Photon Control upgraded to “Buy” at Paradigm Capital

With a recovery due in the semiconductor industry, Paradigm Capital analyst Kevin Krishnaratne has become more bullish on Vancouver-based Photon Control (Photon Control Stock Quote, Chart, News TSX:PHO).

In a research update to clients Monday, Krishnaratne upgraded Photon Control from “Hold” to “Buy” and raised his one-year price target on the stock from $1.10 to $1.50, implying a return of 38 per cent at the time of publication.

The analyst explained the high-level reasoning behind his upgrade.

“Over the past several weeks, comments from semiconductor producers, capital equipment firms, and subsystem companies have suggested stronger support for a rebound in memory spending in 2020,” he wrote. “While the view of a memory recovery materializing next year is something that many players had already indicated three months ago during Q2 earnings, recent commentary, in our view, indicates a slightly higher conviction on that recovery now closer to becoming a reality in 2020.”

Krishnaratne thinks PHO will generate EBITDA of $5.2-million on revenue of $29.6-million in fiscal 2019. He expects those numbers will improve to EBITDA of $7.4-million on a topline of $33.3-million the following year.

Krishnaratne outlined what he expects from tomorrow’s third quarter results.

“Photon Control reports Q3 this Wednesday before market open,” he noted. “We are expecting revenue of $7.1M, flat q/q, versus outlook of $6.5–$8.5M, and EBITDA of $1.3M (was $1.2M in Q2) for a margin of 18.4%. What we view as positive is that compared to some other peers in the industry who reported q/q declines, PHO’s guidance at the midpoint ($7.5M) reflects slight sequential growth. Management has noted that Q3 should benefit from Photon’s new Japanese distribution partner (Japan Laser Corp.) who is placing significant orders with a large customer in the region. We also think the company could see some new product (NPI) revenue growth in the quarter (NPI was $600K in Q2 and also in Q1).”

The analyst says Photon Control continues to manage the downturn quite well.

“Regarding profit performance, management has delivered during the current downturn, undertaking several initiatives, including an office shutdown in mid-August (similar shutdown took place in May), supply chain efficiencies, and an increase in automation,” he said. “As it relates to the company’s backlog, we look forward to signs of strength in the quarter. In Q2, the company reported a backlog of $10.7M, which, as a reminder, is defined as the unfulfilled value of sales orders received and scheduled to be delivered over the six-month period (Q3/Q4). Backlog was $10.8M in Q1, $13.1M in Q4/18, and $14.4M/18 in Q3 following the peak of $24.7M in Q1/18 at the height of the last cycle. We believe it is just a matter of when, not if, the industry starts to rebound and an increase in Photon Control’s backlog would reflect signs of an increase in customer spending. As noted above, VAT group, a leading supplier of vacuum valves and vacuum components used in the semiconductor industry, who can have relatively longer lead times, noted on its call that it is starting to see some spending from larger memory companies.”

Krishnaratne explained his reasoning around valuation.

“We downgraded PHO to a Hold on March 18, ahead of Q4 results, following industry data points near the end of 2018 that suggested weakening memory trends. At that time, shares of PHO had climbed +50% since December lows, a move that in our view was largely related to positive momentum in the semiconductor sector during this period. Shares of PHO are down 18% since our downgrade and were down as much as 33% following Q2 results in August, with the stock up +22% since. YTD, PHO is flat while the Dow Jones U.S. Semiconductors Index is up ~37%. While many other semiconductor companies have more diversified revenue mixes, we viewed Photon’s large exposure to memory as pointing to several more quarters of weakness, as there remained too much uncertainty on the timing of a recovery in memory. While we do not know exactly when that recovery will start to turn, some of the more recent data points, as highlighted in this note, give us more comfort that we are now much closer to a recovery. We have historically considered an EV/EBITDA multiple approach to our valuation on PHO, with shares currently trading at 12.1x NTM EBITDA, a slight discount versus peers at 13.5x. Over the past three years, PHO’s NTM EBITDA multiple has averaged 9.4x versus peers at closer to 9.8x. We note that some of the current target multiples for peers are closer to 15.0x.”