The company has a number of catalysts that are expected to occur in the next several months which should assist the company realize our target valuation. These are as follows:
Board Transition: On August 30, the company’s existing Board was voted out by activist shareholders. This was followed by the Chairman’s resignation on September 18. There had been some investor frustration over recent Board actions.
Value-Enhancing Initiatives: A new Board will be seated over the next 2-3 months and it is likely that it will consider value-enhancing measures such as a share buyback program with the company’s excess cash and plentiful ongoing cash flow.
Strong Business Fundamentals: The company’s core business has been very strong of late. In both Q1 and Q2, backlog was up more than 50% over the prior year. Management has historically been very conservative with guidance and, coupled with this significant increase in backlog, there is a good chance of an earnings beat in our view.
Recent Major Acquisition: The company will give more information about its recent GMI acquisition in an upcoming road show.
Analyst Coverage: Key analysts have been supportive of the company and are likely to reinstate buy ratings on AVT once uncertainty over the Board transition is resolved.
The company has strong financial characteristics including consistent sales growth, high and expanding margins, a capital-light business model, and high free cash flow.
Based on a 3-month average, the stock trades roughly $175,000 (USD) per day on the Deutsche Borse. With the recent activity in the name, trading volumes have been much higher so the stock should have sufficient liquidity for some VIC members.
Background:
Advance Vision (AVT) has been written up in an excellent post by pman908 in February 2007) so this write-up will keep the business background limited and focus on the very significant recent developments.
AVT is an Israeli company that makes machine vision systems for the printing industry. The company’s sales mix is roughly 40% from the US, 40% from Europe, and 20% from the rest of the world.
The company’s machine vision products are installed on printing presses. AVT’s products consist of cameras and software that help detect flaws in printing. In plain language, AVT makes devices that sit on top of large printing presses and electronically “watch” the product to detect quality problems. (Problems include crooked or smudged letters, poor color quality, blurred bar codes.) This is done by comparing digital photographs of the actual printed labels/paper to master images (stored in the software). When problems emerge, AVT’s products can shut down the presses or in many cases make automatic adjustments on the fly to correct problems.
AVT’s products focus on the packaging and label segment of the printing market. The company has a significant competitive advantage in its segment due to its technology. Its solutions are widely considered to be the best in the industry. AVT has over 60% share and is considered to have a significant technology lead over the competition. The company’s main competitors are ISRA Vision and BST Promark.
Although the printing industry is a low-single-digit growth industry, the machine vision market has grown at roughly 7-10% per annum in recent years. This is because only 1-2% of the printing presses in operation around the world have machine vision products installed on them. There is tremendous room for additional penetration, and machine vision systems provide a compelling benefit to the customer. A typical label printing press uses $4 million of material (paper, etc.) a year, and 10% of this, or $400,000, is wasted on average due to printing problems. Machine vision can reduce this waste by half, saving the customer $200,000. A typical machine vision system costs only $100,000 so the payback period is only 6 months.
Currently, AVT has its products installed on roughly 1,000 presses, and the total potential market is estimated to be as large as 30,000-80,000 presses. Given the low penetration, the company should be able to grow for a long time to come. The benefits of AVT’s technology have been proven. The challenge now for the company is to continue to convince more and more printers to spend the money to adopt the technology.
