Description

Summary

El.En. S.p.A., listed in Milan with €820m market cap, is a globally recognized leader in laser technology, backed by 40 years of proprietary know-how. The Company is active in the design, manufacture and global distribution of (i) medical laser devices used in dermatology, surgery, aesthetics, physiotherapy, dentistry and gynaecology (ii) industrial laser systems for applications ranging from cutting, marking and welding of metals, wood, plastic and glass to the decoration of leather, paper, cardboard and fabrics.

El.En. has built a durable reputation and global presence by expanding its manufacturing facilities across Europe, China, and Southern America. With expertise in two distinct end-markets, El.En. stands out as a unique organization capable of meeting the demand of multiple segments through cross-industry know-how and expertise. Products are distributed under the key following brands: DEKA, Ascleption, Quanta Systems, Cutlite Penta and Penta Chutian.

The Company was researched in 2015 by briarwood988 (https://www.valueinvestorsclub.com/idea/El.En/2901497523) with an investment thesis pillared around the cheap market valuation of the business in a framework of promising technology development deemed transformative in terms of operating profitability and cash flow.

Since last March the stock experienced a meaningful correction. It currently trades 42% down from the peak in late 2021. The sudden drop was a reaction to the recent financial information indicating a prudent guidance for the current year, disappointing data of languishing recovery in China (where El.En. has established a sizable business to serve the local market) and a deteriorated financial position to fund a larger working capital.

Today there is the opportunity to invest into this Company at 10x EV/EBIT entry multiple. The business exhibited proven ability to grow profitably posting 15% revenue CAGR and 28% EBIT CAGR since 2011. Return on capital employed exceeded 35% in the last couple of years thanks to extraordinary capital allocation achievements that resulted in higher turnover and steadily improved profitability.

El.En. envisions promising perspectives for the future in its core end-markets in consideration of demographic trends in place that are going to favourably shape the demand for laser medical treatments and productive improvements associated with laser systems applied to industrial processes.

In an industry where the key distinguishing factor for a leading player is the ability to constantly innovate, El.En. presents proven R&D capabilities that allow development of new applications for lasers and progressive improvements to existing products keeping an edge on the competition. Know-how represents a strong entry barrier in addition to an effective and experienced organization able to deal with the global health agencies to obtain clearance of medical devices.

The founders - engineers with strong technical background in the field - are controlling shareholders and managers retaining 45% of the business: the framework offers the ideal commitment to the Company's enduring success and the desired alignment of incentives.

This is a long-term investment story in a valuable business. The current market price reflects a margin of safety, and the prospect of experiencing double-digit growth over an extended period presents an investment opportunity with a very attractive total return.

Introductory notes and the causes behind the recent decline

El.En. (https://elengroup.com/) is one of the leading global players in the laser technology, providing industrial, medical and conservation laser solutions.

Headquartered in Italy and listed in Milan, with a €820m market cap and net positive financial position, the business trades at nearly 10x EBIT and 15x net earnings.

Over the last 10 years, the Company achieved a 15% revenue CAGR, with EBIT growing on average by 28%, thanks to rising margins and effective asset management.

The stock topped at €18 in October 2021 and it is down by 42% from the peak (while YTD it is down by 27%).

There are 3 major explanations of the steep decline observed in March 2023 continuing in recent months:

1. Guidance for 2023 still points to a further year of volumes and revenue expansion, while operating profit is prudentially projected by the management to be flat (€75-80m).
2. The Chinese market for industrial laser manufacturing underperformed in 1Q2023 due to a general macroeconomic sluggishness despite a projected recovery following the end of the local Covid-zero policy.
3. The net financial position deteriorated in the last few months due to the expansion of net working capital. As a strategic decision, management increased the stock of raw materials to ensure stability in the production process, considering the increasingly long and uncertain delivery times. Additionally, management shortened the terms of payment to prioritize supplies. 

The business

El.En. designs and develops laser sources. Around them, El.En. creates laser systems for specific applications. The techniques, over time, have increasingly fine-tuned, refined, and improved through incremental innovation.

El.En. was founded in the early 80s by a group of engineers and academics with the intuition to use the laser technology in a growing number of potential applications. Since the beginning, the group specialized in laser systems for medicine and aesthetics (the “Medical” sector) and laser systems for manufacturing and industrial processes (the “Industrial” sector). Each of these macro sectors includes various segments based on specific applications.

The charts below present the gross return on capital employed based on Direct Margin data made available by the Company as segmental reporting.

On top of selling laser systems, the Company provides (i) post-sale customer service (ii) installation and set-up of the products. The services are an important source of recurring revenue under the form of sale of spare parts and technical assistance.

The group markets its products leveraging on certain major and well-known brands and preserves a lean organization aimed at fostering a culture of independence and accountability of any independent business unit. In fact, any BU belonging to the group (including the many coming from past acquisitions) has maintained its own specialties, brands, and distribution network where and until when they represent a value-added to the business. The described framework does not prevent however to leverage on joint R&D projects and to share elective technology enhancements that might find application in other laser segments.

In terms of expected business development, the outlook looks promising for both the end-markets.

