Semi Sell-Off Offers Opportunity

A flurry of news items last week sent semiconductor stocks lower, with investors appearing to grow wary as the current upswing gets long in the tooth.

We believe the market overreacted to the commentary from these CFOs and the sell-off has created appealing opportunities. In wafer fabrication equipment, wide-moat KLA-Tencor and wide-moat Applied Materials are both trading at attractive discounts to our fair value estimates of $128 and $49, respectively. However, no-moat Micron continues to trade at a premium to our $40 fair value estimate, as we do not foresee the current favorable supply/demand dynamics persisting beyond a few more quarters.

Also last week, Digitimes reported: “Samsung Electronics and SK Hynix both intend to defer their capacity expansion plans, as a slowdown in customer demand will be dragging down DRAM and NAND flash memory prices through the first half of 2019, according to industry sources.” This sentiment is consistent with our view on memory prices and what management teams at wafer fabrication equipment companies have been alluding to in deferred expansion plans.

Despite these well-chronicled memory-related equipment pushouts, we remain very positive on the long-term prospects for the wafer fabrication equipment space. Given increasing complexity across logic, foundry, and memory structures, we foresee a sharp rise in process diagnostic and control intensity that will significantly benefit the likes of KLA-Tencor. We foresee another healthy year of equipment spending in calendar 2019 thanks to material spending for advanced process technologies, particularly in logic and foundry, and we see near-term headwinds as a buying opportunity.

KLA-Tencor Well Positioned for Long Term KLA-Tencor dominates the process diagnostic and control segment of the semiconductor equipment industry. During the fabrication process, wafers must be inspected for defects and proper critical dimensions to identify and correct problem sources. As customers continue pursuing Moore's Law, smaller chips must meet more precise specifications, which in turn increase the need for advanced PDC tools. These tools help customers improve semiconductor die yields, accelerate development and product ramps, and ultimately maximize profitability.

With a 50%-plus share in the PDC market and installed base of 20,000 tools, KLA-Tencor has built its leading technical expertise and extensive knowledge base into a wide economic moat. These competitive advantages have allowed the company to maintain its technological edge through a large research and development budget and close relationships with customers to identify future needs in the PDC space.

The company is not immune to the cyclicality of the semiconductor equipment market and thus may face bouts of low capital expenditures due to prolonged process nodes and increased tool reuse. However, KLA has been able to charge a premium for its specialized products, as competitors’ offerings are generally not as advanced. This allows it to handle cyclical troughs fairly well for a company that operates in the chip equipment industry.

We believe KLA is well positioned for the long term, as chipmakers will require more advanced PDC tools to go with fabrication technologies featuring smaller circuit sizes, new materials, and more process steps. For example, extreme ultraviolet lithography, which is being developed for process nodes 7 nanometer and below, will require new PDC tools to help validate and sustain the new technology. This endeavor will require a large R&D budget that only a company like KLA can provide.

Applied Materials Has Impressive Global Presence Applied Materials is a leading vendor of semiconductor fabrication tools. While competitors tend to specialize in a single core competency, Applied competes in almost every key equipment segment with the exception of photolithography. As a result, all major chipmakers develop strong relationships with Applied that span multiple process steps of their chip production. The company is the dominant player in the material deposition and removal (etch) areas, among others.

Applied boasts an impressive global presence with an installed base of more than 30,000 tools and customer engineers stationed in nearly every chip-manufacturing facility in the world. With semiconductor fabrication becoming increasingly complex, resulting in more process steps and new manufacturing technologies, collaboration between chipmakers and equipment providers is set to reach unprecedented levels. We expect Applied to leverage existing relationships and insights into future customer technology needs to take advantage of the proliferating demand for state-of-the-art chips.

The company’s scale and resources allow a research and development budget in excess of $1.5 billion to serve cutting-edge technologies. Recent inflections such as 3D architectures (found in advanced NAND and logic chips) have been enabled by advanced tools in deposition and removal. As a result, these segments have grown faster than the broader market in recent years, and companies such as Applied have directly benefited, as they can outspend smaller chip equipment companies in R&D to develop relevant solutions.

Beyond semiconductors, Applied is a leading supplier of manufacturing tools for flat-panel displays, including liquid crystal displays and organic light-emitting diodes. The cyclical nature of the chip industry and the display market is a ubiquitous threat to equipment suppliers. However, we believe Applied’s expansive product portfolio and large installed base will allow the company to comfortably weather business cycles over time, and we expect the company to experience decent growth over the long term.