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Intevac: Cheap Hard Disk Stock

Intevac is a small player in the hard disk industry that seems to have been overlooked even as its stock has performed well.
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NEW YORK (TheStreet) -- The amount of data we are flooded with each year seems to grow at a jaw dropping pace. Both the disks we use to store dramatically more information each year and the number of electronic devices that require storage are growing as well. This fundamental demand is behind the huge gains in stocks of the players in the disk drive industry.

Industry leaders


(STX) - Get Seagate Technology Holdings PLC Report


Western Digital

(WDC) - Get Western Digital Corporation Report




have all seen their shares rise dramatically since the March lows of last year when orders dried up during the financial crisis. All three stocks are relatively cheap and are well positioned for the future. All three are well covered by Wall Street and publicized by the press. In the middle of fierce industry competition and staggering technology advancements, one industry small stock story seems to have been missed even though its stock has also performed well.

Industry player and suspension assembly provider

Hutchinson Technology


reported Tuesday a loss of 67 cents versus estimates of a loss of 11 cents and the stock was off 22% in the after hours. While HTCH's difficulties seem to be contained within the suspension assembly market, sympathy selling is providing a good buying opportunity for other stocks in the industry in the short term. We are not recommending HTCH at this time but suggest instead investors move up the value proposition food chain.


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(IVAC) - Get Intevac, Inc. Report

is the leading supplier of magnetic media processing (also called sputtering) equipment to the hard disk industry with a 60% share.



(CAJ) - Get Canon Inc. Report

Annelva subsidiary is the other sputtering equipment provider and also a cheap stock well positioned for the future. Intevac also has a small but rapidly growing photonics business that sells night vision products to the U.S. military and one NATO customer.

Intevac's $4.5 million - $5 million sputtering tools are used by hard disk manufacturers like Seagate and Western Digital to produce hard disk drives. The company's stated charter is to use "lean thinking" to continually develop new technology processes into tools that help manufacturers be more efficient. Intevac has announced orders for 28 tools to be shipped in 2010 and its backlog has swelled as customers aggressively bring on needed capacity to keep up with the demand for storage.

Both Seagate and Western Digital have recently and in past quarters reported results better than the Street's expectations and are running hot with capacity utilization at approximately 99%. In addition, during recent analyst conference calls it's become clear the hard disk industry may have difficulty keeping up with forecasts for demand this year.

At the same time the flash drive industry has come on strong. Industry leader Sandisk has been on fire. Sandisk's stock has more than doubled in the last several months as the company announced dramatic cost reductions in the price of its flash drives that have allowed it to pick up share from the hard disk industry. Despite its run up it still boasts a relatively low valuation at about 13x forward estimates. At this point the flash industry needs to further reduce the relative cost of its storage to continue to take share.

The cost advantage the hard disk industry enjoys over flash becomes clear with the advent of


(AAPL) - Get Apple Inc. Report

's Ipad which uses a flash drive (Apple itself is obviously a huge user of hard disk drives as well). Steve Jobs reportedly loves flash drives as they use relatively less battery power than hard drives that spin. Recently I erased my computer's cache, cleaned up my desktop and got rid of old files and programs I don't use very often. After this cleaning exercise I find that my computer is storing 58GB (gigabytes) of information out of a total of 296GB of space available on my $900 laptop's hard disk drive, or about 20% of the available space (my guess is others use more).

Two or three years from now my guess is the 58GB I'm using now will triple. The base Ipad which starts at $499 has 16GB of storage courtesy of its flash drive. Each additional 16GB runs another $100 so that to match my laptop's storage capacity of 296GB, it would cost thousands with the Ipad's flash memory. Don't get me wrong, as a long term Apple shareholder since $50 a share, I'm a big fan of Apple's product innovation. My point is simply that the Ipad clearly illustrates the need for the flash industry to both lower the cost of its drives and use advanced technology to increase the amount of data that can be stored on them so that it can increase volume and market share.

Contrary to what investors might think Sandisk's success doesn't come at Intevac's expense, quite the opposite. Competition for the hard disk industry is causing the industry to move even quicker down its technology roadmap, commonly referred to as the "areal density roadmap" (or the path to store more and more data on hard disks) to keep its relative cost advantage. Before the financial crisis the hard disk industry had made a major move down the roadmap upgrading to what's called Perpendicular media, the process driving today's hard disks. Using Perpendicular media, manufacturers are already producing hard disk drives capable of storing 600GB - 700GB.

