$MCRNF
A high quality and predictable small cap operating in a niche inside the highly cyclical semiconductor industry.
Company overview
Micro-mechanics, Ltd. is a Singapore-listed designer and manufacturer of consumable high precision parts and tools used in the wafer-fabrication and test and assembly processes of the semiconductor industry. They have a worldwide base of 600 customers that they serve from five manufacturing facilities located in Singapore, Malaysia, China, The Philippines and the USA.
Their mission is to provide customers with “Perfect Parts and Tools, On Time, Every Time”. From what I gather, they do just that.
Industry overview
Semiconductors are almost in everything and will probably be in absolutely everything a few years from now. From computers to smartphones to cars, none of those things will work without one. The semiconductor manufacturers design and build chips that they then sell to companies and governments so they can build their products and sell them to the consumer. The “fabs” are the companies who actually psychically build chips beyond the design stage. The machines these companies use for building chips are some of the most expensive machines on earth. They work on an atomic level. Just one advanced lithography machine from ASML costs around $150 million. That’s why fabrication plants are incredibly expensive. Reports indicate that it costs around $20 billion to build a new generation fabrication plant. The industry requieres large amounts of money every few years to update the fabs that will produce the next generation of chips. It's also why the industry has been consolidating. Twenty years ago there were 20 different companies building the most advanced chips. Today there are only two: Samsung (Korea) and TSMC (Taiwan). There’s geopolitical ramifications that I’m not gonna get into. Suffice to say that China and the US are investing a lot of money to try and control chip manufacturing. As chips become more advanced manufacturers become more stringent with their requirements with suppliers of parts and tools. The company believes it is well position to be the next generation supplier of consumables parts and tools for the industry.
Company overview
The global semiconductor manufacturing equipment market was valued at $95.3 billion in 2021 according to Market and Markets research and it’s estimated to grow at a CAGR of 8.5%. Micro-mechanics operates in a niche inside the semiconductor manufacturing equipment industry specializing in the design and manufacture of consumable high precision parts in the assembly and testing of semiconductors and also the design and manufacture of high precision parts for the wafer-fabrication process. The company estimates TAM at over $500M according to their latest Annual Report. So at $60M sales they have approximately 12% of the market. They manufacture consumable parts for die attach, wire bonding and encapsulation such as rubber tips, high temperature rubber tips, rubber tip holders, pick up tools, dispensing nozzle adaptors, ejector needles, clamps and so on. We are talking about very small parts and tools that need to be replaced on a regular basis. I’m not sure because I haven’t been able to find their average price per product yet but it sounds like their products account for a very small percentage of their customers overall costs so that could be an advantage. If they build high precision parts and tools that overcome the most stringent requirements for a small percentage of the total cost incurred by their customers there’s very little chance they will be easily replaced. That’s why they have been able to grow profitably for the last 20 years. The consumable aspect of their products generates a steady stream of revenue that allows them to be shielded from the cyclicality of the industry. They have never had an unprofitable year since being listed and they grew income from $2 million in 2003 to $14 million in 2022 at a 12% CAGR.
The company operates through five plants located in Singapore, Malaysia, The Philippines, USA and China and serve more than 600 customers located in Singapore, Malaysia, Philippines, Thailand, China, USA, Europe, Japan, Taiwan and the rest of the world. Sales to Malaysia, China and the US account for 70% of consolidated sales. These are also the plants that are growing faster. Revenues from their top ten customers, which are located in those three countries account for 70% of global sales. Their plants are mainly dedicated to the manufacture and distribution of precision parts and tools for the semiconductor test and assembly industry, with the USA plant focused on the manufacture and distribution of precision parts and tools for the wafer-fabrication industry. From 2008 to 2016 the company tried to diversify into de CMA business (in their US operations) to serve other industries but after years of unprofitability decided to refocus on the semiconductor industry. “MMUS” (their plant in the US) is in the midst of a turnaround and after having a profitable 2021 is currently experiencing some pressures. Capital expenditures have been mainly concentrated in their Singapore and US plants for the last couple of years to further improve operational efficiency and capacity (overall capacity utilization stands at 61%) and they believe they are currently well suited for the next leg of growth and only a modest amount of Capex will be required from this point on. As a matter of fact, Capex as a percentage of sales, cashflows, etc, have been declining at 5% CAGR since listing.
