Elbit Vision Systems Ltd. (fka EVSNF)

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Niche Machine Vision Player Near Major Inflection Point In Growth


Brandon Ferro
http://seekingalpha.com/article/4045213-niche-machine-vision-player-near-major-inflection-point-growth?auth_param=3ofmh:1ca5vr8:cb067024612e10be36469bf049414230&uprof=45

Summary

Elbit Vision Systems Ltd. is an Israel-domiciled, $30 million micro-cap provider of machine vision systems that automate defect detection and quality assurance (QA) during the textile manufacturing process.

Despite overwhelming use of industrial automation in other industries, defect detection and QA in the textile industry are still almost entirely done using manual labor on a global basis.

Recent developments increase the likelihood of broad-based, secular adoption of automation in textiles, and along with it, accelerated and growing demand for Elbit Vision Systems' two core products.

Elbit Vision is the clear global leader within its niche vertical of textile machine vision, and, despite its tiny size, is a self-funding, cash-generating, ~20%+ EBIT margin enterprise.

Catalysts include new business wins, a reverse split, potential up-listing, exhaustion of share supply overhanging the stock and a technical break-out on the chart.

Background

Elbit Vision Systems Ltd. (OTCQB:EVSNF) is an Israel-domiciled, $30 million micro-cap provider of machine vision systems that automate defect detection and quality assurance (QA) during the textile manufacturing process. EVSNF commenced operations in 1994 as a subsidiary of Elbit Systems (NASDAQ:ESLT), the multi-national, Israel-domiciled defense conglomerate. It was subsequently spun out as a Nasdaq-listed IPO in 1996 and traded there until shares were de-listed in 2003.

During its genesis in the 1990s, EVSNF set about designing and manufacturing automated inspection systems for the textile industry, initially targeting US-based manufacturers. Problematically, the Asian-based outsourcing wave quickly emerged and crushed domestic-industry profits and cap-ex budgets. Nor was there a need for Asian-based suppliers to adopt automated machine vision at the time as ROIs weren't all that attractive in the context of cheap emerging market labor versus the developed world and how nascent and prohibitively expensive EVSNF's technology still was.

The above secular theme, coupled with the recession that coincided with the new millennium, hurt EVSNF. To offset end-market weakness and the slow adoption of its products, it made three tertiary acquisitions financed with debt - two in 2004 and another in 2006 - of companies with similar technology but geared toward non-textile verticals. This M&A yielded little fruit and left the company levered and on the brink as we headed into and exited the 2008/2009 GFC.

To survive and de-lever, EVSNF i) received a private placement from and restructured its debt with its then controlling shareholder in 2009; ii) named Same Cohen CEO in 2010 (Cohen launched the company's US operations in the early '90s, left and came back in 2003); iii) sold one of its 2004 acquisitions in 2010; iv) restructured its bank debt in 2010, which included outright forgiveness; and v) received private placements in the form of stock sales and warrant grants in 2012 and 2014. As part of i), the company's then controlling shareholder relinquished its equity interest to Cohen and the company's CFO, Yaron Menashe, who has also been at EVSNF since 2003. Both Cohen and Menashe now own ~18% of outstanding shares each, and cumulatively, directors and officers own >50% of the company.

Products

EVSNF's products include a combination of hardware and software. The hardware is used for image acquisition and processing and includes the company's own internally developed cameras combined with LEDs for illumination and dedicated CPUs. Defects detected by the hardware are subsequently processed by proprietary vision understanding and interpretation algorithmic software. The algorithms allow the company to recognize and sequester fabric flaws in real time and to learn the types and severity of flaws a customer wishes to detect, ignoring ones that don't fit certain specifications, as can be seen below.

EVSNF algos detect defectsi in real-time and in color

Source: EVSNF investor presentation

EVSNF essentially offers two core products, IQ-TEX and iBar, with textile customers spread across the automotive, apparel, composites, home, medical and technical materials industries as follows:

IQ-TEX - Visual inspection and QA at the finishing line stage of the manufacturing process for woven and non-woven textiles including knitted, tire cord, film, metal, coated and technical fabrics. This is the last stage of the manufacturing process before fabric is shipped to customers. Defects detected here can then be "optimized" by a bolt-on suite of EVSNF software that allows the manufacturer to cut around defects, thus yielding smaller rolls with better yield and higher selling prices as well as reduced low-quality product that might be returned. Here's a video showing IQ-TEX in action.


