Investors aren't exactly in danger of running out of ways to play expected improvements in semiconductor capital spending in 2014. I've already talked about opportunities in companies like Ultratech (NASDAQ:UTEK) and Mattson (NASDAQ:MTSN), and both appear to offer significant value if and when next-gen capital spending increases.
Entegris (NASDAQ:ENTG) is a different sort of play. Unlike Ultratech and Mattson, there really isn't much of a missionary aspect to sales - semiconductor manufacturers already understand the need for contamination control and advanced material handling, and Entegris already holds solid share in its core markets. That said, more advanced fab processes should require more filtration equipment and a larger sales opportunity for Entegris. While I don't necessarily see as much upside in the Entegris bull-case scenario (compared to Ultratech or Mattson, that is), I believe there is less execution risk here and still an opportunity to generate worthwhile capital gains.
Cleanliness Is Non-Optional In Semiconductor Production
I don't think it will strike anyone as controversial that semiconductor companies need clean operating environments for their chip production processes. Even trace microscopic contaminants can lead to defective chips and meaningful reductions in yield. With financial success in chip production ultimately coming down to yield for companies like Taiwan Semiconductor (NYSE:TSM), Intel (NASDAQ:INTC), and Samsung (OTC:SSNLF) that makes contamination control no trivial concern.
Entegris gets about two-thirds of its sales from its Contamination Control segment, a business built around gas and liquid filtration. Not unlike the models of better-known filtration companies like Pall (NYSE:PLL) and Donaldson (NYSE:DCI), Entegris's business is built around the relatively infrequent sale of capital equipment (about one-third of sales) and the repeated sale of replacement filters and consumables (about two-thirds of sales).
Exacting standards and reliable performance are critical in this market, and Entegris has built a solid reputation for itself. The company counts the likes of Micron (NASDAQ:MU), Samsung, and TSMC among its major customers, and I estimate that Entegris has about 30% share in the semiconductor gas/liquid filtration market - roughly on par with Pall (in liquids) and ahead of rivals like Polypore (NYSE:PPO), Parker Hannifin (NYSE:PH) and Donaldson.
Can New Processes Lead To New Growth Opportunities?
Historically, Entegris's sales have correlated pretty closely to semiconductor fab spend on the capex side and wafer starts on the consumables side. That's all well and good, as large semiconductor equipment companies continue to look for spending to improve in 2014 as companies continue their transition to next-gen processes.
I do believe, though, that there are ways that Entegris can do more than just ride along with the cycle. The increased use of single-wafer clean has become increasingly important to companies like Lam Research (LCRX) and Dainippon Screen, and it creates more potential filtration sales for Entegris as well. Likewise, the increased use of double patterning and the increasing number of steps in next-gen chip production processes creates more sales opportunities for the company's equipment and consumables.
Entegris management is also looking for ways to broaden the commercial potential of its existing technology. Contaminants are just as problematic in the production of photovoltaics, LEDs, and displays, and Entegris should be able to benefit from production growth in these markets as well.
Not Just A Filtration Company
Although gas and liquid filtration supply the majority of Entegris's revenue, there are two other significant businesses here. The company's Microenvironments business (more than 20% of sales) sells high-purity "micro-environments" that hold and carry wafers between various process steps, reducing the likelihood of damage or contamination. Entegris also generates about 10% of its revenue from its Specialty Materials business - a business that sells specialized graphite products for the semiconductor industry and specialty polymers and coatings for semiconductor and aerospace customers.
Disappointment Today, Growth Tomorrow?
Entegris certainly wasn't the only semiconductor equipment company to deliver disappointing guidance for the second half of 2013. While the sell-side had been projecting 10% revenue growth for the third quarter, the guidance with the second quarter results called for a sequential decline. Results from rivals like Pall don't suggest that Entegris is any particular company-specific trouble, but it is still a disappointing slide to the right for future growth projections.
As I said before, I do believe that Entegris has the opportunity to sell more filtration products than before due to the shifts toward single-wafer clean and double patterning. Likewise, the products that Entegris sell are familiar to the industry and don't represent any sort of new way of doing business. With that, I think Entegris is less likely to show the same sort of robust bull-case revenue growth as Ultratech or Mattson, but I think the projections for Entegris carry less risk.
I'm looking for low double-digit revenue growth over the next five years and mid-to-high single digit growth over the next decade, with free cash flow generation likely to peak in the mid-to-high teens before declining again and averaging in the low double digits for the next decade. With that, I get a DCF-derived fair value of about $12.50. EBITDA- and ROE-based valuation methodologies likewise produce targets in the $12.50 to $13.50 range on the basis of three-to-five-year EBITDA growth and prospective returns on equity.
The Bottom Line
Entegris is enough of a threat to Pall that the two companies engaged in back-and-forth litigation for years before making a truce in 2011 with a comprehensive IP settlement. That, coupled, with a long history of selling to fabs and chip producers like Micron, Samsung, and TSMC gives me confidence that Entegris has the technology and industry footprint to participate in this next upswing in spending.
I don't consider my projections to be all that bullish, so I find it reassuring that the shares are looking 25% undervalued even with my base-case assumptions. Although Entegris may not have as much upside to this next generational shift in semiconductor manufacturing processes, I believe there's worthwhile leverage here to a 2014 spending rebound, as well perhaps as the possibility of a buyout down the road.
Disclosure: I am long UTEK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.