The company sources materials from local suppliers for each of their plants so this allows them to be somewhat protected of supply chain problems. Majority of suppliers and service providers have been working with the company for more than 10 years. The same is true for customers. The company serves more than 600 global customers (though Top 10 account for 70% of sales) but provide “fast, effective and local” support to their customers through their local plants. Most of their customers have also been with the company for over ten years. I imagine given the recurring nature of the products they sell and the stringent requirements customers have, customer relations are fairly sticky. Customers come in three different forms mainly: 1) Outsourced Semiconductor Assembly and Tests (OSAT) operators such as Advanced Semiconductor Engineering, Amkor, and Unisem; 2) Independent Device Manufacturers (IDM) such as Bosch, Micron, or NXP; and 3) Wafer Fabs such as TSMC, Intel or Samsung. I haven’t been able to find any evidence of “pricing power” other than the fact that the company has been able to maintain pretty high and steady margins. Management did recognize that in 4Q22 margins slightly declined due to a sharp increase in costs and labor but believe the declined is a product of a time lag between rising costs and their ability to raise prices (which to me means they can actually raise them).
In terms of competition, the company claims they operate in a highly fragmented segment of the chip industry and that they don’t have a single direct rival with a comparable product range, manufacturing scale and geographical coverage. The industry is becoming more and more complex as chips become more advanced so customer requirements in turn are becoming more stringent. The company believes that as this trend continues there are going to be very few companies prepared to meet those requirements. They do recognize bigger competitive threats in the wafer-fabrication equipment segment (which accounts for 17% of overall sales) but believe their proprietary design capabilities and manufacturing know-how, their sound financial position and their ability to provide fast, effective and local support though their global footprint will enable them to compite effectively. Additionally in 2020 the company receive customer qualifications for a family of ultra critical parts used in the wafer-fabrication process and management believes their US plant is well position to become an elite supplier for critical parts in that industry. The following is an excerpt from an answer given to a shareholder inquiring about the competitive landscape of the semiconductor tooling business that sheds some light on the issue:
“While the supply side of the competition equation has remained largely unchanged, the landscape in the semiconductor tooling market is being increasingly dictated by customers' demand for higher precision, smaller feature sizes and shorter delivery lead time (cycle time). Although some of our competitors such as the small workshops may have lower product selling prices than Micro-Mechanics, we believe our value-add to customers lies in our ability to deliver a wide range of "Perfect Tools, On Time, Every Time.”
Overall, what I get from this is the fact that price is not the main competitive force in their industry but quality and cycle (the ability to provide high quality products fast).
The company is led by CEO and founder Christopher Borch who owns approximately 50% of the shares outstanding (personally and through Sarcadia LLC). Insiders own an additional 7% of the company. Management seems very smart and conservative in how they run their business. Illustrated by the fact that they are extremely focused on expenses (to the point where management doesn’t have secretaries or personal assistants and expenses over $500 have to be authorized), they don’t use debt, they own their plants, don’t issue shares and remuneration is tied to business performance metrics such as profitability, sales turnover, assets management, human resource management, quality, customer services, etc. There’s no SBC and bonuses are capped and paid in cash. Among other things this is the reason the company has received more than 30 awards and accolades for sound corporate governance, transparency, investor relations practices, etc. They were also included in the “Asia Best Under A Billion List” in 2022.