• With reference to the Medical sector, management observes a constant increase in the demand of aesthetic and medical treatments by a population which is generally aging, exhibiting higher obesity rate and wish to limit as much as possible the negative effects of certain conditions. Moreover, there is a growing demand for technologies able to minimize the duration of surgeries and of post-surgery recovery and/or to improve effectiveness through a reduction of the impact on the patient.
• As far as the Industrial sector is concerned, laser systems are becoming increasingly important since they offer flexible and innovative technologies that boost productivity. Moreover, the laser technology ensures high quality standards and enables new applications. In the cutting technology, El.En’s demonstrated ability to manage the highly-powered sources represents a distinguished feature. Laser cutting machines market is segmented into automotive, aerospace & aviation, consumer electronics, industrial manufacturing. The continued demand for heavy-duty materials and the unique design in the automotive industry is driving a wide use of laser cutting machines. Regarding the location of cutting machines manufacturing facilities, the Asia-Pacific market held a significant stake (37% in 2022).

R&D is a key feature of this business. Innovation enables new applications for lasers and allows the leading companies to maintain a competitive edge. Products are constantly improved or re-engineered to be available at lower cost and/or with enhanced features allowing productivity gains for the customers. In the Medical sector, the products must be cleared by the authorities like FDA in the US and the analogous agencies in the rest of the world and that requires intense and thorough clinical studies to obtain the authorization to release the product. That creates risks in relation to the potential inability to get the authorization following expensive research and study activity but at the same time it creates the conditions for a skilled organization to maintain its success over time.

The brands

El.En. distributes its products under certain key leading brands:

I encourage the interested reader to look at of the Company presentations (https://elengroup.com/uploads/presentazioni/El.En._Berenberg_06.06.23.pdf) to have a comprehensive view of the devices and systems developed by the Company.

Competitive scenario

The laser industry is characterized by intense competition. In a framework of expanding demand for new applications, the players in the field must innovate. The competitive landscape is driven by technological enhancements, product performance, reliability, and customer support. El.En's proposition has proved to be successful and places the Company among the main reference players.

El.En. offers a comprehensive range of different products. Operating into two distinct end-markets (Medical and Industrial), only a few corporations are in a position to exhibit such a wide-ranging offer: (i) Coherent Inc (USA), a $5bn business listed at NYSE and (ii) Lumenis - that acquired ESC-Sharplan (Israel) – and after some later divestitures executed by its financial sponsor, should exhibit a size similar to El.En. being focused on aesthetics and ophthalmology.

As addressed by the management, there is a bunch of mid-sized companies in the Medical sector covering specific niches: (i) Candela Corp (USA) active in dermatology, (ii) Cynosure (USA), the partner to El.En. for the distribution in the US (acquired in 2017 by Hologic (tender offer) and later sold to a PE) and producing lasers for aesthetic and dermatological applications, (iii) Cutera ($250 business), (iv) InMode ($500m in revenue), (v) Sisram Medical ($350m business), Lutronic ($200m business).

Peers focused on Industrial applications are (i) IPG Photonics ($1.5bn business), (ii) Han's lasers ($2bn business) which offers lasers for industrial automation, (iii) Bystronic AG ($1bn business) offering metal processing solutions through lasers and (iv) Trumpf (Germany) active in the machinery tools business with sales exceeding $4bn.

Financial overview and expected return

El.En. posted an outstanding performance over the last years with revenue expanding on average by 15%+ while EBIT reached €77m in 2022 (11Y CAGR 28%).

2023 guidance points to €690m in revenue and a prudent flat nominal EBIT forecast.

In terms of capital employed, the Company reported nearly €260m as of end of 2022, significantly higher compared to 2021 as per the commented stretch of working capital items. The financial structure is full equity.

2022 cash flows were beaten down by the mentioned working capital evolution while in 2021 an extraordinary level of down payments’ inflow positively affected the cash.

Back in 2018-2019 period, the Company undertook significant investment projects (ca. €35m of cumulative extraordinary Capex) to increase the manufacturing capacity.         

Tentative normalized Net operating cash flow might be seen at €35m in 2021 and €45m in 2022. As far as Capex are concerned, they are stably above D&A (on average 2x) envisaging a substantial component of growth capex.

The evolution of Return on Capital Employed (ROCE) highlights efficient capital allocation, with turnover shifting from 2x to above 3x and resulting in steadily improved profitability.

With €820m market cap and positive financial position, El.En. trades at 10x 2023 EBIT and 15x net income, down, respectively, from 16x and 24x in March.

Historically valuation exceeded 10x EBIT excluding 2018 when the Mona Lisa’s negative news flow extremely affected the sentiment around the stock. Below is the trailing multiple’s series:

The 10% current gross yield highlights a substantial degree of downside protection. Assuming the growth in the key end-markets can continue at a sustained pace for an extended period, El.En. appears as a compelling opportunity to attain a rewarding total return for the long-term patient investor.