As shown below, over the last 5 years as awareness of its products has increased, AVT has tripled the size of its business. The company has moved from a developmental stage company with R&D and marketing costs taking up a large percentage of sales to a company with sufficient scale and sales volume to maintain healthy margins. The table below shows this (amounts in USD which is the company’s reporting currency):
|
2001 |
2002 |
2003 |
2004 |
2005 |
2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
| Revenue |
$ 9,301 |
$ 12,536 |
$ 17,264 |
$ 21,358 |
$ 25,143 |
$ 28,469 |
| Cost of Rev. |
$ (5,086) |
$ (5,881) |
$ (7,096) |
$ (8,272) |
$ (9,669) |
$ (10,839) |
| Gross Profit |
$ 4,215 |
$ 6,655 |
$ 10,168 |
$ 13,086 |
$ 15,474 |
$ 17,630 |
| Gross Profit Margin |
45.3% |
53.1% |
58.9% |
61.3% |
61.5% |
61.9% |
|
|
|
|
|
|
|
| R&D |
$ (4,211) |
$ (3,680) |
$ (3,795) |
$ (3,308) |
$ (3,317) |
$ (3,492) |
| Grants and Participation |
$ 1,069 |
$ 920 |
$ 892 |
$ 610 |
$ 312 |
|
| Selling and Marketing |
$ (5,591) |
$ (5,045) |
$ (5,086) |
$ (6,485) |
$ (6,009) |
$ (6,605) |
| GA |
$ (2,333) |
$ (1,704) |
$ (1,720) |
$ (1,948) |
$ (2,422) |
$ (3,018) |
| Restructuring |
$ (355) |
|
$ (83) |
|
|
|
| Amortization of Deferred Stock Comp |
$ (212) |
$ (1,422) |
$ (336) |
$ (214) |
$ (39) |
|
| Operating Income |
$ (7,418) |
$ (4,276) |
$ 40 |
$ 1,741 |
$ 3,999 |
$ 4,515 |
| Operating Margin |
-79.8% |
-34.1% |
0.2% |
8.2% |
15.9% |
15.9% |
|
|
|
|
|
|
|
| Financial Income/Other |
$ 1,754 |
$ 1,433 |
$ 725 |
$ 661 |
$ 30 |
$ 1,231 |
| Pretax Income |
$ (5,664) |
$ (2,843) |
$ 765 |
$ 2,402 |
$ 4,029 |
$ 5,746 |
| Taxes |
|
|
$ (271) |
$ (199) |
$ 172 |
$ (332) |
| Net Income |
$ (5,664) |
$ (2,843) |
$ 494 |
$ 2,203 |
$ 4,201 |
$ 5,414 |
|
|
|
|
|
|
|
| Diluted Shares |
5,470 |
5,494 |
5,349 |
4,562 |
4,662 |
4,776 |
| EPS |
$ (1.04) |
$ (0.52) |
$ 0.09 |
$ 0.48 |
$ 0.90 |
$ 1.13 |
Over the last two years, AVT has grown revenues at 15% on average and maintained operating margins in the mid-teens. In the last two quarters, order volume has picked up as backlog grew by 50%+ in both Q1 and Q2 (compared to the same quarters in the prior year). So, it is likely that revenue and earnings growth will accelerate in the near term.
Moreover, AVT has attractive financial characteristics including high margins, excellent returns on capital and is asset light. Because the company’s advantage lies mainly in its software, the company’s products do not require capital intensive manufacturing. AVT’s products are assembled by using third-party off-the-self parts. In addition to this, working capital is low. As a result, the company employs little capital in its business.
Recent Developments:
Historically, the investment community had perceived AVT as a company with strong products, strong management, and strong finances. However, some concerns were raised regarding compensation and capital allocation decisions at the Board level. Despite the Board’s lack of involvement in operations, the Board had received significant option grants, and the Chairman’s salary represented 2% of operating income. Early in 2007, the Board authorized issuance of treasury shares at cheap prices which skeptics saw as a move to put more shares in the hands of Board-friendly parties. Additionally, investors were frustrated that the large excess cash balances had not been utilized to buy back shares.
These issues came to a head with the release of the company’s AGM proxy in early August. The proxy contained troubling proposals:
Grant of options to the Board representing 5% of shares outstanding.
Reelection of existing directors to 3 year terms.
Following the release of the proxy, several activist shareholders (Israeli, US, and European) emerged to oppose the proxy. These investors were generally happy with AVT’s management, but believed that Board governance and capital allocation oversight needed to be significantly improved. The vote on the company’s proxy items was held in late August, and these investors were successful in voting out the existing Board.
Given the nature of the investors involved, we believe that they will work with the company to select a new Board. This new Board is likely to contain members with finance backgrounds who, amongst other things, will closely watch capital allocation. As an example, a share buyback program has been a key area of discussion amongst investors.
Acquisition of GMI:
As of the end of Q2, AVT had roughly 6 Euro per share of net cash (or half of its market cap) on its books. Excluding this cash (and the associated interest income), the company traded at less than 9x 2007 earnings. Activists had discussed using this entire cash hoard to buy back shares through a tender offer. However, in September, AVT announced the acquisition of GMI, from Dover Corporation. GMI was a company that AVT’s management had been looking at buying since 2001 because management believed it was a quality company that would fit well with AVT. Following the GMI acquisition, AVT will still have 1.59 Euro of net cash per share which can be used for buybacks.
Currently, investors do not have much information about GMI. However, channel checks on the company have been positive. GMI is the market leader in color control systems for the printing industry. Like AVT, the company is widely considered to have the best technology in its market segment as its spectral analysis of color is considered superior to other methods. Based on information disclosed by AVT, we believe GMI has annual sales of around $32 million with operating margins (EBIT) which will average in the low teens. Using these numbers, AVT paid roughly 1x sales and 11x after tax net income for GMI before synergies. While a share buyback might have been the very best use of capital for AVT, based on the information currently available, buying GMI is accretive and appears a good use of capital.