Performance overview
Sales have been growing at a 7% CAGR (median) for the last ten years (20y CAGR is closer to 9.5%) with pretty steady gross margins (around 53%) while they have been improving efficiencies and cutting costs. Management is very vocal about their cost-cutting focus and they have been automating their operations while maintaining a tight grip on headcount. Operating expenses were 33% of revenues ten years ago and they stand at 22% of revenues according to FY22 financials. EBIT, in consequence, has grown at a 16% CAGR (EBIT margins are in the 27-30% range). They seem to have very high quality of earnings as FCF is typically inline with Net Income (very low working capital needs). CFO is around $17M and Capex is close to $3.5M so FCF is around $13.5M. Management has stated that about a third of capex is focused on growth so actual Maintenance Capex is probably around $2.3M. So technically “Owner Earnings” are actually probably somewhere around $14.7M (Net income + DDA + SBC - Maintenance Capex - Changes in Working Capital), but we'll use the $3.5M as Capex for our FCF calculations just to be conservative. Returns are excellent every way you measure them. Average ROIC for the past ten years is 35% with a Median of 40%. ROE is around 23%, and ROC (EBIT/NTA) is above 40%. After Tax Return on Net Tangible Assets has only been under 10% in 2009 with a mean of 33% and a median of 30% for the last ten years. Moreover, the company has been able to double their sales and quadruple their earnings while retaining a very small portion of their profits. Cumulative profits for the last twenty years are around $150M, while incremental capital for the same period is only $25M. The growth of the business was funded entirely by CFO. So this is a business that can grow at 7-9% rates while retaining only a very small portion of their profits (15%). They haven’t use debt (ever) nor have they issued shares.
So this is a cash cow with what seems to be modest capital requirements. So what do they do with their money? They give it back. They have returned $122M in the form of dividends since 2003. Someone might prefer buybacks instead of dividends but it's important to note that dividends aren’t taxed in Singapore so it seems like a very efficient way to return cash to shareholders. I do wonder why they return so much of their profits instead of retaining a bigger portion to grow faster. I still haven’t been able to answer that.
So, summing all up:
-Profitable growth
-Predictable
-Operating leverage
-Excellent margins and returns
-High quality of earnings
-Modest capital requirements
-Industry tailwinds
-Barriers to entry
-No dilution
-High insider ownership
Valuation
I think is safe to say the company can earn around $13.5M in FCF (TTM FCF is $14.9). They will probably earn more than that as they gain scale and efficiencies and margins expand a bit. Keep in mind their US plant is still in the midst of a turnaround and maintenance capex is lower than $3.5M. But let's go with $13.5M FCF. At an EV of $281M that’s a FCF Yield of around 5%. For valuation purposes I’m gonna say growth is probably in the 5-7% range. So at 21x EV/FCF this company can probably return close to 10-12% CAGR (5-7% growth + 5% FCF yield). Good returns but short of my hurdle rate (15% CAGR).
You could think of valuation in terms of PE. For a high quality, predictable, cash generative company that grows 5-7% CAGR, a PE between 20-30 could be reasonable (if the market returns 10% a year and this company can grow at those rates while returning cash all you need is a 3-5% yield on the stock to match or beat the market). I’m gonna go and call fair value multiple is 25. At 139M shares outstanding FCF per share is close to $0.10. That would put appraisal value at $2.5. Slightly above of what it's trading for right now. Then again, those multiples are a bit high in terms of history. Average PE for the last 10 years is 15x which would imply a $1.50 share price. So it’s marginally cheaper than what it could be worth and considerably more expensive than what’s its traded for in the past. The company is getting better so the 15x multiple is probably on the low side of what it should be worth.
So either way the company seems pretty fairly valued at $2.25. If that’s the case then I would not want to pay more than $1.25 per share for this stock (5-7% Growth + 8% FCF Yield= 13-15% Hold Return).
By all accounts, this is a high quality, profitable, growing company with good corporate governance, room to grow, high barriers to entry and high insider ownership. If growth accelerates or price gets cut in half I’d be very interested in this stock.
PS. As I’m writing the company released a document saying that a proposal to allow management to issue shares will be considered on their next AGM to be held next Friday. I’m not sure what to think of this. The company has almost never issued shares before, growth has been entirely funded by CFO, they haven’t disclose any intention to pursue acquisitions and remunerations are paid in cash (which I like). We’ll find out soon enough.