from operations easily covered investments in property, plant and equipment.  The table also shows the cost of acquisitions in the last 10 years.


Source: barchart

Looking at the income statement for the last 5 years, we see impressive increases in sales.  We see the recent upward trend continuing, even if not at the same impressive rates as the last couple of years, given the expanding opportunities for their components to be used in a wider array of applications.  We think the 10% average annual increase in earnings used in our DCF model above is achievable and has a relatively high probability of being surpassed.  Sales grew by 23.6% on a quarter over quarter basis providing further indication that Cirrus is not slowing down.

Source: barchart

Other positives to keep in mind are the lack of long term debt and the impressive current ratio of 4.0.  On a slightly more negative note, the balance sheet shows an accumulated deficit.  However, it is becoming less negative at an impressive rate and should change to showing retained earnings shortly.


Source: barchart

We think that Cirrus Logic underperforming the NASDAQ by such a wide margin provides new investors with an opportunity to acquire the shares at a fair or even discounted price.  This is based on the discounted cash flow model and the emerging opportunities for the company to broaden its client base and the likely increase in the number of applications for its components.


Final Thoughts

Cirrus Logic is one of the few value plays left in the technology industry.  We see this as an interesting opportunity not only because of valuation but because it is a growth story.  Its audio components are directly related to many hot growth areas such as the connected car, smart home, and secure user identification or authentication.  Yes, Apple is a big customer and we are concerned about customer concentration.  However, the company does have about 3,000 customers world-wide and we think the company can expand on these relationships to build its business with them in these new emerging areas. 

Although the company does not pay a dividend as a result of the focus on growth, there is an opportunity for investors to obtain a yield boost via options.  We recommend looking at the possibility of using a buy-write strategy.  One example would be to sell the call expiring on March 16th with a strike price of $75.  The seller receives $55 per contract sold or $0.55 per share based on the current bid.  This equates to an annualized return of over 2%.  Note, that in this case the investor would only need to sell his or her shares if the stock price increased by over 31% from the current price of $57.02 in slightly over four and a half months. 


Finally, for investors that are adverse to buying something that just went up over five percent in a single day, we understand but suggest keeping Cirrus Logic on the radar with the possibility of taking advantage of any pullbacks.  For investors that consider valuation, looking to put some money to work in the technology sector, we think Cirrus is a logical choice that will provide satisfactory returns in the years to come.

Monday, October 9, 2017

Ichor Holdings – Cheap Small Cap Missed by Wall Street’s Radar

  • Ichor share price does not make much sense after performing a discounted cash flow analysis.
  • The company is producing some of the most complex subsystems needed by semiconductor manufacturers.
  • The stock has already soared this year but we think substantial upside potential remains.

Ichor Holdings (ICHR) has gone up well over 100% for the year.  Despite this the stock still appears grossly undervalued even if we assume little growth.  In reality growth expectations are not low at all for this semiconductor equipment company.  Recommending stocks after such a strong rally is not generally something we would consider but Ichor’s current valuation, to be discussed below, makes us confident that this is still an attractive opportunity for new investors. 


Products

Ichor is a $658 million dollar company involved in the design and manufacturing of fluid delivery systems for equipment used in semiconductor manufacturing.  The main products include gas and chemical delivery subsystems which are key components of tools used in the manufacturing of semiconductors.  The gas delivery subsystems deliver, monitor, and control precise quantities of specialized gases used in semiconductor manufacturing processes such as etch and disposition.  The chemical delivery subsystems blend and dispense the reactive liquid chemistries used in semiconductor manufacturing processes such as chemical-mechanical planarization, electroplating, and cleaning.  Finally, the company also manufactures components for use in fluid delivery systems.

