Description

My top value pick at the moment is MKS Instruments (Nasdaq:MKSI) which makes instruments that measure, analyze, and control gases during semiconductor manufacturing and other industrial processes. The semiconductor industry accounts for about two-thirds of the company's sales. Now you know why the stock was trading at its 52-week low last week (hint: semi stock).

What caught my attention about the stock was when I ran a screen called "Profitable Book Value Gems" in MSN Investor and MKSI turned up with the following characteristics:
Market Cap = $428 m
Net Profit Margin = 13.7%
Book Value/Stock Price = 34% (i.e.1/3rd of its stock price is book value)
Stock was at its 52 week low (the stock has risen $2 since then).

This for a company that soundly thrashed earnings expectations in August! Analysts even increased their earnings estimate for the future.

Talk about investor fears about the semiconductor sector.

My thesis is that MKSI has the advantage of a more widely diversified business than most semiconductor names, so its downcycles are less extreme. For example, MKSI had positive earnings throughout the last downcycle.

The consensus forecast is for MKSI to earn $1.72 this year and $2.33 next year. The stock is currently trading at about 21X trailing earnings, under 13X CY2000 earnings and about 10X CY2001 earnings. That's cheaper than cheap for a company whose earnings growth can be at its worst be 8% annually for the next 5 years.

Consider these other factors:
MKSI has a Price/Book ratio of 4.00
MKSI has a Price/Sales of 2.32
MKSI's Return on Equity is 27.5%.
MKSI's Return on Assets is 19.2%.

Anyway to test out whether this stock is cheap, I performed a DCF based spreadsheet valuation of MKSI, based on what I know about the company's cash flows (I will be happy to email the spreadsheet to anyone who wants to take a look). Here is what I found:

MKSI's DCF Valuation Analysis:

Pessimistic Scenario

Put simply, at its recent low of $17 or so, MKSI was being valued by the market in the following manner:
1. The market was expecting MKSI to do 36% EPS growth for the next year (as analysts expect).
2. However, the market then expects MKSI's EPS growth to dive to 21% in a year and then drop off to a precipitous 6% for the foreseeable future.

Why is the market so pessimistic? Because, the market probably doesn't believe that the semi cycle upturn is real. It probably believes that the semi cycle has peaked and that earnings are going to plunge for these companies after 6-12 months.

Well, you may consider this way too pessimistic. In fact, you may even want to bet against the market... I understand.

However, let's consider another, different, more optimistic scenario, the one analysts were touting just a few short weeks ago.

Optimistic Scenario

Let us assume that the company would grow EPS at 36% for the next 5 years (as analysts expect) and then transition that growth in a steady grind over the next 5 years until it hits a mere 6% growth after 10 years. It is assumed that the company will grow forever afterward at that rate. This is usually how Wall Street analysts value high growth companies.

My results?

The stock is then valued at $63, pretty much where MKSI peaked in March. Coincidence or mere proof of a rational market? I don't know.

In conclusion, I believe that the market was valuing MKSI based on what it believed the extremes of the semi cycle will be. I think that the truth lies somewhere in between. That's where our analysis helps us.

Catalyst

Summer is a traditionally slow time for semi equip stocks, so there is also a tradition for chip and chip equipment stocks to fall off a cliff during the summer months. I believe that investors are overreacting to the possibility of a semi cycle downturn prematurely. Their fears are hammering all kinds of semi stocks irrespective of their prospects. Now is a good time to accumulate MKSI's shares because I believe that the shares are worth $34 (neither too pessimistic nor too optimistic). More proof of my slightly optimistic view is already shaping up as the SOX has bounded higher in the last few days. MKSI is likely to move up strongly once it's value is known and its business understood by the Street and investors.