Long-term investment thesis: competitive advantages and strengths

• El-En. is among the leaders globally in the laser technology with proprietary know-how developed in 40 years. The Company gained its solid reputation and positioning by progressively expanding its geographical footprint (a global business with manufacturing facilities in Europe, China and Southern America to serve the local markets) and widening the portfolio of laser applications offered. By covering two distinct end-markets with clear know-how and technology synergies in place, the Company presents itself as a unique organization in the laser industry able to meet the demand of multiple segments leveraging on cross-industry know-how and expertise.
• El.En. is a Company created and led by engineers (the acronym stands for Electronic Engineering). It traditionally leveraged on collaborations with universities and research hubs. Innovation and engineering are at the heart of the Company's mission and explain the credibility enjoyed by the Company. Founders and managers are shareholders and they retain 45% of the share capital ensuring skin in the game, long-term proposition, thoughtful business approach and effective alignment of incentives. Managers and key employees are granted with stock options that can be exercise after 3-4 years.
• The end-markets envisage long-term structural tailwinds:

- Medical applications are expected to be driven upward by ageing population and increasing demand for non-invasive aesthetic techniques that lasers can efficiently meet.

- Industrial applications provide customers with tools ensuring high quality standards and productivity. Investments in China are strategic to serve a large customers’ base.

• Business is protected by entry barriers in relation to both technological know-how/competencies and ability to deal globally with health agencies/authorities in order get clearance on the products (Medical sector).
• Management demonstrated capital allocation ability. El.En. grew organically by developing new products but also thanks to a series of successful acquisitions over the years, mostly in the Medical sector (e.g. Ascleption, Quanta Systems). Post deal integration is carried out by keeping specialties developed by the businesses acquired (that are effectively independent business units) and later integrating the distribution networks to seize cross-selling opportunities by carrying out a multi-brand distribution strategy and reinforce the leadership in the market.

Catalysts

Although I consider El.En. an outstanding investment opportunity with a long-term perspective, most of the conditions that led to the steep fall in market prices appear to be transitory, creating potential conditions for a re-pricing.

From a mid-term standpoint, in October 2022, the laser cutting business in China executed a capital increase in the interest of two private equity funds. The entrance of institutional investors and related enlargement of the shareholders' base is part of the activities to be carried out during the preparatory phase of the prospective IPO of the business in mainland China. IPO remains a positive catalyst once the ideal conditions will be restored with higher visibility on the economic performance of the Chinese business.

I believe that any of the 3 short-term headwinds that materialized in the last few months have decent chances to be overcome:

1. The management is used to communicating prudently with the analysts offering a cautious guidance. I note that the underlying framework is characterized by expanding revenue in both sectors (confirmed by satisfactory orders intake) and operating profit might result better than expected.
2. Chinese market highlights signs of recovery through orders and improvement in volumes and profitability are expected through the second part of the current year.
3. Working capital could turn back down if there is a normalization of the supply chains’ pressures, freeing up cash and reinstating the net financial position.

Some consideration on risks

Adopting an historical perspective, in 2009 the business declined by more than 30%. In the following year, the group experienced a substantial rebound but not sufficiently strong to overcome the long-standing trouble in the market caused by the GFC. In 2011, the business was weak mostly due to the fragile recovery in a framework characterised by the debt crisis in Europe. Full recovery from pre-crisis level occurred in 2012 and since then the group posted an incessant expansion. The business is far from immune to general macroeconomic conditions: in the short-term, the Medical sector demand (in particular the aesthetical segment) is conditional upon available income (in particular the part considered “discretionary expense”) and consumers’ sentiment while the Industrial sector would certainly suffer a recession of investments. A downturn is not expected to cause El.En.’s market positioning to wane while the lean organisation and the rock-solid financial structure ensures ability to face though market circumstances and continue R&D investing. 

As analysed above, the long-term success of the Company strictly depends on the capacity to realize innovative laser systems. In the Medical sector, the Company must obtain the necessary authorisation to market the product. That requires time, significant efforts in terms of R&D (€20m annual expenses) and ability to interact with authorities in different countries. In 2018, the FDA issued a press release about Monna Lisa Touch, one of the Company's most important technologies for the treatment of vaginal atrophy, indicating potential risks associated with gynaecological treatments like 'vaginal rejuvenation' using lasers or radio frequency. The ensuing interactions with FDA allowed to reach an agreement on marketing material distributed but the demand of the product resulted significantly affected. According to the management, to strongly reinstate the marketing of the product in the US market, El.En. needs a new FDA full clearance with an investment estimated to be of million dollars, which is still under careful evaluation. Despite the negative event, the Company continued to innovate and grow in following years, overcoming the negative Mona Lisa’s outcome. R&D efforts are directed towards several projects simultaneously to prudently manage the risk of issues and obstacles with the development and the execution of any of the project(s). History proves that the management has set up a reliable R&D department structured to develop successful products. In this sense, the limited number of claims over the years supports the effective organisation and the proposition of the Company.  The innovation processes are formalized having to be based on strict and precise medical protocols.

Catalyst

In the mid-term, IPO of the Chinese business.

In the short-term:

• Economics above guidance and consensus
• Recovery of the business in China
• Normalization of the working capital