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I am a fan of paired trading, as I like how having long and short positions in related securities can help reduce risk.

My favorite type of paired trade is to buy (go long) the best company in an industry and short the worst company. This strategy allows for hedging of a position, so if the entire industry suffers a downturn, the overall damage should be minimized because, theoretically, the gain from shorting the worst company should outweigh the loss from owning the best company. I think paired trades are especially good with cyclical or commodity-dependent stocks where there always seem to be unpredictable external macro factors.

One industry that comes to mind with those conditions is semiconductors, where I see an interesting setup for a paired trade.The long part of this trade will be Lam Research (NASDAQ:LRCX), the maker of semiconductor manufacturing equipment. Lam’s specialties are in etching equipment and wafer cleaning systems. Lam has a market cap of just under $7 billion, but $900 million in net cash for an enterprise value of about $6 billion. LRCX trades for 11.6x free cash flow, and from FY2004 to the trailing twelve month period steadily increased gross margins from 46% to 51.3% and net profit margins from 9.7% to 25.4%, as well as FCF return on capital from 17.1% to 31.9%. Lam has also been aggressively using its cash to repurchase stock, and over $200 million remains allocated for further buybacks. I value LRCX at $57/share, or 17% upside from the most recent closing price.

Applied Materials (NASDAQ:AMAT) is another chip fabrication equipment provider, and one of the larger competitors in the space with an enterprise value of $24.4 billion. AMAT trades for 14.3x FCF, although that 23% premium to LRCX is in spite of 5 year forecasted growth of 15% for AMAT and 20% for LRCX. Gross margins stand at 47%, fewer than 100 basis points above where they were in FY2004. Net margin is 18.5% for Applied Materials, 130 basis points above FY2004’s reading. FCF return on capital is a solid 26.5%, but has slipped from the 30.7% return generated in FY2004. Although Applied Materials is a good company, I believe it is overvalued on a peer-comparable basis and cash flow basis. I value AMAT at $17, or 9% below the most recent closing price.

Nearly any metric used to compare Lam and Applied Materials show that Lam is the better company, yet also the more underpriced stock. I have tried to reconcile this paradox and failed, which suggests that there may be a market mispricing present. Yes, concerns about cyclicality in semiconductors abounds, which is why I believe the smart trade is to buy LCRX and hedge the position with a short on AMAT. At the same time, I can’t help but believe that Lam will go higher, while Applied will need to considerably outperform current implied expectations in order to move the stock price higher. In pairs trade terminology, I am suggesting a short of AMAT as the worst company - but “worst” is relative here, and I don’t mean to say that Applied is a terrible company; I simply think Lam is the superior player and the expectations surrounding the stock are too pessimistic, which presents a good opportunity to get long LRCX.

LRCX/AMAT 1-yr comparison chart

Disclosure: none

Source: Semiconductor Pair Trade: Long Lam Research, Short Applied Materials