Source: EVSNF investor presentation

iBar - EVSNF's newest product, introduced in 2H14. Visual inspection and QA on loom that is integrated with individual weaving looms and monitors selected fabric types, usually of higher value, while weaving. This is the holy grail of textile defect detection, as it allows the manufacturer to catch defects and quality issues in process and on loom before they ever make it to the finishing line, maximizing both yield and profit. Here's a link to a video showing iBar in action.


Source: EVSNF investor presentation

Competition

As part of the due diligence process, I've spent the better part of the past six months discussing EVSNF's competitive position within the global machine vision industry with customers that use its products, competitors, like-minded investors and EVSNF itself. Though somewhat hard to believe given the company's tiny relative size, that work indicated it is the clear global leader within the specific niche vertical of textiles, with what appears to be ~80-90% global market share.

Competitors that have been mentioned include Isra Vision AG (OTC:IRAVF, ISR.GY), Shelton Vision, BMS and Ametek's (NYSE:AME) Surface Vision unit which it purchased from Cognex (NASDAQ:CGNX) in 2015 for $160 million (versus $60 million in annual sales, or 2.7x). Cognex's sale appears more about its existing opportunity set than a lack of one within the division it sold to Ametek.

Discussions have consistently revealed favorable differentiation in EVSNF's model. For instance, other systems might lack full-color inspection, are harder to install, are more expensive, make promises the technology has failed to deliver upon or don't possess proper engineering and support infrastructure. In numerous cases, textile manufacturers have ripped out pre-existing competitive solutions and replaced them with EVSNF products instead.

The company's competitive edge appears three-fold. For one, while others tried to penetrate the space in the 1990s, amid painstakingly slow adoption they all ended up waving the white flag and moved on to other industry verticals even as EVSNF, for better or worse (worse until now!), stuck with it. Thus, the company has been singularly focused on automating textile inspection for two decades now, and has tremendous expertise in the vertical. Secondly, the passage of time and its status as a micro-cap make it easy to overlook the fact that EVSNF and its algorithmic inspection software were developed and birthed out a massive defense conglomerate in ESLT, its former parent; as understood, EVSNF's algorithms share lineage with ones used by ESLT in fighter jet, target acquisition applications. Third, by developing its own proprietary camera systems as opposed to outsourcing them at 4x the cost, it has a tremendous cost advantage, sourcing only its camera's lenses externally.

In conclusion, though competition exists, EVSNF is the clear leader and appears better positioned than others to exploit any future machine vision penetration within textile manufacturing that might occur. In addition, this positioning should help insulate and protect the company's exceptional 50%+ gross and 20%+ EBIT margins from competitive-based erosion over time.

The Secular Growth Opportunity

In excess of 90%+ of global textile defect detection and QA is still done manually, but that's been for the case for the past two decades EVSNF has spent proselytizing the industry on the need for automation. So what changes the existing paradigm to accelerate adoption? Numerous emergent and convergent secular trends should.

For one, wage rates in Asia have gone up noticeably over the years versus the early/mid-1990s as the developed versus emerging labor arbitrage has been exhausted. Directionally, labor now adds cost to textile manufacturing rather than removing it. EVSNF believes the IQ-TEX can effectively replace 10 manual inspectors. Beyond labor savings, the technology has advanced enough to do a demonstrably better job of inspection than humans. On a Monday morning, EVSNF's IQ-TEX finishing line system can detect in excess of 85% of all defects versus 65% for humans in optimal conditions. In addition, manual inspection is simply a terrible and monotonous job. Separately, iBar's on-loom inspection introduces QA where none existed. Third and most importantly, like all technology over time, cost has declined enough, and should continue to decline, to make ROIs on such cap-ex outlays ever more appealing for profitability-constrained textile manufacturers.



