2023-10-26 16:19:25 ET
Summary
- inTEST's stock valuation might appear attractive from a discounted cash flows perspective, but several reasons explain the discount.
- The company's long-term financial performance has been volatile and profitability metrics have narrowed as the business scaled up.
- Expected weakness in the semiconductor market and the company's exposure to geopolitical risks are significant concerns.
Investment thesis
inTEST's ( INTT ) stock valuation might look attractive from the discounted cash flows perspective, but there are multiple reasons why the stock is so cheap. The company's long-term financial performance has been volatile, and profitability metrics narrowed as the business scaled up. This might indicate that the growth strategy is either unsustainable or poorly planned and executed. I also expect weakness for the next multiple quarters for semiconductors, the company's largest end market. Having more than 50% of sales generated outside the U.S. also looks like a substantial risk in the current uncertain environment of several ongoing military conflicts and the "Cold War" between the West and the East. Overall, I think the potential benefits do not outweigh the risks and assign the stock a neutral "Hold" rating.
Company information
INTT is a global provider of testing and process solutions for diverse industries, including automotive, defense/aerospace, industrial, life sciences, security, and semiconductors.
The company's fiscal year ends on December 31. INTT conducts its operations via three reportable segments: Electronic Test, Environmental Technologies, and Process Technologies. According to the latest 10-K report , the company generated 57% of its FY2022 sales outside the U.S.
The company also disaggregates its revenue by the end markets, where semiconductors represented almost 59% in FY 2022. None of the other segments represented more than 10% individually.
Financials
I have mixed feelings about the company's financial performance over the last decade. On the one hand, revenue almost tripled, delivering a solid 12.8% CAGR over the last ten years. On the other hand, profitability metrics did not improve as the business scaled up and were quite volatile. Inconsistency in profitability despite solid revenue growth is a red flag to me because it might mean that the company's growth strategy might not be sustainable or well-executed. The company's inability to generate consistent returns is also highly likely to deter risk-averse investors who are seeking more predictability.
The company does not pay dividends, nor does it conduct stock buybacks. Given the company's instability in free cash flow [FCF] and profitability metrics, this looks sound. The balance sheet looks healthy, with low leverage and high liquidity metrics, but it is essential to underline that during Q2, the company issued common stock worth $20 million. It is not a good sign for potential investors because it means that the company started running out of cash and had no better options other than to dilute its shareholders. I do not expect the company to start paying out dividends in the foreseeable future.
Seeking Alpha
The latest quarterly earnings were released on August 4 , when the company topped consensus estimates. Revenue demonstrated solid growth momentum with a 10% YoY increase. The top-line strength allowed the operating margin to expand YoY by one percentage point. As a result, the adjusted EPS expanded from $0.25 to $0.28.
Seeking Alpha
The upcoming quarter's earnings release is scheduled for November 3. Quarterly revenue is expected at $32.7 million, which indicates a 6% YoY growth. Despite revenue growth, the adjusted EPS is expected to shrink from $0.28 to $0.26. This might be due to the increased number of shares outstanding.
Seeking Alpha
The company's wide diversification of end markets allows it to smoothen consolidated financial performance dynamics amid the current harsh environment. However, the exposure to semiconductors is substantial, and this industry is likely to face temporary weakness in the foreseeable future. I think so because recently, the world's largest chipmaker, Taiwan Semiconduc tor ( TSM ), announ ced a sharp drop i n profits, and TSMC management's outlook was very cautious.
It is also important to remember that the way the stocks of industry leaders behave sets the tone for the stocks of smaller players. That said, future movements in INTT's share price significantly depend on the performance of Nvidia's ( NVDA ) stock, which demonstrated a massive rally so far this year. But NVDA's v aluation got ridiculous in my view, an d a notable correction is highly likely to occur before the year-end. I think it is highly likely that a probable weakness in NVDA's stock price will drag down the whole semiconductor industry, especially small-cap players like INTT.
Last but not least, I think that having almost 60% of sales generated outside the U.S. is a substantial risk in the current geopolitical environment. Having most of the sales generated outside of the U.S. also means that the company's earnings are highly dependent on fluctuations in the foreign exchange market, which is also a substantial risk for investors.
Valuation
The stock rallied 24% year-to-date, significantly outperforming the broader U.S. market. Seeking Alpha Quant assigns INTT a decent "B" valuation grade because ratios look attractive compared to the sector median and historical averages. That said, the stock looks undervalued from the valuation multiples point of view.
Since INTT is a growth stock, I want to proceed with the discounted cash flow [DCF] simulation. I use an elevated 13% WACC due to the company's small scale and volatile history of financial performance. I have revenue consensus estimates available up to FY 2027 and project an 8% CAGR for the years beyond. I expect zero FCF margin for the base year with a further one percentage point yearly expansion.
As you can see, the business' fair value is about $210 million, which indicates a 26% upside potential for the stock. That said, my target price for INTT is $17 per share.
Risks to my cautious thesis
This year, we already saw a new sudden introduction of a jaw-dropping software technology that can drive massive growth of semiconductor demand. We live in a world that is evolving rapidly from a technological perspective, and there is always some probability that the "next big thing" can pop up and boost the share prices of semiconductor stocks.
As a growth stock, INTT's valuation substantially depends on the monetary policy. While the Fed's highest officials were mainly hawkish in recent official speeches, the change in rhetoric to more dovish might be a significant catalyst for small-cap growth stocks like INTT. Inflation is already approaching the Fed's long-term target, and the pivot in monetary policy will occur sooner or later.
Bottom line
To conclude, INTT is a "Hold". While the company demonstrates solid revenue growth, I do not like stagnating profitability metrics. This might indicate substantial inefficiencies in driving revenue growth since the top-line strength should improve shareholder value and not diminish it. The recent quarter was solid, but I need to look at how a few more quarters unfold before my thesis can be upgraded to bullish.
For further details see:
inTEST: Cheap For Multiple Reasons