MKSI - MKS Instruments: Uncertainty Prevails

2023-11-22 02:19:30 ET

Summary

• MKS Instruments is suffering from sales declines and margin pressure, creating an uncertain situation amidst a leveraged balance sheet.
• The acquisition of Atotech has not lived up to expectations, leading to a $1.8 billion impairment charge.
• Fourth quarter sales are expected to decline, further increasing leverage concerns.

In September, I believed that MKS Instruments (MKSI) was still suffering from the Atotech (debt) overhang. This came after MKS suffered a sluggish operating performance following a larger and expensive deal, while a ransomware attack added to its woes.

Despite the positioning to long-term growth trends, MKS is suffering from sales declines and margin pressure, with no short-term avail seen here, creating an uncertain and leveraged situation, although that long-term appeal is seen if growth and margin expansion returns.

Some Perspective

MKS Instruments focuses on technologies and products that relate to precise control and related control solutions used in complex technologies, such as semiconductor, life sciences, research, and industrial technologies, creating a diversified play with sound long-term growth prospects.

A $2.4 billion business in 2020 posted earnings around $8 per share, as a $180 share price valued the business at 22 times earnings. Amidst a setback in technology valuations at large, shares fell to the $150 mark early in 2022, as the business got involved with a bidding race for Coherent, with MKS initially willing to acquire the business for $6 billion in cash.

The company, fortunately, withdrew from a competitive bidding process but made another ill-advised move as it acquired German-based Atotech in a $6.5 billion deal in July 2022, at least that was the time when the deal was announced. With a $1.4 billion sales contribution and $440 million EBITDA contribution, the purchase price looked relatively expensive.

The deal resulted in a pro forma business, which would generate $4.2 billion in sales and $1.24 billion in EBITDA, as pro forma net debt of $4.5 billion was rather high, resulting in leverage ratios of around 4 times. Even as pro forma earnings were seen at around $12 per share, there were concerns given the debt load, certainly if earnings and margins would normalize.

Ever since, shares have gradually come down as the operating performance of the business has been lagging. In February 2023, the company posted its 2022 results with revenues up 20% to $3.55 billion, as fourth quarter sales rose by 42% to $1.09 billion. This looks strong, but actually organic revenue trends were negative if we adjust for the purchase of Atotech.

With net debt reported at $4.0 billion, leverage ratios were high as fourth quarter EBITDA of $282 million barely surpassed the $1.1 billion mark on an annual basis, falling short of the pro forma results. Moreover, the outlook for 2023 was soft, with first quarter sales initially seen at $1.0 billion as a ransomware attack made that first quarter sales fall to just $794 million.

The company guided for second quarter sales to recover to $980 million, as revenues eventually came in at $1.00 billion, including some catch-up demand from the first quarter and its ransomware event, as adjusted earnings came in at $1.32 per share. By now, it was clear that Atotech was not living up to expectations, triggering a $1.8 billion impairment charge as net debt actually ticked up to $4.15 billion, while second quarter EBITDA of $254 million was very soft.

Even worse, third quarter sales were seen at just $930 million with EBITDA seen down to $230 million and adjusted earnings seen at $0.98 per share, pushing up leverage ratios to around 5 times. Trading at $92 per share, the $6.2 billion equity valuation meant that MKS was still valued at $10.3 billion if we factor in net debt. Amidst all this, I was very cautious and while the long-term potential was seen, I feared the cyclical and debt element, making it too early to dip my toes into the water, with the burden of proof lying with management.

Coming Down Further

A $90 stock in September has fallen to levels in the mid-sixties by the end of October, before having recovered to $76 per share here. This is despite some positive news in October, when MKS Instruments announced a repricing of its term loan, with the credit spread having narrowed 25 basis points to thereby save the firm about $11 million per annum in interest expenses.

Early in November, MKS posted third quarter sales of $932 million and adjusted EBITDA of $235 million, although that adjusted earnings of $1.46 per share looked relatively strong. Net debt came down in a minimal fashion to $4.01 billion, with leverage issues remain very real, as EBITDA trends around $940 million here. This results in an annualised leverage ratio of about 4.3 times, but that is not the worst news.

Fourth quarter sales are seen down to $840 million, plus or minus $40 million, attributed to inventory work-downs in the semiconductor sector. With adjusted EBITDA seen at just $185 million for the quarter, this number annualised results in a 5.4 times leverage ratio.

Adjusted earnings per share are seen at just $0.85 per share, providing limited room to deleverage, as the company maintained its $0.22 per share quarterly dividend here, despite its woes, depleting the company from an annual $60 million cash flow.

What Now?

With shares down 15-20% from the levels seen in September, it is clear that expectations have come down further, something which I attribute to the softer guidance for the fourth quarter, marking further sequential revenue declines.

While some end markets are certainly hurt by higher interest rates, which defer capital spending cycles and cause generic weakness, but it is the operational weakness that is seen as well, perhaps as a result of the larger deal with Atotech and related distraction. After all, exposure to fast-growing trends like data centers, artificial intelligence, smart industrial, IoT, smartphones, medical, etc. should result in a better growth performance than displayed here.

In fact, the positioning remains sound with about half of the sales tied to the semiconductor industry last year, a quarter to specialty industrial applications, and a quarter to electronic & packaging activities, although the relative share of semiconductor activities has fallen a bit here, amidst the declines in these sales.

While shares have been derisked a bit further, in the sense that shares are down, this has come amidst poor guidance for the fourth quarter, which actually pushes up leverage concerns in the near term. The long-term potential remains clear, but some real stabilization and deleveraging would be welcomed here in order to create a good night of sleep and an improved risk-reward proposition.

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