Orbotech: Technology Manufacturing Growth Stock – Seeking Alpha

On a daily basis, I scan the markets for stocks that have traded sharply lower due to earnings misses, weak guidance or negative press in an effort to find situations where the market has overreacted. Although most of the time there are legitimate reasons behind the size and pace of a selloff, every now and then there are selloffs that are overdone.

This is the case with the recent selloff in Orbotech (NASDAQ:ORBK) after the company reported disappointing 4Q2016 earnings and 1Q2017 guidance a few weeks ago. Despite being an industry leader with a top-notch balance sheet and diversified revenue portfolio, the stock fell over 10%, resulting in valuation multiples below its peer group.

At these valuations, shares of ORBK have an attractive risk/reward profile as I expect growth to accelerate across their divisions during 2017. Based on those growth expectations, I believe that ORBK's valuation multiple should rebound to trade in line with those of the company's peers. As a result, shares should rebound to between $40-$45, representing ~40% upside from current levels.

Overview

ORBK is a supplier of yield-enhancing and process-enabling solutions for the electronics products manufacturing industry. In plain English, their products allow companies that manufacture electronics to efficiently produce complex products and minimize defects to maximize output. The Company is comprised of three divisions: Production Solutions for the Electronics Industry, Solar Energy and Recognition Software.

The Production Solutions for the Electronics Industry segment, which represents 95% of revenue, includes three sub-segments, Printed Circuit Board (PCB), Semiconductor Devices (SD) and Flat Panel Displays (FPD).

Source: Company Presentation

In the Flat Panel Display (FPD) market, ORBK's has established a market-leading position in the fastest growing segments, including Flex OLED. This position has resulted in increased bookings for 2017, providing investors with improved visibility versus previous years.

In the Printed Circuit Board (PCB) market, ORBK's PCB repair tool allows customers to generate 100% yields in manufacturing, thereby reducing costs and improving profitability. As noted on the 4Q2016 conference call, "the PCB industry is expected to return to positive growth mode" in 2017, and management believes the PCB division will become "an even more meaningful part of our growth".

In the Semiconductor Devices (SDD) market, ORBK is the leading company for fan-out packaging, a segment which is expected to grow, and which ORBK should be able to take market share within. Additionally, ORBK is gaining traction in the MEMS market, which the company specifically noted on the 4Q2016 conference call. On the call management noted they expect to "see growth and demand for MEMS coming from the smartphones, automotive, Internet of things and wearables application. As has been widely reported, these industries continue to add a variety of sensors, for example, for automated collision avoidance system, autonomous drive vehicle, and pedestrian sensing in automotive, and new security feature such as fingerprint sensors in small devices."

Based on ORBK's competitive position in its three main markets and the expected growth in each I expect sales to increase to $900M and $970M; and EPS to total $2.75/share and $3.30/share during 2017 and 2018 respectively.

M&A Growth Prospects

In addition to expecting strong organic revenue and earnings growth, ORBK has the balance sheet capacity to make additional strategic acquisitions. Specifically, investors are hopeful that the company makes an acquisition in adjacent markets or further up the value chain.

However, in addition to having the financial capacity to make acquisitions, I believe ORBK management has proven their ability to identify, acquire and integrate acquisitions that deliver significant value for shareholders.

In 2014, ORBK acquired SPTS, a UK-based manufacturer of etch and deposition processing equipment company targeting advanced packaging and MEMS markets. The acquisition, which is now the SDD division of ORBK, cost the company ~$370M ($300M in debt, $90M in cash) and was priced at ~2x sales. Over the last 3 years, the acquisition has proven to be well-timed and well-executed. Since the acquisition, the Fan-Out, advanced packaging and MEMS product lines have driven SDD division a CAGR of ~25% and supported overall company revenue growth.

Source: Jefferies

In addition proving their ability to identify attractive acquisition targets and execute after closing, management has proven its ability to responsibly manage debt loads following acquisitions. As of EOY2016, the company had reduced total debt to ~$88M.

Source: SimplyWall.st

As reflected in the Jefferies analysis below, the company is in a strong position on both a cash/debt basis and Net Debt / FCF basis.

