One of the most important screens on the GuruFocus platform is the Undervalued Predictable.
As the name suggests, it is double-barrelled. The undervalued reference is to a discounted cash flow calculation, based on earnings without non-recurring items. Predictable refers to the company's ability to consistently grow its revenue per share and Ebitda (earnings before interest, taxes, depreciation and amortization) per share.
Until the Covid-19 crash last spring, a portfolio of the top 25 Undervalued Predictable stocks had routinely outperformed the S&P 500 over the past decade:
While Nova Measuring Instruments Ltd. (NVMI, Financial) is not among the top 25 stocks, it is a member of the list and worth our attention. It recently made the jump from small-cap to mid-cap, with a current market capitalization of $2.17 billion (although a modest reversal in the share price could push back into small-cap status).
Based in Israel, Nova describes itself this way in its 20-F for 2019 (the 20-F is the equivalent of the 10-K for non-American companies):
"We deliver continuous innovation by providing advanced metrology solutions for the semiconductor manufacturing industry. Deployed by the world's largest integrated-circuit manufacturers, Nova's novel technologies provide semiconductor manufacturers with process insight and clarity required to boost process performance, product yields and time to market."
Metrology is the science of measurement and is critical in the manufacturing of semiconductors. As Nova explains it:
- The manufacturing process starts with a flat silicon disc known as a wafer.
- A series of layers of thin films are applied to the wafer to construct circuits; these films act as conductors, semi-conductors or insulators.
- As the process moves forward, portions of the film are removed to create circuit patterns or perform other functions.
Given the size of semiconductors, precise measurements are critical; the company added, "Tight control can be achieved through monitoring silicon wafers and measuring relevant parameters before or after each process step with metrology tools such as those we produce."
GuruFocus lists several competitors, but the top three are peers, rather than direct competitors:
- Kulicke & Soffa Industries Inc. (KLIC, Financial) designs, manufactures and sells capital equipment and expendable tools used in assembling semiconductor devices.
- ACM Research Inc. (AMCR, Financial) offers wet cleaning equipment that removes particles, contaminants and random defects during the chip manufacturing process.
- Axcelis Technologies Inc. (ACLS, Financial) sells ion implantation and other processing equipment used in chip manufacturing.
Still, the company warned that it needs "significant" research and development to develop new products and technologies or to enhance its existing products, to "keep pace with the competitive landscape."
To finance an ambitious research and development program, a company needs free cash flow. Although the trendline shows overall growth, Nova's results have been bumpy, especially in 2018 and 2019:
The road to free cash flow begins with sales revenue. As this 10-year chart shows, Nova has consistently grown its top line:
Next, some of that revenue must make it to the bottom line, as measured by Ebitda. GuruFocus reports, "During the past 10 years, the average EBITDA per Share Growth Rate was 17.80% per year." In other words, this is an increasingly profitable company.
That's reflected in its tables for financial strength and profitability:
Several metrics on this table should get our attention:
- Debt: Very low in relation to operating income; indeed, Nova earns enough operating income to pay its interest expenses hundreds of times over (interest coverage ratio).
- WACC versus ROIC: Weighted average cost of capital versus return on invested capital is lopsided in the right way. Nova earns far more from its borrowed and invested capital than it pays for it.
- Margins: Both the operating and net margin are solidly in the double digits and compare favorably with other companies in the Semiconductors industry.
- ROE: Return on equity is 14.3%, which is solid. That suggests Nova enjoys a competitive advantage or moat, which takes us back to research and development spending.
- Growth: Note how revenue, Ebitda and earnings per share without non-recurring items have grown and, in particular, observe that both Ebitda and earnings per share are growing much faster than revenue. This too is a good sign since it indicates the company is becoming increasingly efficient.
What's more, the company has earned a 4 out of 5 rating for predictability, indicating it is well managed, so we can be relatively confident about its ability to keep growing.
Nova does not pay a dividend or buy back its own shares, which is not unusual for a tech company still in its growth phase. That means the only avenue for shareholder appreciation is capital gains.
When we turn to valuation, we come up against a contraction. Nova is on the Undervalued Predictable list, but when we check its discounted cash flow, using the standard defaults and earnings per share, the company turns out to be overvalued:
Why doesn't the DCF valuation show undervaluation? It depends on the growth value and terminal value rates of increase. Here's what we can deduce:
- The default version shown above uses the 10-year average growth rate of 15.40% (earnings without NRI).
- Earnings have accelerated in recent years and the 10-year rate does not reflect the rapid growth of 2019 and 2020:
- If we plug in the three-year average earnings growth rate (as shown in the Profitability table), the stock is deeply undervalued.
- So the Undervalued Predictable algorithm apparently uses an earnings growth rate that is somewhere between the 10-year average of 15.40% and the three-year average of 52%.
Bottom line, we can still consider Nova undervalued but do not know by how much. Looking beyond the DCF calculator gives us other information about valuation.
We start with a 10-year price chart, which shows the share price taking off in 2016, at about the same time the earnings growth accelerated:
The price-earnings ratio is high when compared with the industry's 10-year median growth rate: 48.33 versus 33.16 for the industry. It's also high when compared to its own median over the past decade: 18.11.
The PEG ratio, which factors in the growth by way of the five-year Ebitda growth rate, shows some overvaluation as well. At 1.71, the ratio is well above the fair value mark of 1.00, but not overwhelmingly expensive.
The latter is what we get with the GF Value chart:
To summarize valuation, the Undervalued Predictable approach will or will not matter, depending on how you structure the inputs to the DCF calculator. All other indicators suggest overvaluation, and probably somewhere between the modest overvaluation (the price-earnings and PEG ratios) and significant overvaluation as posed by the GF Value chart.
Three gurus had positions in this small-cap at the end of the third quarter:
- Jim Simons' (Trades, Portfolio) Renaissance Technologies reduced its stake in the quarter by 6.22%, to finish with 1,722,800 shares. That gave it a 6.13% stake in Nova and represented 0.09% of Renaissance's total assets under management.
- Chuck Royce (Trades, Portfolio) of Royce Investment Partners owned 366,124 shares after reducing his position by 9.74%.
- Ron Baron (Trades, Portfolio) of Baron Funds made no changes and finished on Sept. 30 with 220,000 shares.
Conclusion
Thanks to a growing share price, Nova Measuring Instruments recently made the transition from mid to small cap. It dominates a narrow niche in the semiconductor business, providing measuring tools to manufacturers.
It has solid credentials for both financial strength and profitability, scoring 9 out of 10 on both of those metrics. Nova also generates enough free cash flow to keep its research and development initiatives funded, thus ensuring proprietary moats. Valuation is more of a question, but it seems the market is demanding more than fair valuation for that growth. Still, that's an attractive opportunity for three of the gurus.
Nova stock will be most appealing to growth investors who want to generate potentially above-average capital gains. A moderate to significantly overvalued status means value investors are unlikely to be interested, despite the strong balance sheet. And income investors can skip it altogether.
Disclosure: I do not own shares in any of the companies named in this article and do expect to buy any in the next 72 hours.
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