Executive Summary
An old spin-out of Eaton Corp. (ETN), Axcelis Technologies (ACLS) designs, manufactures and services ion implantation, dry strip and other processing equipment used in the fabrication of semiconductor chips. The semiconductor capital equipment industry is very cyclical, and as a smaller player in the industry, ACLS has not been immune, and gone through protracted periods of losses. In the past few years, the company has taken numerous steps to reposition itself for the next cyclical upswing by listening to its customers and investing heavily in R&D to revamp its product line to expand its addressable market opportunity, right-sizing its cost structure to substantially lower its breakeven level, establishing new collaborative partnerships, and optimizing its balance sheet to unlock value. Now with signs of a cyclical upswing occurring, and being led by memory - Micron (MU) and SanDisk (SNDK), ACLS is poised for accelerating earnings potential beginning in Q4'2013 that could drive its stock price substantially higher. However, with a few nearer-term catalysts on the horizon, investors may not want to wait too long before purchasing shares. As an early indicator, investors should consider that insiders recently purchased the stock in the open market in August at current levels. These stock purchases coincide with the one year anniversary of ACLS's new Purion M product line entering an evaluation period with a major customer. Sell-side analysts are starting to take notice and listening in to the company's recent conference call, which at least opens the door to new broker initiations in the future. The downside risk appears mitigated by ACLS's strengthened balance sheet, and dramatically improved operating financial model that has stemmed further cash burn. As the company hits an inflection point with new customer contracts and proves its earnings cycle is under way, we expect ACLS's valuation discount to peers to narrow and the stock to appreciate substantially from ! its current price.
Imminent Customer Contract Announcement Would Open A New $35- $70m Annual Revenue Opportunity
Axcelis offers a complete implant product portfolio, and has invested in excess of $310 million in R&D since 2007 to build a platform of leading equipment used in the fabrication of semiconductor chips globally. Its single wafer, spot beam ion implanters cover all traditional and emerging applications at 32nm and below. The annual implant revenue opportunity is approximately $1 billion annually and split approximately 50%/35%/15% between the High Current, Medium Current, and High Energy segments, respectively. Axcelis has historically dominated the High Energy segment with the Purion XE product, but in order to serve its customers entire spectrum of needs and provide an element of commonality, it has developed a solution for the Medium Current market called Purion M. At the end of August 2012, the company announced its first shipment of Purion M to one of the world's leading chip manufacturers. The product has been in an evaluation period with this customer in Asia for a year, where it is undergoing qualification for DRAM and logic process flows. Two other evaluations have been announced in March and May 2013 by a chipmaker in memory and flash device manufacturing, and a foundry for advanced logic devices. The company has told investors it is confident in its ability to secure revenue opportunities based on the proceedings of these evaluations to date, and expects to provide an additional update to investors in Q3'2013. Validation of the Purion M product through a customer order announcement would be a significant milestone for Axcelis and open the company to an entirely new market segment worth an estimated $350-$400 million per year.
This medium current segment has traditionally been dominated by Varian Semiconductor, which was acquired by Applied Materials in 2011. Axcelis has hired former Varian employees in product engineering and sales to bolster its efforts to suc! ceed in t! he market. Assuming ACLS can capture between 10-20% of this market, it would yield $35-$70 million of new revenue opportunity that didn't exist in previous cycles.
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Substantial Earnings Leverage with Numerous Costs Taken Out During The Last Cycle
Axcelis hired Jay Zager in January 2011 as its CFO to focus on the alignment of its cost structure and right-sizing of the business to the current market. Previously, Mr. Zager had been CFO of 3Com Corp., where he oversaw the sale of the company to Hewlett-Packard (NYSE:HPQ). In the charts below, we can see the success he has had in dramatically lowering the company's operating cost structure. In particular, SG&A expense has fallen by 52% since 2007, while under Mr. Zager's watch, SG&A expense has fallen by 21% since 2011. These efforts have allowed the company to lower its quarterly revenue breakeven point from $86.0m in Q1'2011 to just $56.7m in Q1'13.
