MKSI - MKS Instruments: The Headwinds Outnumber The Tailwinds

2023-03-23 10:29:26 ET

Summary

• MKS Instruments suffered a ransomware attack, which threw a spanner into the outlook at a time when the company least needed it.
• The Atotech acquisition is making its impact felt, both in a good way and in a not-so-good way, which will take years to resolve.
• The health of the balance sheet has deteriorated from where it used to be before Atotech and it comes at a time when a downturn looms ahead.
• There may come a time for long MKSI, but there are currently far more arguments against it than there are in favor of it.

MKS Instruments ( MKSI ), a provider of technological solutions to the semiconductor, electronic and specialty industrial markets, wrapped up FY2022 with the release of the Form 10-K on March 14. The release got delayed due to a ransomware incident in February, which is expected to have a negative impact on the quarterly results. In addition, the completion of the Atotech acquisition is having an impact, both in a good way and in a not so good way. Why will be covered next.

FY2022 was a year of change for MKSI

MKSI completed the acquisition of Atotech in August 2022, which means the quarterly numbers from Q3 on started to incorporate contributions from Atotech. As a result, FY2022 revenue jumped by 20.2% YoY to $3,547M, a record high. On the other hand, GAAP EPS declined by 43.8% YoY to $5.56 and non-GAAP EPS declined by 12.4% YoY to $9.97 in spite of the increase in the top line.

Adjusted EBITDA, however, which strips out the various acquisition costs, integration costs and, more importantly, interest expense associated with the Atotech acquisition, rose to $969M in FY2022, up from $879M in FY2021. The headline drop in earnings was thus mostly the result of changes brought about by the Atotech acquisition.

For instance, MKSI had to issue new shares to Atotech shareholders, which led to share dilution. There were lots of acquisition, integration and other charges associated with the Atotech acquisition, all of which hurt the bottom line. Other factors playing a role in the FY2022 numbers include lockdowns in China, which had nothing to do with Atotech, but which still hurt the bottom line. The table below shows the numbers for FY2022.

Source: MKSI Form 10-K

The Atotech acquisition resulted in major changes to the balance sheet. MKSI paid $16.20 in cash and 0.0552 share of MKSI stock for every share of Atotech. As a consequence, MKSI had to take on debt to finance the acquisition. MKSI ended FY2022 with gross debt of $5.1B, partially offset by $910M in cash, cash equivalents and short-term investments. As recently as the end of Q2 FY2022, these numbers stood at $810M and $1,065M respectively, which shows how much of a hit the balance sheet took due to the Atotech acquisition.

At the same time, it's worth noting that the FY2022 numbers would have looked very differently if not for the Atotech acquisition. Revenue growth, for instance, had gone flat prior to the acquisition. Q1 revenue was $742M and Q2 revenue was $765M, or a combined $1,507M, which was just $1M more than the $1,506M in the two preceding quarters. Revenue moved higher in Q3 thanks to partial contributions from Atotech and again in Q4 with the full addition of Atotech.

Q4 revenue increased by 42% YoY to $1,085M, but GAAP EPS declined by 69.9% YoY to $0.81 and non-GAAP EPS declined by 33.8% YoY to $2 with Atotech playing a key role. Adjusted EBITDA was $282M in Q4 FY2022, up from $268M in Q3 FY2022 and $228M in Q4 FY2021. Note how the weighted-average of shares outstanding jumped higher after the Atotech acquisition to reach 66.7M in Q4, up from 55.7M at the end of FY2021.

Source: MKSI Form 8-K

Ransomware threw a spanner into the outlook

MKSI disclosed on February 3 that it had become subject to a ransomware attack , which negatively affected business, including production. As a result, MKSI pulled its guidance for Q1 FY2023. MKSI was originally looking at Q1 revenue of around $1B, but the ransomware event is likely to reduce revenue by at least $200M. On the other hand, MKSI is optimistic recovery will be fairly quick. From the Q4 earnings call:

What we can share is that prior to Ransomware event, we are planning to guide total MKS revenue for the first quarter to be approximately $1 billion. This reflected widely publicized cycle softness in the semiconductor industry, offset somewhat by a strong backlog coming into the quarter, continued weakening in global electronics spending impacted our electronics and packaging market and a modest sequential decline in revenue, especially industrial market.

We estimate the Ransomware incident will impact our forest quote revenue by at least $200 million. However, we expect to substantially recover this revenue by the end of the second quarter."

A transcript of the Q4 FY2022 earnings call can be found here .

