Description

The investment case for Pfeiffer Vacuum (based in Germany but also trades ADRs in NY) goes like this:

*Extremely profitable, high return business
*Operates in a growth industry
*Industry leader
*No financial risk (15% of market cap in net cash)
*Suffering from cyclically depressed market conditions
*Recovery in semiconductor market could boost share price

Pfeiffer is the leader in vacuum pump technology. Vacuum pumps are used in a whole host of manufacturing and research situations that require an ultra-clean, vacuum environment. Some examples of products manufactured in a vacuum environment include, semi-conductors, CDs/DVDs, computer hard disks, optical lenses, electronics, freeze-dried foods, pharmaceuticals, surface-treated machine parts. In addition, electron microscopes, mass spectrometors and particle accelerators require a vacuum environment. The largest end user industries for Pfeiffer are: the analytic industry 29% of revenue; research and development centers 19% and the semiconductor industry at 14% (down from 22% at the peak). There are no large (more than 2-3%) customers.

Pfeiffer's products range in price from $1,500 up to $40,000. Prices vary according to the amount of vacuum that is needed in a given situation. The high end pumps are extremely sophisticated products with moving parts spinning up to 90,000 RPMs and with clearances less than 1/10 of a millimeter. Given the fragmented nature of the competition, and the high-failure risk application nature of these products, pricing pressure is not a big issue. (See comment below of how well GPMs held up in 1Q02 despite sales down big.)

The competition in the industry is fragmented. The industry is estimated to be about $2b in annual revenue. Leybold Vacuum (part of publicly listed Unaxis) is one player, another is a division of Varian Inc, another is Edwards, a division of BOC Group plc. Pfeiffer is the largest player that I can find.

There are several long-term growth drivers to this business. Increasing electronic and semiconductor componentry, increasing life- science (pharma, biotech) products, and increasingly sophisticated manufacturing and processing applications in everything from food to oil/chemicals have been driving the growth of the business. A normal growth rate should be between 5-10% per year on an organic basis. This is what the company has averaged historically.

The past 18 months have been a big hiccup, however. The semiconductor recession, plus the general economic decline worldwide have impacted pfeiffer. EBITA went from 23m in 1999, to 36m in 2000 driven up by semi-conductor exposure, then back to 28m in 2001. This year should be around 23-28m.

The business is extremely well run. Even last year when EBITA was down 22%, pretax ROCE was 48% and ROE was 25%, even with about 40% of assets in cash. The company is very cost conscious: while revenue went from 128m euros in 1996 to 170m in 2001 (down from 185 in 2000), operating costs were flat and gross margins improved by more than 300 bps. In the first quarter of 2002, reported today, the company showed sales down 20%, while GPMs were actually up. Even at its nadir, this business is generating double digit margins and ROEs. The company continues to increase R&D spending to roll out new products. The company is not acquisitive because it will not overpay for goodwill. Growth has been of the highest organic quality.

Valuation:
Given the gross margin structure (45%), and the SG&A structure, this business should return to 18-20% EBITA margins once revenue growth picks up again. There are already signs that the semi industry is recovering, which will have a disproportionate impact on profitability as the products sold to this industry have high margins. At any rate, it is not a question of if, but only when this business will start growing again. Assuming trend revenue growth of 6% per year, and the current cost structure, we should see revenue of about 190m and ebit of about 33m within the next 18 months to two years. Putting a 12x EBITA multiple on that, adding in the net cash of about 50-55m, gets me to a sell price in the low to mid 50 euros per share or around $47 per ADR. There are no good comps for this business, but I think a 12-13x EBITA multiple is very reasonable for this kind of business given the quality of earnings, the margins and the cashflow returns on capital. The fact that there is no financial risk is icing.

Catalyst

Who knows? Return to growth in the semiconductor industry should help.