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In addition, the company announced in December 2012 that it entered a strategic collaboration agreement on ion implant, dry-strip, etch processes, and photoresist strip applications, including material modification implants and high-dose implant strip (HDIS) with Lam Research (LRCX). Lam also agreed to acquire ACLS's dry strip intellectual property and technology for $10.7m ($8.7m received immediately, and $2.0m based on milestones). ACLS will indefinitely retain the entire service and support contracts of its dry strip installed base. In addition to the immediate financial benefits, ACLS benefits from a partnership with Lam by getting better! visibili! ty into end customer problems, and the ability to expand addressable market opportunities.
Axcelis also recently announced it strengthened its cash position even further in July with a $15m cash infusion from the proceeds of a low interest rate loan secured by a mortgage against its headquarters in Beverly, Massachusetts. This measure enhances the company's cash position to $50m, and increases its financial flexibility to fund growth investments in the Purion ion implant platform as necessary. Most importantly, the company announced on its Q2'13 conference call that it is now projecting to achieve profitability by Q4'13 after 7 quarters of losses. Having recently completed his objectives to financially strengthen the business, Mr. Zager recently retired to pursue Board work, and ACLS named Kevin Brewer as the interim CFO.
Furthermore, the company has given early indications of what investors should expect in the upcoming cycle. Management believes revenues will exceed what was achieved in the Q4'10 - Q2'11 period of $93m per quarter. The revenue gains are primarily forecasted to be a function of a strengthened product portfolio allowing for market share gains, and the introduction of the Purion M system.
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In the Q4'10 - Q2'11 period, Axcelis managed to earn a total of just $0.04c, and its stock reached $3.70 per share. However, this coming upcycle is poised to deliver much more dramatic earnings gains for investors. In the table below, I've modeled a conservative, base, and upside case. In the conservative case, I've assumed that revenues approach 2011 peak levels under the new cost structure of $21m per quarter, but gross margin ranges do not expand much. Under base and upside case scenarios, I've assumed slightly more revenue, and the benefit from gross margin expansion. A wide range of quarterly EPS possibilities result from $0.11 to $! 0.23c of ! earnings per share.
Investors will also benefit from the company's large Net Operating Loss (NOL) position of $118m. Approximately 75% of sales are to foreign customers, but the revenue is booked in the US, which will allow the company to offset future taxable earnings with a portion of the NOLs.
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Numerous Bullish Indicators Include Insider Buying, Heavy Options Activity and New Sell-Side Analyst Interest
For long-term shareholders of Axcelis, achieving a return on investment has been a daunting and frustrating experience. The company missed a key shift in customer preference over a decade ago (from implanting batch wafers to single wafer systems). In February 2008, the company turned down an unsolicited offer for $6 per share from TPG and Sumitomo Heavy Industries. The timing for rejecting the offer couldn't have been worse, as the financial crisis would later force the company to restructure and attempt to refinance its debt in a frozen credit environment. After missing an interest payment on its convertible sub notes, Axcelis announced an agreement to sell its interest in its joint venture with Sumitomo for $133m, allowing it pay off its debt and retain value for shareholders, who had once discarded the stock at prices under $0.20c per share.
Very recently, there have been numerous bullish indicators suggesting that dramatic upside exists, even after the year-to-date rally in the stock from a low of $1.10 in March 2013. For example, on July 16th executive managers were awarded stock options as illustrated here under the 2012 Equity Incentive Plan with a strike price set at $1.99 per share. The options vest ratably over the next four years. However, the options vesting will accelerate according to the following triggers: 1) 50% of options shall be exercisable if ACLS's stock hits $2.50 for 20 consecutive trading days and; 2) 100% s! hall vest! and be exercisable if the stock hits $3.00 for 20 consecutive trading days. Reading between the lines, it appears management views $3.00 as an achievable target where both they and shareholders can be rewarded.
In early August, after reporting second quarter results that were in line with expectations, the company's share price swiftly declined from $2.23 to $1.81 per share. By the following week, a group of four ACLS directors purchased 60,000 shares at an average price of $1.88 per share. This is another bullish indicator that shows support by insiders for the current share price. These open market share purchases were in addition to the option grants that directors received just one month earlier.