Most semiconductor OEMs outsource the design and manufacture of their gas delivery subsystems to a few specialized suppliers such as Ichor.  Increasingly OEMs are also outsourcing the design and engineering of chemical delivery subsystems as a result of the increased fluid expertise required.  Ichor will continue to benefit as this outsourcing trend continues.  The OEMs benefit by outsourcing the work related to these fluid delivery systems if it allows them to reduce the fixed costs and development time.  In its latest 10K, Ichor says its clients include two of the largest manufacturers of semiconductor capital equipment in the world, Lam Research (LCRX) and Applied Materials (AMAT).  The company frequently has its engineers working at its customer’s sites to engage with their product design teams.  This allows the company to build subsystems to meet the exact specifications of the customer and often allows them to be the sole supplier of these subsystems during initial production ramp up.

Company Overview

Ichor has a 17 year history in which it developed deep capabilities in designing and building gas delivery systems.  The company has a global footprint with facilities located close to its customers.  This has allowed the company to establish long standing relationships.  Over two decades, the company has been developing complex fluid delivery subsystems to meet the constantly changing production requirements of semiconductor OEMs.  They have significant capacity in Singapore to support high volume products.  The two companies mentioned previously, Lam Research and Applied Materials, were the two largest customers by sales in 2016.  Sales from continuing operations grew by an impressive 40% to $405.7 million in 2016 with net income coming in at $20.8 million. 

Ichor’s engineering team is made up of chemical, mechanical, software, and systems engineers.  Their engineering teams work directly with their customers’ product development teams to provide technical expertise outside their core competencies.  The company seeks to use its long standing relationships with two of the market leaders to locate new business opportunities created as a result of industry consolidation.  The assembly and integration of high purity gas and chemical delivery systems happens at the company’s locations in Singapore, Tualatin, Oregon, and Austin, Texas.  The company also has a facility in Malaysia for components used in the gas delivery subsystems and in Union City, California for components using in chemical delivery subsystems.  These facilities are located in close proximity to customers.

One of the key elements that make Ichor an attractive investment is the relatively low rate of capital expenditure.  The company is able to grow sales with a low investment in property, plant and equipment.  The company also highlights its close supplier relationships which allow it to scale up production quickly without maintaining a lot of excess inventory.  Risk is reduced by this low fixed cost approach since it minimizes the impact of cyclical downturns on net income.  We prefer this conservative approach even though it results in a smaller increase in gross margin as a percentage of sales in times of increased demand.

Fueling Growth

The company acquired Ajax United Patterns and Molds in April of 2016.  This acquisition is what allowed Ichor to offer chemical delivery subsystem capabilities to its existing customers.  The Ajax acquisition enabled Ichor to manufacture complex plastic and metal products required by the medical, biomedical, semiconductor, and data communication equipment industries.  As a result of deploying more leading edge tools, the company will grow its business as OEMs will need to refurbish legacy systems.

More recently the company acquired Cal Weld, a leader in metal component manufacturing which is considered a strategic business for Ichor.  The acquisition cost was $50 million of which $20 million was paid in cash and the rest borrowed.  It expands capacity and capabilities in the component manufacturing area for gas delivery tools in semiconductor manufacturing.  Cal Weld supports key semiconductor tools such as deposition and etch.  The Cal-Weld facilities are located in Fremont, California and Tualatin, Oregon.  Cal Weld is expected to generate between $65 million to $80 million in revenue next year.


While there is currently a risk posed by customer concentration, the company is seeking to expand its customer base within the fluid delivery market.  The recent annual report mentions that Ichor was selected as a manufacturing partner for a provider of etch process equipment that was previously not a customer.  The company is also planning to diversify its sales exposure and leverage its current capabilities by acquiring new products and solutions for high growth applications in new markets such as medical, research, and energy.

In the second quarter earnings call the company sounded very optimistic on continued growth noting that they are seeing increased business beyond the two largest customers.  The company said its third and fourth largest customers are expected to grow 100% this fiscal year. One of these customers asked Ichor to redesign their gas delivery systems for better performance and lower cost.

Risks

Clearly one concern for Ichor is that the semiconductor equipment OEMs could start developing the gas or chemical delivery subsystems internally.  Otherwise, the primary competitor is Ultra Clean Technology for gas delivery subsystems.  The chemical delivery subsystem industry is highly fragmented as is the tool refurbishment market. 
As a result of the customer concentration issue mentioned previously, the clients have a significant amount of negotiating leverage which could lead to price and margin pressure.  Additionally, the company will be impacted by any decline in semiconductor sales or the various electronic products requiring semiconductors. 

