SLT Core Portfolio: $MKSI
MKS Instruments (Mid-Cap) ranked third following our quantitative screener and is the third company we have analyzed as part of the fundamental analysis step of our investment process. The company exhibits a Value bias, which can add factor diversification to the portfolio.

Thesis
  • MKSI is a market leader. It has strengthened its leading position through patented innovation given the company's technologic moat.
  • Exposed to major secular trends, the company is set to benefit from: (1) the surge in demand and complexity in the semiconductor industry, (2) the transition from mechanical to laser-based manufacturing, (3) technology trends (5G, AI, big data, cloud) as well as advanced end markets such as electric vehicles (EV) and autonomous driving, med tech and industrial automation.
  • Robust and disciplined business process.
  • Financially sound, MKSI has demonstrated over the years that it is one of the better-managed component and subsystem suppliers in the semi-cap equipment market through its ability to quickly respond to changes in the investment cycle and keep innovating.
  • Atotech’s acquisition will reduce the cyclicality of MKSI sales, with healthy margins. The acquisition will bring MKSI to another territory to benefit from advanced electronics strong demand and evolution. Management has a proven record of successful integration of acquisitions and quick deleveraging of the balance sheet in the following years.
  • MKSI shares are attractively valued relative to its peers in the semi-cap, laser and photonics. Valuation is also attractive compared to its historical multiples.


Company Description
MKS Instruments, Inc. (MKSI) is a global provider of instruments, systems, subsystems and process control solutions that measure, monitor, deliver, analyze, power and control critical
parameters of advanced manufacturing processes to improve process performance and productivity.

The company holds a large portfolio of products derived from core competencies such as pressure measurement and control, flow measurement and control, gas and vapor delivery, gas composition analysis, electronic control technology, reactive gas generation and delivery,
power generation and delivery, vacuum technology, lasers, photonics, optics, precision motion control, vibration control and laser-based manufacturing systems solutions.

MKSI serves two major markets:

Semiconductor Market (62% of revenue): A significant portion of total revenue is derived from products sold to semiconductor capital equipment manufacturers and semiconductor device manufacturers. Products are used in major semiconductor processing steps, such as depositing thin films of material onto silicon wafer substrates, etching, cleaning, lithography, metrology, packaging and inspection.

Advanced Market (38% of revenue): The advanced markets can be broken down in three parts:

  • Industrial Technologies: industrial technologies encompasses a wide range of diverse applications, including advanced electronics manufacturing comprising flexible and rigid printed circuit board (PCB) processing/fabrication, electronic component manufacturing, glass coating and electronic thin films.
  • Life and Health Sciences: products for life and health sciences are used in a diverse array of applications, including bioimaging, medical instrument sterilization, medical device manufacturing, analytical, diagnostic and surgical instrumentation, consumable medical supply manufacturing and pharmaceutical production.
  • Research and Defense: Products for research and defense are sold to government, university and industrial laboratories for applications involving research and development in materials science, physical chemistry, photonics, optics and electronics materials. Our products are also sold for monitoring and defense applications including surveillance, imaging and infrastructure protection.

Competitive Moat

MKSI is usually first or second in most semiconductor and advanced markets in which it competes. MKSI is a global technology leader holding over 3,800 patents and employing over 2,000 engineers. It was able to cement its position through a combination of new product innovation, investing consistently throughout the cycle in R&D and strategic mergers and acquisitions. MKSI is a market leader with a broad technology portfolio.

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Sustainable Growth
Secular Trend: The semiconductor decade: a trillion dollar industry.

As the impact of digital on lives and businesses has accelerated, semiconductor markets have boomed, with sales growing by more than 20% to about $600bn in 2021. A McKinsey analysis based on a range of macroeconomic assumptions suggests the industry’s aggregate annual
growth could average 6-8% CAGR up to 2030. The result? A $1tn industry by the end of the decade, assuming average price increases of about 2 percent a year and a return to balanced supply and demand after current volatility.

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MKSI is well positioned to benefit from this secular trend and to enjoy the long-term growth trend in semiconductor capital equipment spend.

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As more data is needed and stored, more powerful semi chips are needed, increasing the complexity of the latter and hence increasing WFE (wafer fab equipment) spending. MKSI is the broadest critical subsystems provider in the WFE ecosystem and addresses 85% of the
market. MKSI unique subsystems portfolio enables the company to address semiconductor
customers’ most complex challenges.

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Secular Trend: Laser-based Manufacturing.
The laser-based manufacturing market is estimated to be a fast-growing segment due to increasing adoption and demand by various industries, especially by healthcare verticals. The advantage of laser technology over traditional material processing techniques is driving the
market's growth. Additionally, the growing nanodevices and microdevices fuel the market's growth. Furthermore, the growing adoption of laser technology for quality checks in various industrial verticals and increasing usage of laser technology for optimal communication are creating potential opportunities for the market to grow in the forecasted period.

