Executive Summary – Aspen Technology helps some of the most capital-intensive industries optimize asset performance via process modeling, big data machine learning, and analytics, and its very own asset-light operations help it generate impressive levels of free cash flow. Shares aren’t cheap, however (it is trading above our fair value estimate range), and current price levels imply one hefty price-to-earnings ratio. Still, it’s hard not to like Aspen Technology’s high-ROIC business model, with the company garnering one of the highest Economic Castle ratings in our coverage. IPG Photonics is home to an impressive portfolio of high-performance fiber lasers and similar technologies that are used in materials processing, advanced communications, and medical applications–areas and applications that are expected to experience strong growth in coming years. We think IPG Photonics’ degree of vertical integration, IP portfolio, and process expertise offer it a number of competitive advantages. The company boasts a GAAP operating margin in the mid-30s and has generated impressive free cash flow expansion in recent years, but shares aren’t cheap either (it is trading at the high end of our fair value estimate range). Customer concentration and expansion into unproven markets add a layer of risk.
By Kris Rosemann
Aspen Technology (AZPN)
Aspen Technology is a leading supplier of asset optimization solutions optimizing asset design, operations, and maintenance in complex industrial environments all around the globe. The company boasts decades of process modeling and operations experience, which it combines with big data machine-learning and analytics. Aspen has a blue-chip customer base with more than 2,100 customers, and more than 60% of its business is outside North America.
Image shown: Aspen’s shares have had a very strong run since the beginning of 2016.
In fiscal 2016, 95% of its revenue was generated in the Energy (40%), Chemicals (26%), and Engineering & Construction (29%) industries. As these are some of the most cyclical industries in the global economy, Aspen’s business has a tendency to be materially impacted by the health of the overall economy, and it can also be sensitive to energy resource pricing, though its financial performance fared well through the course of the most recent downturn in crude oil prices.
Aspen Technology is firmly aligned with the ever present search for productivity gains in capital-intensive industries. The company is expecting growth in its industries served, deeper research in existing accounts, new accounts in emerging regions, price increases (2%-3% escalators on average term contracts), and product innovations to drive top-line growth potential, along with the ongoing pursuit of acquisitions. Its ‘Software and Subscriptions’ segment accounts for 90%+ of total revenue, and this revenue is primarily derived via subscription-based licensing of its software product suites.
The company also provides training and professional services, which account for the balance of revenue. Management is working to transition its revenue recognition practices, and such changes are expected to result in it carrying a lower level of deferred revenue on its balance sheet. We’ve made adjustments for the high levels of deferred revenue on the books, a decision that positively impacts our calculations of ROIC and its related Economic Caslte rating, which is among the highest in our coverage.
Aspen is expecting strength from its energy end markets in the near term as spending recovers along with energy resource pricing, while its engineering & construction business continues to face a less rosy outlook. Growth in China, new investments in North America, and GDP expansion are expected to drive demand growth for its chemicals-serving business. Aspen’s 5-year target operating model includes a gross margin target of 87%-90% and a GAAP operating margin target of 42%-45%. We like the firm’s capital light operations, which translate into impressive free cash flow generating capacity. Capital spending averaged ~1.1% of total revenue from fiscal 2014-2017, and management expects free cash flow of $180-$185 million in fiscal 2018, up from $179 million in fiscal 2017.
Despite Aspen Technology’s tremendous free cash flow generating capacity and reasonably strong growth prospects, we find shares to be overvalued on a discounted cash flow and unattractive on a relative value basis. We arrive at a fair value range of $37-$61 per share in part by assuming a solid mid-single-digit pace of revenue expansion through the mid-cycle, as well as solid margin expansion that results in a mid-cycle operating margin that is roughly in-line with management’s 5-year target operating model. Seemingly supporting our opinion of the valuation of Aspen, shares are trading at more than 30 times the upper bound of management’s non-GAAP net income per share guidance. The company’s equity is ~$65 per share as of this writing.
IPG Photonics (IPGP)
IPG Photonics is a leader in the production and manufacturing of a broad line of high-performance fiber lasers, fiber amplifiers, and diode lasers. Its lasers and amplifiers are used in materials processing, advanced communications, and medical applications. The company’s customers include OEMs, system integrators, and end users. IPG Photonics is vertically integrated in that it designs and manufactures most of the key components used in its finished products. This allows the firm to reduce manufacturing costs, control quality, rapidly develop and integrate new products, and protect its proprietary technology.
Image shown: IPG Photonics’ shares have accelerated to the upside in recent months.
Throughout its impressive growth in recent years–revenue has more than doubled from 2011 to 2016–IPG’s operating margin has held relatively steady in a range of 33.5%-38%. Cash flow from operations has expanded nicely as well, more than tripling from 2011 to 2016. The company expects to continue growing its business by leveraging its technology, deriving new applications, expanding the markets it serves, expanding its product portfolio, lowering costs via improvements and innovation, and expanding its global reach. Its business benefits from barriers to entry in the form of IP and process expertise, in addition to its scale and low-cost provider advantages, but it does have a degree of customer concentration, as its top 5 customers account for 22%+ of total revenue and its top customer accounts for ~9%. Adding another layer of risk is that this customer is located in China.
IPG Photonics lists the following new applications and products as growth opportunities: beam delivery, ultraviolet fiber lasers, ultrafast lasers, laser systems, medical, additive manufacturing, laser ablation, and cinema & display. As of mid-2017, IPG Photonics pegs its addressable market at ~$6 billion, roughly $2.4 billion of which is expected to come from a portion of the aforementioned new applications. Its core materials processing applications represent a ~$2.6 billion market opportunity, with the balance being made up by micro material processing applications. This addressable market breakdown is especially noteworthy as a large portion of it is made up by a largely unproven market for IPG, and though it may be able to effectively penetrate these markets, its ongoing sales growth is dependent on its ability to continue to expand applications for fiber lasers.
Though IPG Photonics serves a broad range of end markets, it expects long-term revenue growth to be in-line with its end markets served. Other long-term financial targets include a GAAP gross margin of 50%-55% and a GAAP operating margin of 32%-37%, both of which are also targets for 2017. We must note the operating leverage that comes with a high level of its costs being of the fixed variety, a result of its vertically integrated business. Investors should also be aware that Chairman and CEO Dr. Valentin P. Gapontsev, together with the three trusts he created, beneficially own approximately 32% of the IPG’s common stock.
We’re anticipating a strong double-digit pace of expansion for revenue through our mid-cycle assumptions, and our gross and operating margin assumptions are slightly higher than that of its target long-term operating as noted above. Our projections include a continuance of strong momentum in free cash flow growth as well–free cash flow has grown to $165 million in 2016 from less than $50 million in 2013. However, we still find shares to be rather rich on a discounted cash flow basis and unattractive on a relative value basis as we find shares to be fairly valued in a range of $143-$215 per share. Shares are trading at the high end of this fair value range as of this writing, representing a multiple of more than 30 times 2017 consensus earnings estimates.