ORBOTECH LTD ORBK
March 01, 2013 - 10:13am EST by
repetek827
2013 2014
Price: 9.58 EPS $0.00 $0.00
Shares Out. (in M): 44 P/E 0.0x 0.0x
Market Cap (in $M): 417 P/FCF 0.0x 0.0x
Net Debt (in $M): -216 EBIT 0 0
TEV ($): 200 TEV/EBIT 0.0x 0.0x

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  • Electronics
  • Manufacturer
  • Israel

Description

 

     Orbotech is an Israeli capital equipment manufacturer for the electronics industry that  operates two divisions: Printed Circuit Boards (PCB) and  Flat Panel Display (FPD).  They have a third division, Orbograph, which is 4% of revenues that provides check recognition services to financial institutions that is not material to the overall story but is profitable.  In light of Orbotech’s industry leading position (they are #1 or #2 in all their markets), 10,500 unit installed base in printed circuit boards and 1,700 units in flat panel display , and $154mm of annual service revenue (never had a down year), we think Orbotech’s $200mm enterprise value does not adequately reflect improvements in underlying profitability that have increased trough EBITDA to between $30mm-$44mm and ignores the possibility that earnings could increase materially as the cycle turns.  By the middle of 2013 Orbotech will be debt free for the first time in five years. They have already initiated a share buy-back and there could be further return of capital to shareholders.  Given the high barriers to entry and the quality of its underlying businesses and the probability that Orbotech will at least return to its mid cycle EBITDA, we think Orbotech should be valued at 6x mid cycle EBITDA or ~$13/ share.  
 

     The best way to think about Orbotech is to  split the business into three pieces: Printed Circuit Boards, Flat Panel Display, and Service. Orbotech employs a capital light model and outsources the actual manufacturing of its products.  As such, capital spending is modest - $9.6mm in 2012, $7.6mm in 2011, and $6.8mm in 2010. Having been in business for over thirty years and having spent hundreds of millions on R&D, Orbotech has consistently been the first to market in most key technological cycles in the industries served by its products. In addition, their intellectual property portfolio contains 482 patents.  This is not an easy business to get into and once the sale is made the relationship is very sticky as evidenced by the consistent service revenue.


Printed Circuit Boards

     In 2012 printed circuit boards product revenues  accounted for approximately $181mm out of a total of $400mm in revenues. Of the two main product lines, printed circuit boards is the gem of the business. Practically every electronic device on planet earth contains a printed circuit board produced using Orbotech systems.  


     As devices become smaller, mobile, and more powerful, the complexity of the underlying board(s) increases dramatically.  To understand the sweetspot of Orbotech’s offering, it’s necessary to go into some basic printed circuit board manufacturing.  Generally, production starts with a sheet of epoxy-fiberglass laminated with a conducting material such as copper. The sheet is coated with a thin layer of light-sensitive material (‘photoresist’). A transparent film containing the desired circuitry pattern is then laid on the photoresist. The sheet is then exposed to light, which copies the conductor pattern from the production phototool into the photoresist.  The problem with this process is that it can produce imperfections and sub par yields depending on the complexity of the underlying circuit.  Alternatively, the conductor pattern may be transferred directly into the photoresist without the use of a production phototool.  This process, called laser-based direct imaging, enables the manufacture of of higher density, more complex boards with higher yields. The reason why this is important as it relates our thesis is that Orbotech’s  Paragon  system is the market leader in direct imaging. In 2012, which was a down revenue year for Orbotech in printed circuit boards (and a year in which global printed circuit board  production declined by approximately 2% based on dollar value of production, its installed base of direct imaging units increased by over ~20%. This is the highest margin part of the business and the least subject to cyclicality and the business where Orbotech has the most differentiation over the competition.

     Orbotech’s other printed circuit board solutions relate to the test and repair of flawed circuit boards. Inevitably, during the manufacturing process, boards are susceptible to various defects (electrical shorts, open circuits ) which necessitate  inspection throughout the manufacturing process.  Early detection of these defects, particularly in the case of multi-layered boards, increases the possibility of successful repair and reduces the number of unusable boards, thereby reducing the overall cost to the manufacturer.

