MKSI - MKS Instruments: Atotech Overhang Continues

2023-09-11 13:17:08 ET

Summary

• MKS Instruments, Inc. has seen a sluggish operating performance and high leverage, with a ransomware attack adding to its challenges.
• The company's acquisition of Atotech was considered expensive, leading to concerns about high debt and a soft outlook.
• Despite the potential for long-term growth, the company's current performance and high leverage make it unappealing for investment at this time.

In January, I believed that there were some challenges for shares of MKS Instruments, Inc. ( MKSI ) after an expensive Atotech deal. The company pursued this acquisition after it dropped out of the bidding race for Coherent.

Unfortunately, I believed that this deal was rather expensive, and with underlying momentum cooling off, I was not yet enticed despite the potential of the company and its shares.

I am glad that I did not get involved, as the company has seen sluggish operating performance, with a ransomware attack not helping either of course, as leverage remains high, and the outlook remains non-convincing.

Right here, I see no reason to get involved, even as continued profitability and a substantial cash buffer should alleviate leverage concerns, as some real execution is needed to create a more compelling investment case.

The Business

MKS Instruments is a company which focuses on precise control, generation and control solutions for complex technologies. These skills and services are used in a variety of promising sectors which include semiconductors, life science, research and industrial technology, resulting in diversified exposure to long term growth areas.

A $2.4 billion business in 2020 posted earnings around $8 per share, with the business valued at 22–23 times earnings at the time, as shares traded around $190 per share. Given the earnings power, this looked reasonable, but the prevailing share price at the time was actually the peak.

Shares had fallen to the $150 mark by early 2022 as the company got involved with the bidding race for Coherent, with MKS initially willing to pay $6 billion in cash for Coherent, a huge valuation and a substantial number in relation to its own valuation.

As the company withdrew from a very competitive bidding process for Coherent, the company surprised the market somewhat in July 2022 when the company announced a $6.5 billion deal for German-based Atotech. Atotech was set to add $1.4 billion in sales and $440 million in EBITDA to MKS which itself generated $2.8 billion in sales and $800 million in EBITDA.

Shares fell nonetheless as the deal was rich and pro forma net debt of $4.5 billion would be equal to about 4 times leverage. Shares fell some 5% overnight to $170 as the deal felt to be executed in a rush, with closing taken place in August 2022, so soon after dropping out of the bidding war for Coherent. With pro forma earnings seen around $12 per share, valuations looked reasonable, yet there were the concerns of normalization if margins and the high debt load.

After shares fell to lows of $65 in November 2022, they recovered to just below the $100 mark at the start of 2023. With earnings trending around $11 per share, the valuation looked very compelling below the $100 mark, but there was the issue of high debt and a soft fourth quarter outlook with lower earnings set to increase relative leverage ratio.

If the company could stabilize and growth returns, shares looked dirt cheap, but that was a big if, as a 50% return from the lows in the time frame of just a few weeks made me a bit cautious as well.

Trading Stagnant

Tear to date shares of MKS have traded in a relatively narrow range between $80 and $115, currently trading towards the lower end of the range at $92 per share, marking some modest share price losses this year.

In February of this year, MKS posted its results for 2022 with revenues up 20% to $3.55 billion and fourth quarter sales up 42% to $1.09 billion. This is worse than it looks, as it, of course, includes the contribution of Atotech with standalone revenues likely down.

The company posted adjusted earnings of $133 million, equal to $2.00 per share, as GAAP earnings only came in at $0.81 per share, with most of the reconciliation related to amortization charges. Net debt was reported at $4.0 billion, resulting in steep leverage ratios with fourth quarter EBITDA of $282 million trending at just over $1.1 billion here.

The outlook for 2023 was highly uncertain as first quarter sales were seen at $1.00 billion, down nearly 10% from the fourth quarter numbers. Perhaps worse, a ransomware event would hurt sales by at least $200 million, a devastating outlook.

In May, the company posted first quarter sales of $794 million, with adjusted earnings down to $32 million, equal to $0.48 per share. Net debt actually ticked up small on a sequential basis, in part due to a $0.22 per share dividend, which is continued despite these conditions. Following the ransomware incident, second quarter sales were set to recover to a midpoint of $980 million, with adjusted earnings seen at $1.13 per share.

In August, MKS posted its second quarter results with revenues reported at $1.00 billion and adjusted earnings coming in at $1.32 per share, both coming in ahead of the original outlook. A huge $1.8 billion goodwill impairment charge resulted in a big GAAP loss. Net debt ticked up to $4.15 billion, as the second quarter EBITDA number of $254 million worked down to a leverage ratio at just over 4 times.

Moreover, the company guided light for the third quarter with sales seen at $930 million, adjusted EBITDA at $210 million and adjusted earnings of $0.98 per share. Annualized, such EBITDA performance makes that leverage might increase towards 5 times.

And Now?

With 67 million shares trading at $92 per share, the company commands a $6.2 billion equity valuation, and $10.3 billion enterprise valuation. This clearly shows, in combination with the massive goodwill impairment charge and the lackluster operating performance, that the purchase of Atotech deal was far too expensive.

Quite frankly, I completely understand the continued sluggish share price performance, as the first two quarters of the year have been quite soft, and while the ransomware attack was a fair argument for the softer first quarter, the same cannot be said for the soft third quarter outlook.

Given all these developments, the first half of the year has been a bit of a waste of time. The operating performance has been anything but impressive and leverage remains very high, in fact only ticks up, albeit that the company is actually profitable and holds a large cash buffer.

Given all these trends, I am not impressed with MKS Instruments, Inc. here, yet the long-term potential is there, which requires great execution and debt to overcome. Hence, I think it is too early to dip my toes into the water, but the burden of proof is really with management here.

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