Why Advanced Energy Industries is a short

Advanced Energy Industries (NASDAQ:AEIS) develops power products that transform electrical power into various usable forms. The firm’s primary markets are semiconductor capital equipment and industrial power sector. It has demonstrated strong fundamentals and top line growth for last four years, and the period has also been profitable for its peers. Everything was going good until the US-China trade war began to escalate, after Q2 earnings missed expectations while Q3 guidance was given below consensus, the stock went down 5%.

Although fundamentals look good for both the semiconductor equipment and industrial power industry in the medium to long term, macroeconomic impact dominates fundamentals at this point in time. Uncertainty in the semiconductor sector due to cyclicality, weakness, pricing pressure and trade-war escalation is affecting AEIS and similar firms. My discounted cash flow model (DCF) model indicates that the intrinsic value of AEIS is $38.33, implying an overvaluation of $8.17 a share (AEIS trading at $46.5). Relative value suggests mixed results. Incorporating my valuation with the expected uncertainty in semiconductor industry, AEIS is a short.

Performance analysis

AEIS has demonstrated good fundamentals in last four years, sales growth have averaged 23%, along with 5.35% in bottom line margin and 23%+ in FCF margin. But further investigation indicates considerable volatility in the trends, reflecting the cyclical features.

Let’s take a comprehensive look at AEIS by analysing the performance spreads. In last two years AEIS has particularly demonstrated industry-above strength in performance, but the magnitude of changes clearly indicate inherent volatility in the industry, which is passed on to AEIS.

Performance spread
*AEIS minus comps average	2012	2013	2014	2015	2016	2017
Gross margin	0.85%	10.35%	11.87%	12.25%	12.32%	9.57%
EBITDA margin	-0.37%	-1.72%	5.78%	-36.47%	14.37%	6.80%
EBIT margin	-1.11%	-0.86%	6.27%	-34.92%	16.25%	8.75%
Profit margin	-1.62%	3.80%	3.57%	-35.98%	16.77%	5.92%
FCF margin	10.83%	1.77%	7.63%	11.40%	15.26%	8.21%

Valuation

My DCF model indicates that AEIS’s intrinsic value stands at $38.33, implying an overvaluation of $8.17 per share. The intrinsic value also represents the upside associated with the short, implying an upside of 19.72% without transaction costs.

DCF Summary
Total PV of Unlevered FCF	331,833,809	Cost of equity	8.00%
Terminal year Unlevered FCF	65,735,535	After-tax cost of debt	6.00%
Perpetual growth rate	2.00%	Equity weight	100.00%
Terminal value	1,117,504,100	Debt weight	0.00%
PV of terminal value	760,554,513	WACC	8.00%
Implied Enterprise value	1,092,388,322
Less: Total Debt	0
plus: cash and cash equiv	407,283,000
Implied Equity Value	1,499,671,322
weighted avg shares	40,176,000
Intrinsic value	38.33
Market Price	46.50
Overvalued(Undervalued)	8.17
Implied upside	17.58%

Intrinsic value’s sensitivity to perpetual growth rate

Sensitivity analysis indicates that AEIS would begin to appear undervalued if perpetual growth rate outlook is beyond 4%, which is 200 bps more than my estimate.

Relative value shows mixed results- P/E and EV/EBITDA suggests undervaluation while P/B suggests the opposite

Ticker	Company Name	Market Cap	PE Ratio	Price/Book	EV/EBITDA
AEIS	Advanced Energy Industries, Inc.	$1.82B	12.69	3.07	8
MKSI	MKS Instruments, Inc.	$4.1B	10.83	2.28	8.23
COHR	Coherent, Inc.	$3.22B	13.34	2.62	7.58
UCTT	Ultra Clean Holdings, Inc.	$428.29M	4.76	0.96	5.34
NVMI	Nova Measuring Instruments Ltd.	$675.53M	14.85	2.55	9.76
BRKS	Brooks Automation, Inc.	$2.14B	17.3	3	17.76
		Average	12.30	2.41	9.45

AEIS faces a number of financial and business risks. On the financial front, the firm is exposed to interest rate risk and foreign currency exchange risk. As of 2017, the firm’s investment portfolio consisted primarily of certificates of deposit with maturity of less than 1 years. The short term maturity is helpful for managing default risk, market risk, and reinvestment risk. The firm’s functional currencies primarily include the USD, EUR, KRW, TWD, GBP, and CNY while purchasing and sales activities are primarily denominated in the USD, JPY, EUR and CNY. Adverse move in currency exchange could impact the firm.

The effect of foreign currency translations on cash had a $2.2m favorable impact for the year ended December 31, 2017 compared to a $1.9m unfavorable impact for the year ended December 31, 2016. Escalation of US-China tradewar is current the prime business risk. Although AEIS has less than 6% of the sales generated from China, there was significant sales growth expectation from China (before tradewar escalation). As a result, the market increasingly factoring the tradwar into AEIS’s pricing.

Conclusion

Expected weaknesses in semiconductor industry along with pressure from trade war is reflecting increasing uncertainty for AEIS. Combining the performance factors, along with valuation, industry structure, and risks, AEIS is a short. Investors can effectively manage their exposure with available call options.

Negative from trade war and cyclicality could drive down AEIS's price towards its intrinsic value, as a result, AEIS is a short.