     The current trend  in mobile devices such as smartphones and tablets will continue to  drive the need for production, inspection, test and repair solutions that are cutting edge and will force printed circuit board manufacturers to spend on capx.   While capx, especially big ticket items that Orbotech sells, are easy targets for cuts at the first sign of economic uncertainty, upgrading and maintaining equipment to keep up with the explosive growth in these end markets make these purchases a question of “when” and not “if.” Orbotech is the classic arms dealer in today’s technology battlefield: agnostic to any any specific technology or platform and always ready to sell more systems as Moore’s Law continues its inevitable march.


Flat Panel Display

     Similar to their offerings in printed circuit boards, Orbotech’s flat panel display systems assist in the manufacturing and testing of LCDs which are particularly susceptible to various defects in the  production process. Unlike printed circuit boards which we characterize as having average cyclicality as compared to semiconductors in general, the  flat panel display business  is subject to extreme ebbs and flows of demand.  2012 was a  particularly challenging year given unfavorable industry conditions as can be seen by the last five years of revenues: $57mm in 2012, $192mm in 2011, $230mm in 2010, $170mm in  2009, and $158mm in 2008.  During 2012 the flat panel display industry experienced its lowest level of investments in facilities for more than a decade. The only area to show growth was LCD panels for mobile devices.

     Clearly there  has been a dramatic reduction in capx demand among Orbotech’s flat panel display customers since the business peaked in 2010. Fortunately as it relates to our thesis, we have the liberty to  take a conservative view of this business improving in light of the other parts of the business which we think provide more than enough value for our margin of safety and potential for upside. Be that as it may, there are reasons to be optimistic about this business that it will experience growth off its current base:

 

1) On January 17, 2013 Orbotech announced that it won significant bids for flat panel display related equipment  totaling approximately $40mm from one of the largest LCD manufacturers in China. To put that in context, that one bid is equal to 70% of the total flat panel display revenue generated in 2012;


2) The most common FPD technology currently in use is the thin film transistor LCD (which are also known as ‘active matrix’ LCDs). Orbotech dominates this business with a #1 market share in Automated Optical Inspection and Testing. However,  recent trends, especially in Korea, are paving the road for the next generation of OLED technology which would necessitate an upgrade of the existing manufacturing fabs which would be great for flat panel display.

3) Many FPD manufacturers are expected to return to profitability in 2013 and  industry analysts anticipate increased levels of investment in capx in 2013.


     At the end of the day, demand for high definition, power efficient, low cost flat panel displays across a number of sectors ensures at a minimum that Orbotech can rely on a steady flow of service revenue from this business just from customers investing merely to keep up with end market demand. The way we see it is that every couple of years you get a “call option” on an upgrade cycle and revenues can easily increase by several fold in such an event.  


Service

     As we mentioned in the introduction, one of our favorite aspect of Orbotech is its service business. In the context of the revenue swings in  printed circuit boards and especially flat panel display, we don’t think the market gives enough credit to the service business which has experienced impressive growth over the last five years. $105mm in 2008, $108mm in 2009, $120mm in 2010, $141mm in 2011, and $154mm in 2012 which is an 8% CAGR. Given that 70% of the service revenue is related to printed circuit boards, we take comfort in the durability of this stream as a floor for our valuation. Although gross margins in this business hover in the low 30% vs. a more normalized corporate average of around 40% for the rest of the business, the revenues are secured through long term contracts that are virtually guaranteed as long as the customer is still in business.


Valuation

     At today’s stock price Orbotech has an Enterprise Value of ~$200mm  ($417mm of  Marketcap - $280 of Cash and Marketable Securities - $64mm of current maturities of long term debt).  Management said on February 19, 2013 that they had retired $32mm of the debt since year end and intend to pay down the remainder by the middle of the year so the company will be debt free. We see 2012 as a trough year for EBITDA and they generated $30mm:


(thousands)
Net income                        $(45,579)
Equity comp.                     $3,070
Write downs of inventory    $14,255
Restructuring                     $5,063
Income tax expense           $456
Financial expenses             $5,100
Fixed asset depreciation     $8,057
Amortization of intangibles  $9,907
Impairment of intangibles    $30,142
                                       _____________
EBITDA                             $30, 471