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Connected devices expansion fueled by the internet of things (IoT) increases the number of components required per device, but also the processes and complexity in order to manufacture them. The company is uniquely positioned to address critical needs for laser precision manufacturing.

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Financials:

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Source: SLT Research

Revenue reached c.$2.95bn in 2021, up just a little bit less than 2.3x 2016 sales. Revenue is expected to exceed $3B in 2022. More importantly, net income grew faster than revenue and has been multiplied by 5.3x over the period.

Gross margin is relatively high for an industrial company, around 45%. We would be right to expect higher gross margin with scalability, however certain components have been really complicated to source in the last couple of years. Ironically, chip shortages caused delay in MKSI production, and hence could not deliver its products required by semiconductor manufacturer to produce more chips...

Operating profit/margin grew and fluctuated more than the Gross Profit from 15.75% in 2015 to 25.08% in 2021, lowering 13.79% in 2019. Margin improvement can be explained by both a slight reduction of SG&A and R&D as a percentage of revenue over the period.

In 2021, the company returned a ROA of 13.06%, aligned with 2017 & 2018 levels, and higher than 2019 & 2020. ROE also improved significantly reaching 21.02%. Let's now see what drove MKSI profitability using a three steps DuPont analysis. Given the historical cyclical nature of the business, we will use an adjustment factor in order to normalize the net income margin.

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The analysis shows that ROE is mainly driven by MKSI net profit margin. We can also see that recently, the company had a less efficient use of its asset to generate revenue (asset
turnover) but actually increased or maintained high ROE due to slightly higher debt levels.

MKSI balance sheet is solid. From a liquidity point of view, current assets almost represent 4.7x current liabilities. As of Q2 2022, the company was sitting on $1.065bn of cash & cash equivalents. The cash ratio improved almost 3x faster than current ratio. This is explained by accounts receivable and inventory representing a lower portion of the current assets.

From a solvability perspective, MKSI level of debt is low for an industrial company. Total debt represents a bit more than one third of total equity and slightly more than 22% of total assets.
2021 EBIT was at a level able to cover more than 27x the company’s interest expense. The Altman’s Z-Score above 7 shows that MKSI’s probability of bankruptcy is close to 0 (if not 0) and overall solvability improved since 2019.

The company generated a free cash flow (FCF) of $555m in 2021. The latter fluctuated in line with Net Income. The main use of cash was the acquisition of subsidiaries (Newport and Electro Scientific Industries), notably in 2016 and 2019 with acquisitions of both c.$900m. Following those acquisitions, the company exhibited a strong ability to repay LT debt. It is translated by the solvability numbers mentioned above, with higher gearing in 2016 and 2019, and significant improvement thereafter. It is worth mentioning that MKSI repurchased shares every year for the last 10 years except in 2017 (following 2016 acquisition, and 2017 was the year with highest debt repayment over the last decade).

  1. Quick comparison with a few competitors in terms of profitability (LTM):

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MKSI experienced above median top line growth. Net Income growth is actually the group median. Both EBITDA and Net Income margins are significantly above median with interesting low level of Capex/Revenue. As a result, MKSI enjoys stronger return on invested capital,
assets, and equity compared to its competitors, using similar levels of gearing.

Looking forward: Acquisition of Atotech.
On July 2021, MKSI entered into an agreement to acquire Atotech, a leading specialty chemicals technology company. The total value of cash and stock consideration was c.$5.1bn at time of deal announcement. MKSI has announced recently the completion of the acquisition for approximately $4.4bn. 2021 consolidated income statement below gives a snapshot at a group level. Both gross and EBITDA margins should not be impacted.

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Moreover, with Atotech, roughly 40% of the MKSI combined business will come from a steady contribution of consumables and service revenue (recurring), providing greater resilience to its financials and less cyclicality.

Atotech’s leadership position in electronics chemistry aligns well with MKSI’ via-drilling business and the industry’s advancing interconnect technologies. The combination will likely make MKSI a key player in next-generation interconnect architectures.

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Atotech is well positioned for attractive secular trends like electrification, 5G infrastructure & smartphones, and renewable energy.

At the time of the agreement to acquire Atotech was announced, MKSI said the combined company will have pro forma net cash and investments of ~$800M and total debt of $5.3B at closing, with net leverage of 3.5x (currently 2.75x).

Management Checklist and ESG considerations

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MKSI has a reasonable score using our Management Assessment Checklist, we particularly like management’s communication skills and level of compensation. However, a goodwill representing c.27% of total assets ($1.2B, and not taking into account Atotech's acquisition) impacts the capital allocation skill score.

MKSI mission statement is “Our mission is to be the innovation leader and trusted partner that pushes the boundaries of possibility.”

As already mentioned MKSI has been constantly repurchasing shares over the last 10 years (except 2017). The company introduced the payment of a dividend in 2011 and the latter has been growing without interruption at a conservative rate. Dividend yield was c.0.5% in 2021 and dividend payout ratio was less than 10%. A small dividend is nice to have, but we like that more than 90% of the net income is reinvested in the business, organically and externally via
M&A.