Still, earnings estimates were taken down. Consensus estimates predict a non-GAAP loss of $0.13 per share on revenue of $772M in Q1 FY2023. For the whole year, estimates expect MKSI to earn $2.40-4.21, a decline of 57.77-75.93% YoY, on revenue of $3.53-3.88B in FY2023. However, MKSI is expected to recover the following year with estimates predicting $5.60-6.97 on revenue of $3.93-4.29B in FY2024.

Multiples have been impacted as well. Multiples were in the single digits before the Atotech addition, but MKSI now trades at 141 times forward GAAP earnings with a trailing P/E of 15.7. In comparison, the sector median is 23.3x and 21.9x respectively. On the other hand, EV/EBITDA is in the low teens because it does not account for say interest expense. The newly acquired debt on the balance sheet is also the main reason why enterprise value of $10B is so much higher than market cap of $5.8B.

Source: Seeking Alpha

There is another factor affecting the outlook for MKSI. MKSI tends to grow in line with the wafer fab equipment market. Currently, this market is forecast to shrink in 2023. For instance, a recent forecast from SEMI predicts the equipment market will decline by 22% YoY to $76B in 2023, down from a record $98B in FY2022.

On the other hand, the market is expected to rebound with an increase of 21% YoY to $92B in 2024. The consensus is that the market will shrink in 2023, but return to growth in 2024. Current earnings estimates are predicated on this happening. Of course, it's always possible the expected recovery does not play out as predicted.

The stock has underperformed and may still be in a downtrend

The chart below shows how the stock has not made much headway in recent months. In fact, the stock has underperformed with a gain of 2.5% YTD. In comparison, the iShares Semiconductor ETF ( SOXX ) has gained 23.8% YTD. Most semiconductor stocks have done quite well in 2023, but not all of them. MKSI is in the latter group.

The stock seems to have hit bottom when it posted an intraday low of $64.77 on November 9, 2022 for a 52-weeks low, but that does not mean the stock cannot reach new lows, especially if the stock is still in the downtrend that began in April 2021 when the stock hit an intraday high of $199.44. The stock proceeded to enter a downtrend which culminated in the November 2022 low.

In doing so, the stock retraced the entire uptrend that started in March 2020 with an intraday low of $66.87 and which ended with the April 2021 high. Note that if intraday lows are excluded, then the stock came within pennies of matching the March 2020 low of $74.75 on October 14, 2022 with $74.65.

The stock has managed to fall below the March 2020 low last November, if only on an intraday basis. If it also turns out that the recent rally off the November lows, which ended on February 2 with an intraday high of $114.15, was nothing more than a bounce or a countertrend move off the lows, then it's not out of the realm of impossibilities that the stock retests the November lows. It may even go for new lows.

Investor takeaways

I remain neutral on MKSI as stated in a previous article . The ransomware attack came at a bad time. MKSI was already dealing with weakening demand with semiconductor demand falling in a number of key markets, but MKSI is now projected to post its first quarterly loss in years in Q1. Still, the ransomware attack should not have any lasting impact on MKSI.

On the other hand, while the Atotech acquisition may some day become a tailwind for MKSI, the acquisition is very much a headwind in the short to medium term. EPS is expected to remain depressed while MKSI spends the next few years digesting the Atotech acquisition, including the various acquisition costs, integration costs, and above all, interest payments on the debt acquired to finance the acquisition.

MKSI will likely prioritize paying down the debt in the coming years, which suggests shareholders should not expect too much in terms of capital returns anytime soon, including dividends. It doesn't help that the Atotech acquisition seems to have come at a bad time with the semiconductor industry entering a downturn after several years of expansion.

It appears MKSI bought at what could have been the peak. It will now need years to fix the damage done to the balance sheet, which used to be in pristine condition before the acquisition. If it also turns out that industry forecasts of a rebound in 2024 are too optimistic and demand remains weak, then MKSI might well regret making the Atotech acquisition, at least in terms of the price paid and timing.

Bottom line, there is a lot that argues against long MKSI and not a whole lot in favor of it. The stock looks like a better bet over the long run, but in the short run, not so much. An expected rebound in the industry next year could help the stock, but this forecast could be subject to subsequent revisions. If the downturn becomes worse, the stock could get dragged lower, something the charts suggest is possible.

MKSI is not exactly a bargain with multiples where they are. Earnings are not expected to get back to the recent highs anytime soon through a combination of an industry downturn and the need to incorporate Atotech. Add on the fact that MKSI will need years to fix the balance sheet and it may just be better to not take any unnecessary risks at a time when the stock market is showing signs of wobbling.

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