Much to Steve Job's dismay, the hard disk drive industry seems well positioned to keep its cost advantage for years to come. Perpendicular media should support hard disk data storage up to about 1000GB. Beyond that the industry will need its next major planned technology upgrade to what's called Patterned media. R&D on Patterned media is already under way. Intevac has shipped two Patterned media R&D tools to customers. Based on the current pace of technology advancement, the upgrade to Patterned media is expected as soon as 2013 or about 2.5 years. Technology advancement is happening fast and Sandisk's success could quicken that pace.

As the hard disk drive industry moves down the areal density roadmap leading to a Patterned media upgrade there are two key points that will benefit Intevac. First, as current Perpendicular media processes advance beyond current technology it will require upgrades to Intevac's current installed base. During the downturn Intevac's spares and upgrades business tapered off to about $30 million - $35 million, a cyclical low which analysts have extrapolated out into the future. Upgrades to the current Perpendicular media installed base will drive Intevac's spares and upgrades business well beyond these levels over the next two to three years. The spares and upgrades business carries a higher gross margin. Current Wall Street estimates imply a gross margin of 41% for 2010 even though at current revenue levels Intevac has generated 45% gross margins in the past with a higher percentage of spares and upgrades revenue than current street estimates imply.

Second, once Patterned media arrives it will double Intevac's sales of new tools as the Patterned media process will require an additional etch tool that Intevac will provide. At the current sales rate that would imply 25 - 28 additional tools equating to $110 million - $120 million in additional revenue and $40 million to $45 million in additional gross margin contribution, which would more than double Intevac's currently estimated EPS in as little as three years (Currently there are 22.6 million shares outstanding and an average EPS estimate of 98 cents for 2010). Even Wall Street should begin to forecast a Patterned media upgrade a year in advance, suggesting investors who can wait a year or two should start to see the benefit of a Patterned media upgrade boosting the stock.

Intevac is a stock that's performed well at the beginning of past industry cycles and this cycle is no different. At its low it traded at $3.43 a share or about half of its tangible book value (most of which was cash and no debt) as investors gave the stock away in March of last year.

Goldman Sachs

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and Thomas Weisel dropped coverage of the company during the downturn and the company is under-covered even though all three analysts who follow the stock have a buy or outperform rating on it. As the industry screamed back and as orders came in the stock reached $16.85 earlier this year (during the past up cycle when its backlog hit similar levels shares traded north of $30 with almost no contribution from photonics). But despite the run up of the past year, the stock is still cheap. As Intevac's largest shareholder with 12.8% of the stock as of the most recent filing,

T Rowe Price

would probably agree. Here's why.

Like all good companies Intevac has historically under-promised and over-delivered; it's who they are. For years now it's been sandbagging numbers. (Admittedly IVAC had to lower expectations as orders hit historic lows during the second half of 2008 and the first half of 2009). But even after lowering expectations Intevac's reported results always beat estimates. On average over the past four quarters the company beat estimates by 7 cents per share with the smallest beat being by 5 cents. At $14.62 a share the company trades at about 15x 2010 Street estimates. But giving the company credit for the 28 cents of beats it provided over the past four quarters would suggest that a fairer earnings estimate for the company would be at least $1.26 for 2010, suggesting investors are really paying about 11x likely 2010 earnings (or less).

The company reports Monday, May 3 and my guess is, as it has in the past, Intevac will beat by no less than 5 cents and up to 9 cents. And true to form, they'll also likely guide low as they do each quarter.

Despite the street's sandbagged 2010 numbers, it's the future analysts are underestimating. With the exception of cyclical downturns like 2008 and 2009, Intevac has been a rapidly growing company and there's no reason for that to stop. (The company's small photonics business grew even during the downturn.) This year it's expected to add $10 million to revenues over 2009's $26 million. But according to


, analysts expectations are that IVAC will increase revenues only $1 million in 2011 to $200 million (and increase EPS only 2 cents to $1.00). This implies that either the rapidly growing photonics business stops growing (which it has no reason to do based on current momentum) or the hard disk business declines next year (what analyst estimates are forecasting).