Source: EVSNF investor presentation

For instance, EVSNF now sells IQ-TEX systems for ~$120-240K, representing ~25% of the cost of a typical $500K-1,000K finishing line. ASPs should settle in at ~$100K per system over time. By contrast, the newer iBar sells for ~$20K-30K per weaving loom, representing a much larger proportional spend relative to the cost of 80% of the globe's installed weaving looms making low-end fabrics, which run as little as $50K. EVSNF believes it can get the cost of iBar down to ~$8K per system, or ~15% of the average cost of a low-end loom in the near/intermediate term. At this level, the product's ROIs should become attractive across 100% of globally installed looms, not just the 20% making high-value, complicated fabrics that EVSNF has targeted to-date.

In terms of a total addressable market (TAM), the numbers are staggering relative to EVSNF's TTM revenue of ~$10 million, especially for the iBar. The company estimates the following:

IQTEX - 10K global finishing lines * $100K long-term ASP = $1 billion
iBar - 800K global weaving lines * $8K long-term ASP = $6.4 billion


Source: EVSNF investor presentation

Before you laugh about the size of the TAMs above, I get it: we should all be insanely incredulous when we see any company pitching multi-billion-dollar TAMs that are currently 1% penetrated as the ones above are. Having said that, consider the following:

EVSNF's TAM estimates could be off by magnitudes of order, and the resulting growth would still fundamentally alter the size of the company.
Textile customers of EVSNF who use the products have suggested their own customers (apparel companies) believe automated defect detection could become a standard across the industry over time, and that manufacturers could be forced into adoption simply to survive. Indeed, the company announced in September that it had received a US patent that covers the process for objectively identifying and measuring textile defects, and that it hopes to use this as a benchmark for a global industry standard of quality.
Raw material costs are a textile manufacturer's single biggest input cost; a tiny incremental reduction in the % of material lost to defects yields material improvements in profitability for a profit-challenged industry.
Land & Expand: Inflection Point in Growth Approaching

EVSNF currently generates ~$10 million in annualized revenue. Recent growth has been strong, driven by legacy IQ-TEX installations and ~150-200 cumulative iBar installations since 2H14, but part of this is attributable to the tiny base of business the company had coming out of the GFC.

Moving forward, though IQ-TEX should continue to provide a strong foundation for growth, the sheer volume of global weaving looms versus finishing lines (800K versus 10K) makes iBar the obvious growth opportunity and rationale for owning the stock. Here, it appears that we may be reaching an inflection point whereby small iBar installations that have been "landed" as proof-of-concept trials at various textile manufacturers over the past two years are on the verge of morphing into much larger "expansion" and follow-up orders.

To generalize, when the product was introduced in 2H14, a typical iBar customer might have made an initial purchase of 10-20 units and installed them on only a small percentage of a single product line's weaving looms, despite there usually being multiple product lines running in the same facility. These orders were proof-of-concept trials whereby the manufacturer spent the better part of the past 12-18 months assessing iBar's efficacy and ROI. Results have been favorable. As such, initial buyers are likely beginning to make larger follow-on iBar orders. Follow-ons will be to dial up iBar penetration on the product lines that were trialing, but will also be used on new product lines. In addition, whereas initial installations required a good deal of time and EVSNF engineering support at the customer's facility, follow-ons will be much more expedient, and unless they choose to have EVSNF do it, the customers can actually install the equipment themselves.

Beyond the latter follow-on order dynamic for iBar, note that there are ~20-30 textile manufacturer customers that have purchased at least a single unit for trial so far, and that the average customer has ~200 looms. Thus, existing customers represent the potential for ~4K-6K iBar sales in the near or intermediate term, or a $32-48 million revenue opportunity.

For those skeptical of the company's TAM estimates, EVSNF has sold IQ-TEXs for ~800 finishing lines in its history, penetrating only 8% of this TAM. While increased IQ-TEX adoption alone provides an avenue for strong future growth, on average, ~100 weaving looms feed into each of these individual finishing lines. Thus, existing IQ-TEX installations provide a pool of ~80K iBar units (800 finishing lines * 100 weaving looms) at full penetration, which, at an ASP of ~$8K per iBar, equates to a $640 million revenue opportunity over the intermediate to long term.

