Lam Research Corporation (NASDAQ:LRCX) is a prominent player in the specialty semiconductor business. Established in 1980, the Fremont, California-headquartered company specializes in semiconductor processing equipments used in the fabrication of integrated circuits. Its customers include semiconductor manufacturers, as well as other chip makers. Samsung Electronics and Toshiba are among the key customers. The company has done well over the last year, boosting its profits by 113%, but the stock has been an underperformer, returning -24% in the same period.
As of the time of writing, Lam Research stock was trading at $42 with a 52-week range of $35 - $59. It has a market cap of $4.9 billion. Trailing twelve month (ttm) P/E ratio is 12.6, and forward P/E ratio is 10.8. P/B, P/S, and P/CF ratios stand at 2.0, 1.8, and 7.3, respectively. Operating margin is 17.2% and net profit margin is 14.6%. The company has some debt issues. Debt/equity ratio is 0.3. Lam Research does not have a dividend policy yet.
Lam Research has a 3-star rating from Morningstar. Out of 5 analysts covering the company, 3 have buy, 1 has outperform, and 1 has hold ratings. Wall Street has diverse opinions on Lam Research's future. Average five-year annualized growth forecast estimate is 10%. This is a reasonable estimate given the double-digit growth rate of the industry.
What is the fair value of Lam Research given the forecast estimates? We can estimate Lam Research's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E_{0} + E_{1} /(1+r) + E_{2} /(1+r)^{2} + E_{3}/(1+r)^{3} + E_{4}/(1+r)^{4} + E_{5}/(1+r)^{5} + Disposal Value
V = E_{0} + E_{0} (1+g)/(1+r) + E_{0}(1+g)^{2}/(1+r)^{2} + … + E_{0}(1+g)^{5}/(1+r)^{5} + E_{0}(1+g)^{5}/[r(1+r)^{5}]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E_{0}(1+g)^{5}/[r(1+r)^{5}] = E_{5} / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my growth estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year.
E_{0} = EPS = ($3.32 + $3.71) / 2 = $3.52
Wall Street holds diversified opinions on the company's future. While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 10%. Book value per share is $20.60. The rest is as follows:
Fair Value Estimator | ||
V (t=0) | E_{0} | $3.52 |
V (t=1) | E_{0} (1+g)/(1+r) | $3.48 |
V (t=2) | E_{0}((1+g)/(1+r))^{2} | $3.45 |
V (t=3) | E_{0}((1+g)/(1+r))^{3} | $3.42 |
V (t=4) | E_{0}((1+g)/(1+r))^{4} | $3.39 |
V (t=5) | E_{0}((1+g)/(1+r))^{5} | $3.36 |
Disposal Value | E_{0}(1+g)^{5}/[r(1+r)^{5}] | $30.54 |
Book Value | BV | $20.60 |
Fair Value Range | Lower Boundary | $51 |
Upper Boundary | $72 | |
Minimum Potential | 22% | |
Maximum Potential | 70% |
I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Lam Research is between $51 and $72 per share. At a price of $42, Lam Research is undervalued by at least 22%. The stock has up to 70% upside potential.
Summary
Lam Research has a great moat in the semiconductor business as it focuses on the etch market, which is a key step in this business. The company is also involved in strategic alliance with Novellus (NASDAQ:NVLS) in a deal worth around $3 billion. The details of the deal suggest that each Novellus shareholder will receive 1.125 shares of Lam Research. According to Helix Investment Management, that is a win win for both companies.
Interestingly, Novellus is up by a significant return since the deal was announced, whereas Lam has been an underperformer. Right now, comparing two stocks, it is easy to see that Novellus is already priced with a merger premium. The deal is not finalized yet. If it is finalized, Novellus should be priced at 1.125 times the Lam's closing price, which is around $47.25 according to the stock's latest closing price.
Nevertheless, I think both companies are cheap. They may not be the cheapest stocks among the market, but at single-digit P/FCF ratios, they offer attractive entry points. Based on my FED+ analysis, Lam Research has up to 70% upside potential, which also implies that Novellus has more or less the same potential.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.