Indeed R&D spending increased each year, and its financially sound situation, allows the company and management to keep investing even in down cycles, which may not me the case of all competitors. Ultimately, it enables the company to stay ahead in terms of technology and gain market share. The later went up from 9% to 18.6% in the last decade (critical subsystems/semiconductor market share).

Management made a few significant acquisitions. We are usually careful when it comes to M&A. However, as highlighted by high debt repayments following purchases, MKSI’s management has a history of quickly deleveraging after large deals. In addition, and as
outlined by MKSI’s CEO in a recent conference, MKSI has strong skills in integrating new subsidiaries, with the example of Newport where revenue grew organically from c.$600m to $1bn since acquisition. We are just concerned that, given goodwill level, the management might usually overpay.

On the ESG front, MKSI made important strides in strengthening its Corporate Social Responsibility (CSR) efforts with the issuance of an inaugural CSR report (commitments to diversity, equity and inclusion, environmental management, employee development, and governance). The company is above peer group median regarding Environmental and Social matters, and leading the group in terms of Governance (Bloomberg ESG Scores).

Valuation

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The company is currently trading below or around -1 standard deviation from all historical multiple average presented above, representing a more than 30% potential upside to assessed value. MKSI shares also trade at a 25% discount versus competitors (P/E).

Beyond secular trends and MKSI leading position, we believe Atotech’s acquisition could unlock more upside. MKS is employing the same M&A playbook it successfully executed on in the semiconductor and fragmented laser and photonics markets. The acquisition would take MKS into new territory. Atotech appears to be a well-managed business, with a strong competitive position in its key markets and healthy margins. We view the deal favorably as it aligns well with the company's inorganic growth strategy. Revenue synergies and management's history of quickly deleveraging after large deals remain underappreciated by investors. Furthermore, with c.40% of the consolidated revenue considered recurring (consumables and services), we believe the company's reduced cyclicality will be rewarded by the market in the mid- long-term.

Risks

  1. In 2021, 57% of MKSI revenue was from sales to customers in international markets, including China and Taiwan. China has turned to the familiar playbook of trade restrictions following US House of Representatives Speaker Nancy Pelosi’s visit to Taiwan. Rising geopolitical tensions between the US and China about Taiwan could impact MKSI revenue and growth in general. The company sees a number of R&D and cross-selling synergies especially geared towards China, where Atotech currently has a strong presence. Escalation of the tensions could impact both synergies expected from the merger and Atotech operations in Asia.

However, it is unlikely that China will hit hard on semiconductors given its reliance on them.
For Beijing, targeting Taiwan’s semiconductor industry would come at the cost of inflicting significant harm on itself.

  1. Continued supply chain disruptions or further manufacturing interruptions or delays could affect MKSI ability to meet customer demand and lead to higher costs, hence impact margins and profitability. MKSI inventory to sales ratio was lower in 2021 than pre-Covid however, the failure to estimate customer demand accurately could result in excess or obsolete inventory.

Given the geopolitical tensions in the past few years, MKSI has begun to diversify its supply chain in China and invest in manufacturing facilities in other regions. While this redundancy may initially create some inefficiencies in the manufacturing network, MKSI believes it can pass along some of the costs through higher pricing as its customers are willing to pay a little more to have a more secured supply chain, especially given many of MKSI's products are
considered critical to its customers.

We hope you have enjoyed the analysis and please do not hesitate to give us your feedback!

Disclaimer: The information provided in this post is for information only and solely on the basis that you will make your own investment decisions after having performed appropriate due diligence.
Josh Kohn-Lindquist's avatar
Fantastic write up. Thank you for the information 🙏

This popped up on a screener for me over the weekend, might have to start a little watchlist position in this one, looks promising.
SLT Research's avatar
@joryko thanks Josh for your feedback. Always appreciated.
Conor Mac's avatar
Jesus, another one. These are great SLT.
SLT Research's avatar
@investmenttalk thanks Conor. And still more to come ;)
StockOpine's avatar
Thank you for sharing @slt_research . Great work and love seeing the DuPont analysis👌🏼

Can you elaborate a bit on CEOs length of tenure and whether the company had any write-offs/impairment of Goodwill in recent years?
SLT Research's avatar
@stockopine thanks guys, as I commented in your recent post, I really like running through a DuPont analysis when relevant.

Regarding CEO tenure, the current CEO of MKSI joined 2.7 years ago, and we consider it being low vs. Russell 3000 average CEO tenure (7.2 years in 2020).

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We have not seen any goodwill being written down in the recent years.

Thanks for asking - I know it is always relevant when it comes to you.
StockOpine's avatar
@slt_research thank you for the clarifications. Appreciated. Keep up the good work!
Reasonable Yield's avatar
Really great quality stuff here, really enjoying these buddy.

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