One more unique concern is the fact that Ichor is a largely controlled by a single investor, Francisco Partners, which owned over 74% of the outstanding shares at the time of the last annual report.  This is a board governance issue since it means that Francisco basically controls who is elected to the board of directors which could mean that the interests are not always aligned with the interests of other shareholders. 

Also, keep in mind is that the company is incorporated in the Cayman Islands and Cayman Islands law provides less protection for shareholder interests compare to the laws of the United States.  Another drawback that comes along with investing in a company that only recently became public is that there is not the same level of historical data available as compared with companies that have been public for an extended period.  The company provides financial statements going back to 2014 which will be discussed in sections that follow.

Financials & Valuation

 The balance sheet is not ideal given that retained earnings, or in this case accumulated deficit, are negative and there is some long term debt even if it is not an unreasonable amount.  While there is currently still an accumulated deficit the value will not be negative for long if the current pace continues as seen in the table below. 

Source: barchart
The current ratio comes in at an acceptable 1.80 and long term debt to equity stands at 0.22.  A clear positive is seen when looking at the income statement where we see incredible sales growth in the last three years as well as the last few quarters.  We also like the way the annual cash flow numbers are looking where cash flow from operations easily covers capital expenditures and even the 2016 acquisition.


Source: barchart
Looking more closely at recent results, it should be noted that we are seeing some margin pressures.  For the quarter ending in June, although sales increased, net income actually decreased as a result of increases in the cost of goods sold and operating expenses.  The table below shows cost of goods sold and operating expenses as a percentage of revenues.  One part of the drop in income not shown in the table is the negative contribution of -$610,000 from discontinued operations.

Source: barchart
Next, we will take a quick look at our discounted cash flow model.  Rather than use the trailing twelve month EPS of $3.64, we will use the lower EPS estimate for next year which is $2.79.  We rather use the lower of the two numbers to keep the model slightly more conservative.  The current forward P/E is 9.46.  We think this is unreasonably low in comparison to the industry and market in general and will use a future P/E ratio of 15 in the model.  Finviz  provides an optimistic long term EPS estimate of 29.25%.  Earnings did grow by 310% on a quarter over quarter basis.  Keep in mind that this is at least partially related to the acquisitions mentioned above.  We will not use either of these growth numbers in our DCF model.  Instead we will adjust the required long term growth rate until the model shows that the current price is equal to the target buy price.  In this way, we see the growth rate that would be required to get the return on investment we are looking for.  The DCF model inputs are summarized below:

  • ·         EPS estimate for next year: $2.79
  • ·         Future P/E ratio: 15
  • ·         Discount rate (desired annual return):  10%
  • ·         Long term annual EPS growth rate:  1%  (Read notes below)

Again, the long term EPS growth rate used above is not what we actually expect the growth rate to be.  This is just the calculated growth rate required to make the current price equal to our target buy price.  Basically, the model is showing us that the stock is grossly undervalued if one actually believes the analyst estimates or assumes any kind of substantial growth from here like we do.  Despite the massive run up since the IPO, the DCF model makes us think there is still plenty of room to the upside.  The table below provides some key valuation and financial metrics for Ichor.


Source: finviz

Final Thoughts


Clearly the right thing to do was buy the shares at the IPO price or anytime at the beginning of the year since the stock has already gone up well over 100% for the year.  However, this does not mean it is too late to initiate a position.  In the case of Ichor, we think there is still plenty of room to the upside from here based on the discounted cash flow model and growth prospects.  We rate Ichor a buy.  Unfortunately, a buy-write strategy is not a possibility since there are no options available for this stock.  Of course, we do not think this is a reason to ignore Ichor given the significant undervaluation.  The potential of this small cap company, with a market cap of $661.83 million, appears to be going unrecognized by the market and it may make sense to buy before it starts getting the attention it deserves.  Finally, keep in mind that other companies in the space like Ultra Clean Holdings (UCTT) trade at much higher multiples.