Source: Jefferies

Given its strong financial position, I would expect the company to pursue another large, strategic acquisition in the next 12 months. Based on management's proven ability to create shareholder value through M&A, as represented by the STPS acquisition, I believe any M&A announcement would be a positive catalyst for the share price.

Valuation

Following the company's 4Q2016 earnings call, on which the company reported weaker than expected 4Q2016 results and 1Q2017 guidance below consensus, shares plunged over 10%.

Source: YCharts, Internal Model

To recap, the company reported 4Q16 revenue of $215M (up +5% Q/Q, +14% Y/Y), which was below the midpoint of guidance and consensus due predominantly lower SD sales (down 14% Q/Q). One bright spot of the report was the strength in the FPD and PCB segments, which were +20% Q/Q and +12% Q/Q, respectively. Gross margin came in at 46.8%, which was below both guidance and consensus and was attributed to product mix, foreign exchange and hedging losses. Overall the lower revenue and lower margins led to EPS of $0.70, which was $0.07 below consensus. As a result of the slow SDD sales in 4Q2016, the company revised its guidance lower for 1Q2017, which put further pressure on the shares.

Although it is never great when companies miss and guide lower, I believe the underlying reason for ORBK's 4Q2016 performance and 1Q2017 guidance (lower than expected SDD segment revenue) has been misinterpreted by market participants leading to an overreaction in the share price. Unfortunately, SDD revenues are typically lumpier and a single customer order delay can meaningfully impact revenue. As I see it, the company simply faced SDD order delays during the period and is being conservative for 1Q2017. Despite these short-term headwinds, I believe the SDD division along with the FPD and PCB segments should accelerate through the second half of 2017. In contrast to my view, the market seems to be discounting ORBK's 2017 growth potential because one segment underperformed for one quarter, and that to me represents an opportunity to buy.

Due to the selloff, ORBK not only has underperformed its peers on a historical basis but is also undervalued on a variety of historical metrics. In my analysis I included Applied Materials (NASDAQ:AMAT), Lam Research (NASDAQ:LRCX), KLA-Tencor (NASDAQ:KLAC), Nova Measuring (NASDAQ:NVMI), Nanometrics (NASDAQ:NANO) and Teradyne (NYSE:TER).

Source: YCharts, Internal Model

In addition to being undervalued on a historical basis, the company also seems to be undervalued relative to its future growth.

Based on my EPS and Sales targets, which are in line with many sell-side analysts, if ORBK traded at peer average PE or P/S ratio levels, the share price would be meaningfully higher.

Based on the peer average PE / 2017E Earnings ratio of 15.6x and target earnings of $2.75/share, the stock is trading at a 39% discount to the fair value price of ~$43/share.

Risks

Despite its growth prospects and valuation, there remain risks associated with an investment in ORBK.

First, should macroeconomic conditions deteriorate, causing a decrease in spending by ORBK's customers, my earnings estimates and price target would be negatively impacted.

Second, given that ORBK operates in a cyclical business, should electronics demand weaken or capital investment in China slow, it would materially impact ORBK's stock price. Additionally, ORBK has relatively high customer concentration and geographic (China and larger Asian-Pacific region) concentration risk. Should one of their major customers reduce spending or a regional macroeconomic event unfold in Asia, ORBK would be negatively impacted.

Finally, while I believe ORBK has a strong competitive position in the markets it operates in, there is always the risk that competition drives prices and margins lower.

Summary

As a leading supplier of solutions that are critical in the time-to-market sequence of its technology-focused customers, ORBK is ideally positioned to benefit as demand for mainstream products, such as smartphones, tablets, monitors, and flat panel TVs increases for the foreseeable future.

The company has a strong competitive position, the firepower to make another strategic acquisition and is undervalued relative to its peers across a variety of metrics.

I believe an investment in ORBK offers an attractive risk/reward profile at these price levels following the overreaction of the market to the most recent earnings release.

Disclosure: I am/we are long ORBK.

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.

Additional disclosure: I recently opened a position in ORBK based on the thesis outlined in this article.

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Orbotech: Technology Manufacturing Growth Stock - Seeking Alpha