AEIS - Advanced Energy: In Spite Of Massive Improvement Still Not Cheap Enough

Summary

• Advanced Energy is too expensive in spite of the wonderful financial performance in 2022. The company has grown earnings dramatically and the capital structure is very much improved.
• Shares are actually cheaper today in spite of the run up in price, but "cheaper" is not the same thing as "cheap." I'd recommend waiting for the proverbial "fat pitch."
• I made what I think is a great risk adjusted return by selling deep out of the money puts previously. There's no opportunity to repeat this great performance now, though.

Just under three months ago, I wrote another cautious article on Advanced Energy Industries Inc. ( AEIS ), and in that time, the shares have returned 21% against a gain of 2.6% for the S&P 500. I thought I’d check back to see if it’s now worth buying. As I frequently do, I’m going to make that determination by looking at the most recent financial results, and by looking at the valuation of the stock. Additionally, although I didn’t buy the stock previously, I sold some put options which are about to expire worthless, so I can’t wait to write about how that trade worked out.

Welcome to the “thesis statement” portion of the article, where I give readers the gist of my thinking in a hopefully pithy single paragraph. I do this because I’m absolutely obsessed about trying to give readers what they want: an understanding of my thinking with as little exposure to the Doyle mojo as possible. You’re welcome. I think the latest financial results have been spectacular. The company continues to grow very well, and the capital structure is much improved when compared to the previous year. The problem is the valuation. Although it’s cheaper than it was when I last reviewed the name, “cheaper” is not the same thing as “cheap.” For that reason, I’m going to continue to avoid the name. I’m going to continue to remind myself of the fact that I initially did very well with this stock because I bought it when it was cheap. Finally, although I didn’t participate in the recent upswing in stock price, the deep out of the money puts I wrote earlier are about to expire, and I’m very happy with my excellent risk adjusted returns on this company. Although I don’t see the point of selling any at the moment, I think the performance of my short puts is yet further evidence that investors would be wise to familiarize themselves with these instruments. They offer a wonderful way to make excellent risk adjusted returns.

Financial Snapshot

In my estimation, the most recent financial performance here has been outstanding. As I lamented in my latest piece on the company, there’s very little relevant history here. This is a company that has basically transformed, so any comparison to earlier states is very challenging. For example, the company is much different since the SL Power acquisition. That written, the company has done very well against the small amount of history that is relevant. Revenue and net income during the first nine months of 2022 were higher by about 28% and 64% (!) respectively when compared to the same period in 2021. Management has started to reward shareholders for this performance with a recently enacted dividend.

At the same time the level of indebtedness has declined, with long term debt down about $19.5 million, or 4.9%. This reflects the repayment schedule that I’ve lamented previously. In case you have forgotten, the company is “on the hook” for debt maturities of $20 million per year until it jumps to $315 million in 2026.

This is obviously a very fast growing company, and I’d certainly be willing to buy it at the right price.

The Stock

Some of my readers have excoriated me in the past because I’ve sometimes talked myself out of gains because I insist on only ever buying stocks when they’re cheap. So, the phrase “at the right price” can be viewed by some as a financial kiss of death. If you’re heading to the comments section to remind me of this yet again, I’d suggest you save yourself the effort and I’ll remind you that there’s nothing new under the sun. I understand that I’ve missed out on (temporary) capital gains by insisting on being overly prudent with my capital. I'm of the view that it's better to miss out on some gains than lose capital. My regulars also know that I consider the "business" and the "stock" to be quite different things. Every business buys a number of inputs and turns them into a final product, like power conversion equipment, for instance. The stock, on the other hand, is an ownership stake in the business that gets traded around in a market that aggregates the crowd's rapidly changing views about the future health of the business, future demand for products, future margins, and so on. The stock also moves around because it gets taken along for the ride when the crowd changes its views about "the market". A reasonable sounding, if counterfactual, argument can be made to suggest that some portion of the returns of Advanced Energy have enjoyed since I last wrote about this business came from the overall uptick in demand for “stocks.” It's impossible to prove this point definitively, but it's worth considering. In any case, the stock is affected by a host of variables that may be only peripherally related to the health of the business, and that can be frustrating.