We also note the observance of a significant open interest in the $2.50 strike for December 21, 2013 expiration. Currently there are almost 13,400 contracts open which equates to 1.3 million shares, or 1.2% of the total shares outstanding. At a price of $0.15c per contract, a bullish investor is wagering that ACLS's stock price will be at least $2.65 per share by the end of the year to break even on the position. Such a large open interest in a micro-cap stock is a highly unusual and a very bullish indicator.
Lastly, we note that just one sell-side analyst at Craig Hallum research covers Axcelis, and has a buy rating with a $3.50 price target. In reviewing the estimates for 2014, it appears the analyst is giving significant room for upside revisions to sales and earnings estimates. We note that quarterly revenue and earnings peak at just $80.1m and $0.06c per quarter. If management can deliver on its promises of revenue exceeding its prior cyclical peak of $93m, and capturing medium current market share, the likelihood of further price target increases appears skewed to the upside.
In reviewing the recent Q2'13 investor conference call, Edwin Mok, semiconductor capital equipment analyst from Needham & Company, asked questions of management. In the prior quarter, not even a singl! e analyst! joined the call to ask a question. Meanwhile, the company has kick-started its investor relations campaign, and presented earlier this year at investor conferences hosted by Stifel Nicolaus, UBS, and Piper Jaffray. The company will continue to present at additional investor conferences in September and through the remainder of the year. Given the renewed interest by the analyst community, there is an above average likelihood of broker research initiations in the coming months.
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Strong Balance Sheet and Global Service Business Offers Downside Protection
Axcelis offers investors a clean and strong balance sheet that offers downside protection at the current share price. After receiving an immediate $8.7m cash infusion from the sale of its dry strip business, and $15m in proceeds from the recent mortgage debt financing, the company has approximately $50 million in the bank, and is expected to be cash flow breakeven this quarter.
In the table below, we've carefully analyzed the balance sheet and made adjustments to the book value to mark the balance sheet to market. ACLS owns its headquarters, land and property outright. In the course of doing our checks on these assets, we've determined that its currently appraised value is approximately $50m, however, the assets sit on the balance sheet at a depreciated value of just $33m. Therefore, we've adjusted the PP&E book value higher accordingly.
Furthermore, we note that the company may have significant value in its patent and intellectual property portfolio that is not captured on the balance sheet. According to the company's May 2013 investor presentation, Axcelis has an IP portfolio with > 800 patents.
We also should point out that Axcelis has a! stable a! nd growing aftermarket business called Global Service and Solutions (GSS), which is a contractual and annuity-like business that mitigates industry downturns. The company offers customers extensive aftermarket service and support throughout the lifecycle of the equipment they manufacture as well as equipment previously manufactured. Approximately 3,000 of its products are in use globally. The service and support provided includes spare parts, equipment upgrades, and maintenance services. Revenue generated through this service and support business represented about 51.7%, 46.2%, and 61.0% of revenues in 2010-2012. Naturally, GSS's percentage of total revenue increases through a downcycle, but the company is now focused on growing this business even in an upcycle. They recently hired a former Varian employee who is solely focused on business development and growing GSS.
Valuation Scenarios Point to Considerable Upside Share Price Potential
Because Axcelis is not widely followed by investors and sell-side analysts, the stock is not receiving a valuation commensurate with its above average revenue and earnings growth potential. The shares currently trade at 0.6x and 11.0x 2014E revenues and EPS (all based on one conservative analyst's estimates). Moreover, we've previously illustrated the stock trades at a negligible premium to book value, which also doesn't capture the company's robust IP patent portfolio or value of the large NOLs.
In the table below, we've listed a sample of small-cap semiconductor capital equipment stocks such as Entegris (ENTG), Advanced Energy Industries (AEIS), ATMI Inc. (ATMI), MKS Instruments (MKSI), Photronics Inc. (PLAB), Rudolph Technologies (RTEC),FormFactor (FORM) and Mattson Technology (MTSN). The peers trade at approximately 1.0x and 15.5x 2014E revenues and EPS, respectively. Furthermore, the average peer trades at 2.1x tangible book value. However, these multiples are based on average 2014E industry revenue and earnings growth of 18% and 119%, res! pectively! . Axcelis is poised to grow at a rate substantially above the industry average.
