Lam Research (LRCX) is one of the leading providers of semiconductor manufacturing equipment and seems to be deeply undervalued at $42 per share in my opinion. Here is why.
Semiconductor manufacturing is a complex process involving several manufacturing steps. LRCX is the leader in etching machines and a strong provider of wafer cleaning equipment after their acquisition of SEZ for $600M in 2007.
The total market for semiconductor is $250B-$300B per year, while the market for semiconductor equipment is around $30B to $40B per year. The market for etching equipment is around $5B to $8B per year.
LRCX is a strong performer
LRCX had impressive operational performance in the last 10 years: sales per share grew from $7,46 in 2001 to $26,20 in 2010.
Value creation and “Buffett Test”
The company creates a lot of value for shareholders and boasts an impressive 19,8% average Return on Tangible Capital Employed (ROTCE) during the same period. Furthermore, management allocated capital so far in a shareholder friendly way and passes the “Buffett Test:" the retained earnings (earnings less dividends) generated subsequent earnings growth at an average 20% to 40% return.
LCRX seems to be cheap at $42 per share right now
- LRCX has $17 per share in cash
- LRCX generated $5.86 of EPS in 2010. Taking into account the cash available, the trailing PER is 4.26.
Fair Value (DCF)
The market, which is cyclical, will decline in 2012 and LRCX will not generate the same earnings in 2012 as in 2011. However, taking into account a potential decline of 25% of earnings next year (assuming $4 EPS), the intrinsic value of LRCX seems to be way over its current price:
- Assuming 0% growth after 2012: the DCF value is $51 per share
- Assuming 7% growth after 2012: the DCF value is $64 per share
- Assuming 15% growth after 2012: the DCF value is $82 per share
NB: LRCX grew at a rate of 25% per year since 2000 and the average growth of the semiconductor market is 12% per year.
- Etching equipment is mission critical. The clients are wary of switching equipment for an unknown supplier. This is a plus for an established, dominating player such as LRCX.
- The number of layers to produce wafers increases in order to accommodate more functions on each chip. Each production line may need more etching equipment in the future.
- 3D will require more sophisticated equipment, raising the bar for potential contenders.
- Lam research has a good reputation on the market.
- The market is cyclical: 2012 is forecasted to be a bad year, and nobody knows when the demand will pick up again.
- The founder and former CEO is being replaced by the former COO. This is not a high risk since the COO has been with the company for quite a while.
- The customers are concentrated, with Samsung accounting for 25% of LRCX’s revenues.
- LRCX might miss the step to new wafer generations (such as 3D or new wavelength processes). While this risk is real, LRCX seems to be heavily investing in R&D to stay ahead of the race.
Other aspects of the investment
- While LRCX does not serve dividends (unlike AMAT), the company recently announced a large shares repurchase program, and management hinted at a possible dividend for the next years.
- Insiders sold in march 2011 for $48 to $58 per share.
LRCX is a strong buy for investors who have the patience and the nerves to hold on through the 2012 weak semiconductor market.