Electro Scientific Industries Inc (NASDAQ:ESIO) is one of the more complex undervalued asset plays we’ve dug up, but a worthwhile one to watch nonetheless. ESIO has announced a merger with Zygo Corporation (NASDAQ:ZIGO) and an authorization to buy back $100M in stock (see the October 16 announcement here). Activist investor David Nierenberg of Nierenberg Investment Management owns 15% of ESIO, supports the merger and is pushing the company to buy back stock. Management expects the the merger to be completed in the first calendar quarter of 2009.
About ESIO
ESIO and its subsidiaries provide high-technology manufacturing systems to the global electronics market, including advanced laser-based systems that are used to microengineer semiconductor device features in high-volume production environments. Website is here.
About ZIGO
ZIGO designs, develops, and manufactures ultra-high precision measurement solutions to improve its customers’ manufacturing yields, and top-tier optical sub-systems and components for original equipment manufacturers (OEM) and end-user applications. Website is here.
The value proposition
1. ESIO
As it stands now, ESIO is an undervalued asset sitation, with a market capitalization of $177M at yesterday’s close of $6.56. We estimate ESIO’s stand alone liquidating value at around $277M or $10.12 per share, which is 54% higher than its close, as the following summary analysis demonstrates (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):
2. ZIGO
ZIGO, ESIO’s partner in the merger, has a market capitalization of $110M at it’s $6.54 close yesterday. We estimate ZIGO’s stand alone liquidating value at $118M or $7.00 per share. At $6.54 ZIGO is trading only slightly lower (about 7%) than its $7.00 per share liquidating value, and so is close to value, as the following summary analysis demonstrates (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):
The catalysts
1. Details of the merger
ESIO is offering 1.0233 shares of ESIO for each share of ZIGO. In the merger, ESIO will issue to ZIGO stockholders 18.1m shares of ESIO. This will increase the issued stock of ESIO from 27M pre merger to 45.1M post merger and give ZIGO stockholders 40% of ESIO. On October 15, the day before the announcement, ESIO closed at $10.07, valuing the merger $10.30 for each share of ZIGO, which had closed at $7.57.
The merger will reduce the liquidating value of each share of ESIO because ZIGO at $6.54 is trading much closer to its liquidating value than ESIO at $6.56. The following summary analysis shows ESIO after the merger with ZIGO is complete (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):
After the merger we estimate that ESIO stock will have a liquidating value of $391M. This equates to $8.66 per share when the expanded number of ESIO stock on issue are taken into account, down from $10.12 per share pre-merger with ZIGO. A liquidating value of $8.66 per share is around 32% higher than ESIO’s close yesterday but it’s nothing to get excited about. Fortunately, the buy back goes some of the way to restoring ESIO’s liquidating value to pre-merger levels.
2. Effect of the buy back
In the announcement of the merger with ZIGO, ESIO also announced an authorization to buy back $100M of stock. If that $100M buy back was completed at $6.56, the closing price of ESIO yesterday, ESIO would buy back around 15.2M shares, leaving around 29.9M on issue. The following summary analysis assumes that ESIO buys back $100M of stock at $6.56 and shows ESIO after the buy back is complete (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):
The buy back increases ESIO’s per share liquidating value from $8.66 to $9.74. It’s legitimate to question whether all of this sturm und drang is worth it if it only serves to reduce the liquidating value of ESIO. The honest answer is that we don’t know but we suspect that it’s probably not. We think it would have made more sense for ESIO to buy back its own shares rather than merge with ZIGO. If a merger with ZIGO was an inevitability, perhaps it would have been better to buy back the shares before the merger, especially since ESIO seems to be getting less in value from ZIGO than the value it is issuing to ZIGO’s shareholders. There is also a risk that the buy back will not proceed. According to the announcement,
The repurchases will be made at management’s discretion in the open market in compliance with applicable securities laws and other legal requirements and are subject to market conditions, share price and other factors. There is no fixed completion date for the repurchase program.
3. David Nierenberg
According to his most recent 13D, David Nierenberg (The Motely Fool has a profile here) of Nierenberg Investment Management owns 15% of ESIO. The filing details Nierenberg’s agreement with ESIO regarding ESIO’s stockholder rights plan, which prevents any stockholder – other than 19.99% owner Third Avenue Management LLC – from owning more than 15% of the company. If any stockholder purchases more than 15%, the plan limits the stockholder to voting only that portion of the stockholding up equivalent to 15% of the outstanding stock. The other shares automatically vote with ESIO’s board. Nierenberg’s agreement with ESIO provides that if ESIO buys back enough stock to push Nierenberg’s holdings over 15% of the outstanding shares, he will still be able to vote all of his stock as he wishes. The agreement will be in effect for a minimum of three years.
Conclusion
ESIO as a stand alone entity is deeply undervalued, trading at less than two-thirds of its $10.12 per share liquidating value. The effect of the merger – which appears likely to succeed – is to reduce ESIO’s per share liquidating value to $8.66, which is only 35% higher than the company’s close yesterday. This will be remedied by the $100M buy back authorized for ESIO, which will increase ESIO’s per share liquidating value to $9.74, which is nearly 50% higher than yesterday’s close. There is a risk that the merger will go through but the buy back will not be completed but we think this risk is relatively low.
There are two ways to play this:
1. If you are confidant that the merger will go through, buying ZIGO at $6.54 is buying ESIO for $6.41 (a 2.3% discount). This is because in the merger each share of ZIGO equates to 1.0233 shares of ESIO ($6.56 / 1.0233).
2. If you believe there is a risk that the merger will not go through, ESIO offers the better downside protection because it is at a deeper discount to its liquidating value.
ESIO closed yesterday at $6.56.
ZIGO closed yesterday at $6.54, which equates to paying $6.41 for ESIO.
The S&P 500 closed yesterday at 868.57.
[Disclosure: We do not presently hold either ESIO or ZIGO. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only.]
Greenbackd 