Valuation

The fact that it's a pure-play on machine vision in the textile vertical, Israel-domiciled and a micro-cap means the company doesn't necessarily have an easy or direct set of comparables. However, because it is a machine vision play, if we're willing to overlook the vast differences in size, we can compare it to the likes of Cognex Corp., Isra Vision Ag, SinterCast AB (OTC:SRVQF, SINT.SS), IAR Systems Group (IARB.SS) and even Rockwell Automation (NYSE:ROK), all of which directly or peripherally have exposure to this theme, more or less. As a check, we would expect EVSNF's TTM gross, EBIT and ROE margins of 55%, 21% and 42%, respectively, to be similar to those of our comparables - and they are.

EVSNF trades at 3.0x and 14.0x TTM EV/sales and EV/EBIT versus 7.0x and 26.0x for the comp group and 3.5x-4.0x and 20x for the group's cheapest members. Despite the optical discount, shares likely aren't as cheap as they might appear given the company's riskier characteristics. EVSNF's current multiple of sales is also consistent with the 2.7x multiple Ametek paid for CGNX's Surface Vision unit in 2015.



In concluding, EVSNF appears reasonably valued based on its current run rate of business. However, it isn't a valuation play; with this exercise, we're just looking for a general framework to help us understand whether we're paying at least a semi-reasonable multiple for what is instead a transformational, micro-cap growth story.

Catalysts

Reverse stock split: Effective March 24, 2017, shareholders will receive 1 share in exchange for every 10 they currently own. Beyond removing the "penny stock" stigma, management has discussed its desire to up-list shares to a major exchange in the future, and the reverse split likely presages such a move.
New business: As noted, demand for iBar could be reaching a major inflection point whereby adoption could begin to accelerate rapidly, which would necessarily coincide with more frequent announcements of large, new business wins. In fact, due diligence suggests EVSNF could be close to displacing a large, publicly traded machine vision company's inspection technology (a multi-national consumer products company) on a specific product line that has caused a few high-profile consumer quality-related complaints.
Acquisition: EVSNF's financial characteristics are appealing - it's debt-free, cash generative and highly profitable. It's also a clear leader in its vertical. Should the company gain scale, it would likely make an easy and logical acquisition candidate for a larger competitor.
Turnover in float: Since mid-/late 2015 ~40 million shares, representing the entirety of the company's float, have changed hands as the stock has consolidated around a 10-year high of ~$0.30-0.35. With insiders accounting for the entirety of the other outstanding shares, this implies that most of any available supply that has prevented further upside has likely been soaked up.
Technical break-out: Over the past week, EVSNF has cleared ~20-year resistance dating back to 1998; said resistance has marked all of the stock's most dramatic cyclical highs and starting points for declines over this period. Concurrently, it has broken out of a bullish, ascending triangle that has formed over the past ~18 months.


Source: Bloomberg, author's annotations

Risks

EVSNF's textile end markets are tremendously cyclical, capital-intensive and have historically been profitability-challenged. Even marginal global macro weakness will all but eviscerate purchasing power and demand for the company's products.
Outside of cyclicality, EVSNF's model is a discreet capital equipment one which is inherently lumpy, lacks visibility and has no recurring revenue component.
Despite the tremendous opportunity for growth in demand for its products, adoption of these products may continue to prove challenging and more time consuming than my thesis accounts for.
EVSNF has suggested on some of its earnings calls that one of its recent growth bottlenecks has been on the engineering side of the house, and that it has deliberately been measured and methodical in installing iBars, understanding it has one opportunity to get it right. Given its limited resources, any more rapid a rate of iBar adoption could necessitate hiring additional engineers, which would involve execution risk. The company recently expanded the size of its headquarters in Caesarea, Israel, and believes it has plenty of manufacturing capacity to support future growth.
EVSNF is micro-cap, OTC-listed and Israel-domiciled, with different accounting and corporate governance standards relative to companies domiciled and listed on major exchanges in the US.
Disclosure: I am/we are long EVSNF.