So why are the Street's numbers off? Don't get me wrong, I'm not trying to pick on the analysts, but rather teasing the company for its incredibly conservative guidance (guidance at the beginning of the year was even lower than current Street estimates). For 2010 the company still has until the end of August to receive orders it can ship in 2010. Any friction in the 99% capacity utilization manufacturers are running at could generate orders. This year's spares and upgrades estimate is also probably too low, causing the Street's 41% gross margin estimate to be low historically. But the 2011 number predicting a decline in Intevac's hard disk business is almost silly. Hard disk manufacturers are barely able to keep up with demand as is and are running at near 100% capacity utilization. During the financial crisis they operated this way out of a need to conserve cash but logic suggests they'll want to build at least a little cushion to their capacity next year given a relatively unlikely double dip scenario and the industry's relatively rosy growth outlook. Current analyst estimates for 2011 are predicting virtually no benefit for future upgrades to the current Perpendicular installed base as the industry moves down the areal density roadmap over the next two to three years.

But Intevac has opportunity and "optionality" in two key areas the Street is giving very little credit for: Solar and Semi-equipment. Intevac is attempting to leverage its experience delivering high volume cost reducing processes honed in the hard disk industry in both the solar and semiconductor equipment markets. Intevac recently announced a relationship with a newly created and funded private company


that is using Intevac's thin film process technology to create solar cells. Rather than attempt to build its own thin film equipment like other players who have largely failed, AQT is outsourcing the expertise to a proven equipment manufacturer. If successful AQT could add $25 million - $30 million to Intevac's 2011 earnings and significantly more in future years as the equipment market for solar is significantly larger than the hard disk equipment market. Intevac's relationship with AQT is not exclusive and it's still possible that Intevac could add at least one more solar customer for possible meaningful sales in 2011. If successful, solar equipment could more than double Intevac's revenues over the next five years.

But the real upside to Intevac's story would come from the semiconductor equipment market. Several years ago Intevac began the lengthy and expensive process of developing a potentially groundbreaking etch tool for the semiconductor equipment market. Intevac's management comes mostly from the semiconductor equipment industry. The company's product changes the process by which semiconductors can be made, increasing efficiency. Since announcing the product and over the past three years there has been very little chance of breaking much ground as semiconductor equipment manufacturers cut capacity. The last several years were about the hardest time period imaginable to attempt to bring a new product to market as getting a manufacturer to change their tool of record and bring on a new supplier is a lengthy process and manufacturers were ordering tools hand-to-mouth with a focus on quick turn-around. Over the past several months the industry is showing signs of life and Intevac has re-hired an old hand, Luke Marusiak to bring a renewed marketing focus to the product, likely its first real chance.

Intevac's semiconductor mouse trap boasts a 30% cost advantage over current etch tools and the process improvement can be extended to other areas outside of etch. Ironically this cost advantage should appeal most to segments of the semiconductor industry like the flash chip manufacturers and the flash industry which needs to bring down the relative cost of its storage to increase its volume and gain share. Samsung is the leading manufacturer of flash chips and the most likely candidate to utilize Intevac's new process. Internal changes at Samsung and the market environment seem to have precluded that over the past year but the newly upbeat semi-equipment environment might change that. Intevac has teamed up with


, a Korean company to sell the tool as Korea has mandated that Korean manufacturers buy from Korean companies. If Intevac was able to capture even a small share of the semiconductor equipment market it would be several times the size of Intevac's current revenues. The opportunity is huge both for Intevac and the semiconductor industry.

While larger semi-equipment players like

Applied Materials

could bundle their products together to price compete, it's logical to believe in a semiconductor equipment up cycle that somebody in the semiconductor manufacturing industry would want to give Intevac's product a try in an attempt to reduce costs. At the very least the flash industry needs it. As the flash industry chip leader, my bet is on


. My guess is Apple's Steve Jobs would want them to give it a try.

Clearly Intevac's semi and solar opportunities are upside optionality and hard to value. But what's an appropriate multiple to pay for a company whose EPS should more than double over the next two to four years from the next major upgrade cycle to Patterned media. 15x a clearly sandbagged 98 cent number seems low and 11x a fairer $1.26 estimate seems absurdly low. Multiples of 20x and 16x respectively seem like more reasonable valuations, although still cheap on a PEG basis for a technology innovator. Even without success in solar and semi, but with continued growth in its photonics business and the upgrade to Patterned media, earnings of $3 per share don't seem farfetched three to four years out. Slapping a lowly 15x multiple on $3 per share of earnings suggests upside without solar or semi of $45 per share three to four years out. Despite its valuation the company has a 4.5% short interest which means there's almost 1 million shares that need to be bought back as the stock rises. Intevac is a classic growth opportunity trading at value prices.

At the time of publication, Clay Fisher owned Apple and Intevac.