Even though we are not factoring it into our valuation, GMI should have some synergies with AVT. GMI is strong in the US and weak in Europe while AVT is stronger in Europe and weaker in the US. So, there should be some opportunity for each company to pick up customers from the other. AVT has indicated that its customers have already expressed interest in GMI’s products. GMI’s color control technology will be integrated into AVT’s machine vision systems to produce a combined product which should be attractive to end users. Furthermore, GMI is strong in the sheet fed printing market which is an area that AVT is trying to enter.
Valuation:
As shown below, AVT is trading at 10.5x 2007 earnings and 9.9x 2008 earnings (ex 1.59 Euro per share in excess cash):
|
2006 |
2007E |
2008E |
|
|
|
|
| AVT Revenue |
$ 28,469 |
$ 33,309 |
$ 38,305 |
| AVT Operating Income |
$ 4,515 |
$ 4,663 |
$ 5,363 |
| AVT Operating Margin |
15.9% |
14.0% |
14.0% |
|
|
|
|
| GMI Revenue |
|
$ 32,000 |
$ 34,560 |
| GMI Operating Income |
|
$ 4,480 |
$ 4,147 |
| GMI Operating Margin |
|
14.0% |
12.0% |
|
|
|
|
| Tax Rate on AVT |
|
5% |
5% |
| Tax Rate on GMI |
|
30% |
30% |
|
|
|
|
| AVT After Tax Income |
|
$ 4,430 |
$ 5,095 |
| GMI After Tax Income |
|
$ 3,136 |
$ 2,903 |
| Consolidated After Tax Income |
|
$ 7,566 |
$ 7,998 |
|
|
|
|
| Shares Out |
|
5,400 |
5,400 |
| EPS USD |
|
$ 1.40 |
$ 1.48 |
| EPS Euro |
|
€ 0.99 |
€ 1.05 |
|
|
|
|
| Price |
|
€ 12.00 |
€ 12.00 |
| Cash |
|
-€ 1.59 |
-€ 1.59 |
| Price Ex. Cash |
|
€ 10.41 |
€ 10.41 |
|
|
|
|
| P/E |
|
10.5x |
9.9x |
(Please note that AVT’s tax rate is low due to subsidies the Israeli government provides to companies with strong R&D focus. These subsidies are believed to be sustainable as the government continues to support them and has for many years. AVT believes that it should be able to lower GMI’s tax rate by taking advantage of some of the tax benefits it is able to get in Israel. For now, we are using a 30% tax rate in our models for GMI, but we think the actual rate could be lower.)
In the press release announcing the closing of GMI, AVT’s management released 2008 guidance for the combined company. Our 2008 estimates are 6% above management guidance on revenue, but 8% below management’s guidance on operating income. We believe both our estimates and those released by management are conservative. Management has had a history of being overly conservative with estimates.
We believe that the stock is currently suffering from a temporary overhang created by selling from institutions (mainly European) who cannot or do not want to hold the company until the current Board situation is resolved. Although investors believe that AVT’s Board changes will benefit the company, many institutions want to avoid uncertainty. Echoing this mentality, First Berlin, the most knowledgeable brokerage that covers AVT, has removed its buy rating until the new Board is in place.
Given its 15% long-term growth rate, strong cash flow, and high ROE we believe the company should trade at least at 18x earnings plus excess cash. This would give a value of 20 Euro.
Over the coming months, this value may be unlocked by a series of catalysts. A new Board will be seated, a share buyback program is likely to be put into place, and shareholders will receive more information on GMI. Growth may pick up (as the strong Q1 and Q2 backlog is delivered). Finally, once the Board issues are settled, institutional investors who have sold the stock may get back in, and analysts may reinstitute their buy ratings.
Key Risks:
We believe the two key risks to the story. Firstly, the company’s products represent a discretionary capex item for its customers, regardless of the compelling payback period. If the US and European economies slow, the company could be affected. The company is growing its recurring revenue rapidly, but this is now only 10% of total revenue. Management says so far it has seen no effect from economic weakness, and as mentioned earlier, recent backlog numbers have been very strong.
Secondly, GMI is a major acquisition. With the limited information currently available there is the possibility that the business is not as attractive as it appears. With that said, management has been following the company for many years and this is unlikely in our view. There is also integration risk associated with any acquisition.
Notice: Funds affiliated with the author are long shares of AVT. We may buy or sell at any time.