     We actually think trough EBITDA could be higher. In  2012 Orbotech undertook a restructuring that reduced Opex by $10mm on a  going forward basis and in 2012 they spent $4mm defending themselves against allegations that they stole trade secrets from their Korean customers (they expect the case to be resolved by mid year).  Adding these  to 2012’s numbers gets you to an EV/ EBITDA  <5x.
    The  view espoused by Sellsiders on the name is “waiting for more visible signs of demand to pick up in printed circuit boards and flat panel display.”  We take the view that on a sum of the parts basis, using a conservative multiple,  you can basically justify the entire enterprise  value based on the service revenue stream alone. It’s not unreasonable to value this recurring stream of $154mm at 30% gross margins and growing in the high single digits at 1.3x revenue. We don’t understand Mr. Market valuing the two remaining industry-leading businesses at 0.
    For whatever it is worth, management points to a long term model in their most recent investor presentation, albeit without specifying a time frame, that has them generating over $550mm of revenue at 44-45% gross margins and 20-21% EBITDA margins which would value Orbotech at 2x EV / projected EBITDA.  While it is good policy to take such projections with a huge Dead Sea grain of salt, Orbotech actually printed $565mm in 2011 so it doesn’t take heroic assumptions to see them getting back there in the next 3-5 years. Yes, this is a cyclical business but given the high weighting to recurring service  revenue as a percentage of total revenue  and the high barriers to entry in the core business we think 6x mid cycle EBITDA of ~$60mm which translates into $13/ share is a  more appropriate valuation. Should we have a repeat of 2011 with a breakout year on the topline  and the company gets more serious about returning cash to shareholders then we could easily see a double from these levels.  



RISKS

     In June 2012, charges were filed in the Seoul Central District Court of the Republic of Korea against the Korean subsidiary of Orbotech Ltd. and six employees related to the alleged acquisition and misuse of confidential customer information.  In the latest 20F Orbotech management estimates the liability at  1.50 billion Korean Won (approximately $1.38 million at the exchange rate in effect on January 31, 2013 ) but obviously the collateral damage of losing business with Samsung, LG, et al would be be much worse.


    -Continued reluctance among printed circuit board and flat panel customer to invest in capx. 
I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

 -Further build out of next generation flat panel display fabs in Asia
 -Return of capital to shareholders - further share buybacks or dividends
 -Positive growth in printed circuit boards in 2013
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    Description

     

         Orbotech is an Israeli capital equipment manufacturer for the electronics industry that  operates two divisions: Printed Circuit Boards (PCB) and  Flat Panel Display (FPD).  They have a third division, Orbograph, which is 4% of revenues that provides check recognition services to financial institutions that is not material to the overall story but is profitable.  In light of Orbotech’s industry leading position (they are #1 or #2 in all their markets), 10,500 unit installed base in printed circuit boards and 1,700 units in flat panel display , and $154mm of annual service revenue (never had a down year), we think Orbotech’s $200mm enterprise value does not adequately reflect improvements in underlying profitability that have increased trough EBITDA to between $30mm-$44mm and ignores the possibility that earnings could increase materially as the cycle turns.  By the middle of 2013 Orbotech will be debt free for the first time in five years. They have already initiated a share buy-back and there could be further return of capital to shareholders.  Given the high barriers to entry and the quality of its underlying businesses and the probability that Orbotech will at least return to its mid cycle EBITDA, we think Orbotech should be valued at 6x mid cycle EBITDA or ~$13/ share.  
     

         The best way to think about Orbotech is to  split the business into three pieces: Printed Circuit Boards, Flat Panel Display, and Service. Orbotech employs a capital light model and outsources the actual manufacturing of its products.  As such, capital spending is modest - $9.6mm in 2012, $7.6mm in 2011, and $6.8mm in 2010. Having been in business for over thirty years and having spent hundreds of millions on R&D, Orbotech has consistently been the first to market in most key technological cycles in the industries served by its products. In addition, their intellectual property portfolio contains 482 patents.  This is not an easy business to get into and once the sale is made the relationship is very sticky as evidenced by the consistent service revenue.


    Printed Circuit Boards

         In 2012 printed circuit boards product revenues  accounted for approximately $181mm out of a total of $400mm in revenues. Of the two main product lines, printed circuit boards is the gem of the business. Practically every electronic device on planet earth contains a printed circuit board produced using Orbotech systems.  


