Zeev's Turnips Patch-No Politics (ZEEV)

[Train Guy]

Crystal power
18 Nov 2004
Marc Gerstein
Director of investment research Reuters.com

II-VI's proficiency in crystal-growing is for profit (mainly laser components), not meditation.

Given that this week's bottom-up investing theme is the Reuters Select High P/E Ratios screen (which was featured on 11/13/04), it should come as no surprise to see companies with very bright growth prospects appearing in current Company Focus features. So you'd think big market opportunities would be a crucial consideration. Actually, though, sometimes market size isn't all it's cracked up to be. Take, as an example, specialty material manufacturer II-VI (IIVI.O), pronounced "two-six", which appeared recently in the High P/E screen. The good news is that its potential market is not exactly small. The better news is that the potential market isn't so huge as to make it worthwhile for rivals to come in and try to replicate the company's unusual production competencies.

Specialized manufacturing

Essentially, IIVI grows crystals.

In this new-age era, that sounds uplifting enough to make me want to hunt for an old Kitaro CD. And the company's crystals do, in photographs, look quite nice. Actually, though, they are hard-core commercial. And while growing crystals sounds so nice and folksy, the fact remains that growing the right kinds of crystals for such uses in commercial-sized quantities and to appropriate quality specifications is not easy.

The sexy applications are defense and security, wherein the crystals are used as components in laser systems, radiation detectors, and so forth. They can be used for night vision, missile detection, X-ray and gamma ray detection (used in airport security screening, targeting, missile guidance, etc.).

The topical appeal of such businesses nowadays is self evident. But it's not the main driver of the company's fundamentals, producing a bit less than 20 percent of annual revenue.

The bread-and-butter consists of industrial manufacturing uses, which accounts for more than 60 percent of sales. This doesn't sound as interesting, unless you happen to be involved in manufacturing and, as part of your job, are accountable for cost efficiencies, speed of production defect rates and things like that. In that case, IIVI's competencies would seem very enticing.

Simply put, day-to-day basic activities such as cutting, stamping or marking can be done faster, cheaper and with much greater precision when using lasers as opposed to blades, presses or inks. IIVI's specialty crystals are critical components of such laser equipment.

This area definitely has a cyclical component. Hence the company experienced a profit downturn. But this is not all there is. Laser use in these bread-and-butter production processes is on an upswing. When we talk about business capital investment in productivity improvement, this is one of the things we're talking about. So there is a secular growth component here as well.

Right-sized growth prospects

Getting back to our original point, then, we see that this is a generally good market, enough so to generate nice growth fundamentals and prospects for IIVI. Sales and EPS growth rates over the past five years (a period that included a downturn) averages 19.5 percent and 22.8 percent respectively.

Looking ahead, there are two analyst projections of long-term EPS growth, one at 18 percent and one at 20 percent, averaging to a consensus of 19 percent.

My data-driven estimate is lower at 16 percent. But that's because I factored in return on investment figures that are lower. Eventually, we should assume returns and growth rates will converge. I assumed, conservatively, that both would move toward a midpoint. Realistically, though, if we get sustained economic progress and assuming continuing new defense, security, industrial and medical tech uses (the latter being the other major market for laser products) I don't have much trouble envisioning convergence occurring closer to the higher end of the range. But in the interest of conservatism, I simply plugged my 16 percent figure into the mix and wound up with an overall annual EPS growth capacity estimate of 17.5 percent.

In most businesses, growth prospects of that magnitude, while not necessarily eyebrow-raising, would be deemed good enough to warrant attention for prospective rivals and, in all likelihood, efforts on their part to get a piece of the action. Another positive factor: returns on capital, while not spectacular in an absolute sense, are decent on that basis, and they above industry averages. That, too, according to basic economic theory, should suggest increased competition in the future.

But as noted, this isn't most businesses. We're not talking about standard activities, as we might if we were considering chip manufacturing, or something like that. The process of growing the type of crystals IIVI makes is very specialized and it would require a steep learning curve for newcomers. While the fundamental numbers are fine for IIVI, they're not so spectacular as to make it likely there will be an onslaught of new competition.

So from the vantage point of IIVI, when adjusted for qualitative business risk, the returns it generates actually look quite good.

The stock

IIVI is not necessarily a bargain. It did, after all, come to light through our High P/E screen. But it looks tome like the expectations embedded in the valuation metrics may well be reasonable.

I estimate that IIVI's stock price is acceptable if we can accept an assumption that annual EPS growth in the coming five years will average out to 14.8 percent or greater.

On the surface, that seems OK since it compares favorably with my overall 17.5 percent growth capacity estimate.

In addition, there are two safety cushions incorporated into my calculations.

One involves beta. This is a measure of share price volatility relative to the S&P 500, with higher numbers indicating more volatility and hence higher risk. That tends to exert upward pressure on the returns an investor should require thereby driving up the required future stock price and the EPS growth requirement.

My calculations are based on use of the historic beta attached to this stock which is 1.47, well above the 0.90 industry average. Persistence of beta over time is one of the weaknesses of the academic valuation models. Hence my willingness to often use judgment to override the actual number. Looking at a long-term stock price chart, we see some exceptional volatility back in the 1999-2001 period and a bit this year. But both instances seem, in my opinion, out of proportion to what seems likely going forward given the nature of the company's business prospects. So we could make a case for lowering the beta assumption. If I cut it to 1.25, the required growth hurdle drops to 13.8 percent. A beta of 1.00 would produce a required growth rate of 12.6 percent.

Separately, my assumption of what the stock's relative (to S&P 500) P/E will be five years hence might have been a bit conservative. For the trailing 12 months, the high of the past five years and the low of the past five years, the relative ratios were 1.284, 1.072, and 0.982 respectively. I used those numbers, and also the relative PEG, which is 0.540 (I think the PEG is deflated by the market's not having fully taken into account the company's growth prospects). If I drop the low PEG from the model, I would wind up raising my relative P/E assumption from 0.946 (the number I used) to 1.113. If I use a 1.11 relative P/E assumption and stick an assumed beta of 1.47, the required EPS growth hurdle would wind up at 11.7 percent; with assumed betas of 1.25 and 1.00, the required EPS growth hurdles would be 10.7 percent and 9.6 percent respectively.

So as High P/E stocks go, the expectations underlying this one do not seem all that aggressive.

http://dai.investor.reuters.com/Article.aspx?docid=6647&target=companyoftheday&nd=111804_DAI...