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From a historical valuation perspective, ACLS still trades well below its average valuation throughout each of its previous cycles. Furthermore, we analyzed the share price performance during previous cycles where revenues and EPS exceeded $100m and $0.10c EPS and find that its stock price easily reached targets of $6.50 per share, representing 225% upside from the current price.
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We also note there has been a healthy pace of M&A consolidation in the semiconductor capital equipment industry in the past few years. For example, ASML Holdings (ASML) recently acquired Cymer and Tokyo Electron Ltd. (TYO: 8038) acquired FSI International. Lastly, we noted previously that Applied Materials (AMAT) acquired Varian Semiconductor in 2011, a close competitor to Axcelis. Our analysis suggests that the minimum valuation for a company in the industry is 1.2x, 11.0x and 2.2x revenues, EPS, and tangible book value, respectively. Furthermore, the average premium paid to the stock price has been a minimum of 35%.
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In summary, we believe that when the market begins to realize that a new earnings cycle is upon ACLS, the valuation disconnect to peers will begin to narrow. Looking at current trading valuations and minimum M&A values paid in the industry, we believe ACLS will trade closer to 1.0x - 2.0x revenues, 2.0x - 3.0x tangible ! book valu! e, and 14.0x - 18.0x EPS. The share price scenarios and price targets are illustrated in the table below.
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Conclusion
Axcelis Technologies is strategically well positioned at the early stage of the next upcycle in the semiconductor capital equipment market. Having removed substantial fixed operating costs during the last cycle, bolstered its balance sheet, and invested significant R&D resources into positioning its Purion platform to take share in the medium current market, the company is poised for accelerated earnings growth in 2014. Its share price trades at a substantial discount to intrinsic value as investors and sell-side analysts had written off the company from missing a key industry shift many years ago. However, insiders, certain investors and analysts, appear to be taking a different view on the stock. Insiders recently purchased shares, new analysts are starting to dial-in to conference calls, and a large option position is being built, which implies a substantial move to the upside. It's easy to see why some of these increasingly bullish indicators are emerging. The risk/reward of owning ACLS stock at this level is attractive. The company trades at little more than its book value, which is supported by lots of cash and property value, but captures none of the value from its 800+ patent/IP portfolio. Furthermore, looking at trading values for peers and very recent M&A transactions in the industry, would conservatively suggest a minimum of 50% upside to the current price.
Disclaimer: This research report expresses Spruce Point Capital Management LLC's ("Spruce Point") opinions. Use of the research produced by Spruce Point is at your own risk. This is a long-biased article and you should assume the author of this report and its clients and/or investors hold a long position and derivatives tied to the security ! of Axceli! s Technologies Inc. that will benefit from a rise in the price of the common stock. Following publication of the report, the author (including members, partners, affiliates, employees, and/or consultants) along with its clients and/or investors intend to continue transacting in the securities covered therein, and may be long, short, or neutral at any time hereafter regardless of the initial recommendation. The author of this report has obtained all information contained herein from sources believed to be accurate and reliable and has included references where available and practical. However, such information is presented "as is," without warranty of any kind- whether express or implied. The author of this report makes no representation, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. Forward looking statement and projections are inherently susceptible to uncertainty and involve many risks (known and unknown) that could cause actual results to differ materially from expected results. For a list of the risk factors specific to Axcelis and its industry, review the company's Risk Factors in its financial filings at the SEC. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any of the information contained herein. Spruce Point is not a broker/dealer or financial advisor and nothing contained herein should be construed as an offer or solicitation to buy or sell any investment or security mentioned in this report. You should do your own research and due diligence before making any investment decision with respect to securities covered herein, including, but not limited to, the suitability of any transaction to your risk tolerance and investment objectives and consult your own tax, financial and legal experts as warranted.
Disclosure: I am long ACLS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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