         As devices become smaller, mobile, and more powerful, the complexity of the underlying board(s) increases dramatically.  To understand the sweetspot of Orbotech’s offering, it’s necessary to go into some basic printed circuit board manufacturing.  Generally, production starts with a sheet of epoxy-fiberglass laminated with a conducting material such as copper. The sheet is coated with a thin layer of light-sensitive material (‘photoresist’). A transparent film containing the desired circuitry pattern is then laid on the photoresist. The sheet is then exposed to light, which copies the conductor pattern from the production phototool into the photoresist.  The problem with this process is that it can produce imperfections and sub par yields depending on the complexity of the underlying circuit.  Alternatively, the conductor pattern may be transferred directly into the photoresist without the use of a production phototool.  This process, called laser-based direct imaging, enables the manufacture of of higher density, more complex boards with higher yields. The reason why this is important as it relates our thesis is that Orbotech’s  Paragon  system is the market leader in direct imaging. In 2012, which was a down revenue year for Orbotech in printed circuit boards (and a year in which global printed circuit board  production declined by approximately 2% based on dollar value of production, its installed base of direct imaging units increased by over ~20%. This is the highest margin part of the business and the least subject to cyclicality and the business where Orbotech has the most differentiation over the competition.

         Orbotech’s other printed circuit board solutions relate to the test and repair of flawed circuit boards. Inevitably, during the manufacturing process, boards are susceptible to various defects (electrical shorts, open circuits ) which necessitate  inspection throughout the manufacturing process.  Early detection of these defects, particularly in the case of multi-layered boards, increases the possibility of successful repair and reduces the number of unusable boards, thereby reducing the overall cost to the manufacturer.

         The current trend  in mobile devices such as smartphones and tablets will continue to  drive the need for production, inspection, test and repair solutions that are cutting edge and will force printed circuit board manufacturers to spend on capx.   While capx, especially big ticket items that Orbotech sells, are easy targets for cuts at the first sign of economic uncertainty, upgrading and maintaining equipment to keep up with the explosive growth in these end markets make these purchases a question of “when” and not “if.” Orbotech is the classic arms dealer in today’s technology battlefield: agnostic to any any specific technology or platform and always ready to sell more systems as Moore’s Law continues its inevitable march.


    Flat Panel Display

         Similar to their offerings in printed circuit boards, Orbotech’s flat panel display systems assist in the manufacturing and testing of LCDs which are particularly susceptible to various defects in the  production process. Unlike printed circuit boards which we characterize as having average cyclicality as compared to semiconductors in general, the  flat panel display business  is subject to extreme ebbs and flows of demand.  2012 was a  particularly challenging year given unfavorable industry conditions as can be seen by the last five years of revenues: $57mm in 2012, $192mm in 2011, $230mm in 2010, $170mm in  2009, and $158mm in 2008.  During 2012 the flat panel display industry experienced its lowest level of investments in facilities for more than a decade. The only area to show growth was LCD panels for mobile devices.

         Clearly there  has been a dramatic reduction in capx demand among Orbotech’s flat panel display customers since the business peaked in 2010. Fortunately as it relates to our thesis, we have the liberty to  take a conservative view of this business improving in light of the other parts of the business which we think provide more than enough value for our margin of safety and potential for upside. Be that as it may, there are reasons to be optimistic about this business that it will experience growth off its current base:

     

    1) On January 17, 2013 Orbotech announced that it won significant bids for flat panel display related equipment  totaling approximately $40mm from one of the largest LCD manufacturers in China. To put that in context, that one bid is equal to 70% of the total flat panel display revenue generated in 2012;


    2) The most common FPD technology currently in use is the thin film transistor LCD (which are also known as ‘active matrix’ LCDs). Orbotech dominates this business with a #1 market share in Automated Optical Inspection and Testing. However,  recent trends, especially in Korea, are paving the road for the next generation of OLED technology which would necessitate an upgrade of the existing manufacturing fabs which would be great for flat panel display.

    3) Many FPD manufacturers are expected to return to profitability in 2013 and  industry analysts anticipate increased levels of investment in capx in 2013.