This stock price volatility driven by all these factors is troublesome, but it's a potential source of profit because these price movements have the potential to create a disconnect between market expectations and subsequent reality. In my experience, this is the only way to generate profits trading stocks: by determining the crowd's expectations about a given company's performance, spotting discrepancies between those assumptions and stock price, and placing a trade accordingly. I've also found it's the case that investors do better/less badly when they buy shares that are relatively cheap, because cheap shares correlate with low expectations. Cheap shares are insulated from the buffeting that more expensive shares are hit by.

As my regulars know, I measure the relative cheapness of a stock in a few ways, ranging from the simple to the more complex. For example, I like to look at the ratio of price to some measure of economic value, like earnings, sales, free cash, and the like. I like to see a company trading at a discount to both the overall market, and to its own history. In case you don't have your copy of "Doyle's Almanac of 2022 Trades" in front of you, at the time that I was suggesting the shares were “not yet cheap enough”, the PE was hovering at just under 20 times, and price to free cash was just under 50. Fast forward to the present and the shares are about 13.5% on a PE basis, and about 30% cheaper on a price to free cash basis. Per the following:

So, the stock has risen in price, yet the shares are cheaper. This is obviously a function of the increase in “E” that I referenced in my earlier work on this name.

Although the shares are now cheaper than when I last reviewed the name, they are far less cheap than they were when I first found the shares compellingly priced way back in 2018. I’ll admit that this company is different now than it was then, but there is an objective reality that a business changing hands at 15 times cash flow is definitionally less risky than one that’s trading at a price to free cash flow of 35 times.

As my regulars also know, in order to validate (or refute) the idea that the shares aren’t objectively cheap, I want to try to understand what the crowd is currently "assuming" about the future of a given company. If the crowd is assuming great things from the company, that’s a sign that the shares are generally expensive. If you read my articles regularly, you know that I rely on the work of Professor Stephen Penman and his book "Accounting for Value" for this. In this book, Penman walks investors through how they can apply the magic of high school algebra to a standard finance formula in order to work out what the market is "thinking" about a given company's future growth. This involves isolating the "g" (growth) variable in this formula. In case you find Penman's writing a bit dense, you might want to try "Expectations Investing" by Mauboussin and Rappaport. These two have also introduced the idea of using the stock price itself as a source of information, and then infer what the market is currently "expecting" about the future.

Anyway, applying this approach to Advanced Energy again suggests the market is assuming that this company will now grow profits at a rate of about 7.5% in perpetuity. That is a very optimistic forecast in my view, which doesn’t fill me with a strong urge to buy more shares. I’ll admit that the shares are cheaper now in spite of the run up in price, but “cheaper” is certainly not the same thing as “cheap”, and for that reason I’m going to continue to eschew the shares.

Options Update

While I obviously don’t want to pay current prices for the stock, I see value here, which is why I previously wrote put options on this name. I specifically sold the January 2023 puts with a strike of $55 for $1.15 each. Unless things go catastrophically wrong over the very near term, these are about to expire worthless. So, my puts have netted me $1.15 per share. Although this is far less than the $15 that shareholders have earned, I’d suggest that I took on much less risk to earn my return. The strike price on my puts was $19 or 26% out of the money at the time I wrote them, so the results would have been excellent no matter the result in my view. Had the shares swooned, and I was “forced” to buy at a net price of $53.85, that would have been a great outcome. Since the shares have remained elevated in price (for now at least), I’m going to simply pocket the premium and move on. Thus the power of deep out of the money put options on companies that you are interested in owning.

While I normally like to try to repeat success, I can’t in this instance, because I think the shares are just too far above a reasonable strike price. For instance, the July puts with a strike of $55 are bid at $.20, which is too little return for the risks here. I think the shares are going to drop in price from current levels, and so I’m going to wait for them to return to get back to a more reasonable valuation before considering selling puts once again. That should in no way discourage investors from learning about these instruments in my view. They may not always be appropriate, but when they are, they are a powerful way to generate great, risk adjusted returns.

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