Varian: A Rare High-Tech Company With Unassailable Market Position

Varian Semiconductor Equipment Associates (VSEA) is the undisputed leader in a small but important segment of the semiconductor cap equipment industry. Several years ago, the company positioned itself to take advantage of an industry shift to single wafer implanters. It gained market share as a result and moved closer to a quasi-monopolistic position (only remaining credible competitor is struggling Axcelis). The implanter segment has high barriers to entry and should exhibit mid to high single-digit growth in the long term. While the industry is undergoing a cyclical downturn, we believe Varian shares offer compelling value.

BUSINESS OVERVIEW

Varian is a semiconductor capital equipment maker and the leading producer of ion implantation equipment.

SELECTED OPERATING DATA

FYE September 30	2006	2007	2008
% of revenue by geography:
North America	22%	22%	22%
Asia Pacific	67%	71%	70%
Europe	11%	7%	8%
Revenue growth by geography:
North America	20%	45%	-21%
Asia Pacific	20%	53%	-22%
Europe	39%	-10%	-12%
D revenue	22%	44%	-21%
D unit shipments of tools	33%	51%	n/a
D deferred revenue (period end)	6%	10%	-41%
% of revenue by type:
Product	88%	91%	90%
Service	11%	8%	10%
Royalty	1%	1%	0%
% of shipments by market:
Memory	51%	70%	n/a
Logic	19%	14%	n/a
Foundry	30%	16%	n/a
% of shipments by wafer size:
300 mm	75%	91%	n/a
200 mm	25%	9%	n/a
Top 10 customers (% of revenue)	63%	72%	n/a

VARIAN’S SHARE OF GLOBAL IMPLANTER MARKET1

	Market Size	Varian Market Share
($ in millions)	CY06	CY07	CY06	CY07
Medium current	$414	$454	53%	57%
High current	720	672	46%	78%
High energy	230	147	17%	13%
Ultra high dose	na	64	na	100%
Overall	$1,364	$1,337	43%	65%

1Source: Garter Dataquest, VLSI Research, Company.

INVESTMENT HIGHLIGHTS

• #1 in $1 billion implantation equipment market, with share up from 43% in CY06 to 65% in CY07. Varian has grown share—and is likely to continue to do so—in the largest segments while maintaining 100% of the fast-growing, ultra high-dose market.
• Gained high-current share due to industry shift from batch ion to single wafer implanters. Varian began developing the technology in 1994, giving it large lead over Applied Materials (AMAT) and Axcelis (ACLS). AMAT was effectively forced to exit the high-current segment in 2007, with Varian benefiting.
• Large barriers to entry due to role of patents and technical expertise. Implanters weigh 20+ tonnes and sell for roughly $4 million each. The industry has seen no credible new entrants in decades.
• PLAD plasma tool expands addressable market through creation of ultra high-dose segment, with sales potentially surpassing $100 million in FY09.
• Little risk of commoditization, due to advances in implanter technology and changes in wafer and chip size. Implantation has become a higher-value step in semi production, giving Varian more pricing power.
• Gary Dickerson (50) joined Varian as CEO in 2004, having served for ten years in roles at KLA-Tencor, including as Group VP, EVP, and COO.
• $209 million of net cash and short-term securities.
• Repurchased $179 million of stock in FY08, $427 million in FY07 and $109 million in FY06.

INVESTMENT RISKS & CONCERNS

• Sharp drop-off in business, driven by drop in capital spending, particularly by manufacturers of DRAM devices. Revenue fell 37% and 52% y-y in the June and September quarter, respectively. The company expects to post a small loss in 1Q09.
• Cyclical business, dependent on semi makers’ capacity investments, which exhibit large volatility (particularly in the case of memory manufacturers).
• Axcelis may become strong competitor if bought. Sumitomo Heavy Industries made a hostile bid for Axcelis in February, but shelved its proposal after Axcelis rejected a sweetened $616 million offer. ACLS now has a market value of $54 million, practically crying out for an activist to come in and force a sale.

COMPARABLE PUBLIC COMPANY ANALYSIS

($mn)	MV	EV	EV/Rev	P/TB	08 P/E	09 P/E
ACLS	64	97	.3x	0.2x	n/m	n/m
AMAT	13,725	11,827	1.5x	2.3x	13x	9x
KLAC	3,067	2,505	1.1x	1.7x	36x	14x
LRCX	2,248	1,488	.7x	1.6x	138x	15x
VSEA	1,269	1,063	1.3x	2.5x	250x	22x

MAJOR HOLDERS

CEO Dickerson <1% │ Other insiders 2% │ Fidelity 15% │ Oppenheimer Funds 10% │ Wellington 7% │ Turner 3%

THE MANUAL OF IDEAS RATINGS

VALUE: Intrinsic value materially higher than market value? 4 stars

MANAGEMENT: Capable and properly incentivized? 4 stars

FINANCIAL STRENGTH: Solid balance sheet? 5 stars

MOAT: Able to sustain high returns on invested capital? 4 stars

EARNINGS MOMENTUM: Fundamentals improving? 2 stars

MACRO: Poised to benefit from economic and secular trends? 2 stars

EXPLOSIVENESS: 5%+ probability of 5x upside in one year? 3 stars

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Comments

[spongebobwho:]

This all is well and fine, but the recent cutbacks in staffing to meet the bottom line has resulted in a large section of talent that has exited the building. Once the cycle turns back up, how much this loss of talent will cost them in customer satisfaction is yet to be seen. Once over 1700 strong, now down to around 800, With more cuts thru this year, only senior staff will be left, no legacy talent, leaves a large hole ...

Jan 28 09:57 AM