         At the end of the day, demand for high definition, power efficient, low cost flat panel displays across a number of sectors ensures at a minimum that Orbotech can rely on a steady flow of service revenue from this business just from customers investing merely to keep up with end market demand. The way we see it is that every couple of years you get a “call option” on an upgrade cycle and revenues can easily increase by several fold in such an event.  


    Service

         As we mentioned in the introduction, one of our favorite aspect of Orbotech is its service business. In the context of the revenue swings in  printed circuit boards and especially flat panel display, we don’t think the market gives enough credit to the service business which has experienced impressive growth over the last five years. $105mm in 2008, $108mm in 2009, $120mm in 2010, $141mm in 2011, and $154mm in 2012 which is an 8% CAGR. Given that 70% of the service revenue is related to printed circuit boards, we take comfort in the durability of this stream as a floor for our valuation. Although gross margins in this business hover in the low 30% vs. a more normalized corporate average of around 40% for the rest of the business, the revenues are secured through long term contracts that are virtually guaranteed as long as the customer is still in business.


    Valuation

         At today’s stock price Orbotech has an Enterprise Value of ~$200mm  ($417mm of  Marketcap - $280 of Cash and Marketable Securities - $64mm of current maturities of long term debt).  Management said on February 19, 2013 that they had retired $32mm of the debt since year end and intend to pay down the remainder by the middle of the year so the company will be debt free. We see 2012 as a trough year for EBITDA and they generated $30mm:


    (thousands)
    Net income                        $(45,579)
    Equity comp.                     $3,070
    Write downs of inventory    $14,255
    Restructuring                     $5,063
    Income tax expense           $456
    Financial expenses             $5,100
    Fixed asset depreciation     $8,057
    Amortization of intangibles  $9,907
    Impairment of intangibles    $30,142
                                           _____________
    EBITDA                             $30, 471

         We actually think trough EBITDA could be higher. In  2012 Orbotech undertook a restructuring that reduced Opex by $10mm on a  going forward basis and in 2012 they spent $4mm defending themselves against allegations that they stole trade secrets from their Korean customers (they expect the case to be resolved by mid year).  Adding these  to 2012’s numbers gets you to an EV/ EBITDA  <5x.
        The  view espoused by Sellsiders on the name is “waiting for more visible signs of demand to pick up in printed circuit boards and flat panel display.”  We take the view that on a sum of the parts basis, using a conservative multiple,  you can basically justify the entire enterprise  value based on the service revenue stream alone. It’s not unreasonable to value this recurring stream of $154mm at 30% gross margins and growing in the high single digits at 1.3x revenue. We don’t understand Mr. Market valuing the two remaining industry-leading businesses at 0.
        For whatever it is worth, management points to a long term model in their most recent investor presentation, albeit without specifying a time frame, that has them generating over $550mm of revenue at 44-45% gross margins and 20-21% EBITDA margins which would value Orbotech at 2x EV / projected EBITDA.  While it is good policy to take such projections with a huge Dead Sea grain of salt, Orbotech actually printed $565mm in 2011 so it doesn’t take heroic assumptions to see them getting back there in the next 3-5 years. Yes, this is a cyclical business but given the high weighting to recurring service  revenue as a percentage of total revenue  and the high barriers to entry in the core business we think 6x mid cycle EBITDA of ~$60mm which translates into $13/ share is a  more appropriate valuation. Should we have a repeat of 2011 with a breakout year on the topline  and the company gets more serious about returning cash to shareholders then we could easily see a double from these levels.  



    RISKS

         In June 2012, charges were filed in the Seoul Central District Court of the Republic of Korea against the Korean subsidiary of Orbotech Ltd. and six employees related to the alleged acquisition and misuse of confidential customer information.  In the latest 20F Orbotech management estimates the liability at  1.50 billion Korean Won (approximately $1.38 million at the exchange rate in effect on January 31, 2013 ) but obviously the collateral damage of losing business with Samsung, LG, et al would be be much worse.


        -Continued reluctance among printed circuit board and flat panel customer to invest in capx. 
    I do not hold a position of employment, directorship, or consultancy with the issuer.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

     -Further build out of next generation flat panel display fabs in Asia
     -Return of capital to shareholders - further share buybacks or dividends
     -Positive growth in printed circuit boards in 2013
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