FSI International: This Small Semiconductor Company Could Clean Up

| About: FSI International, (FSII)

It has already been a fairly solid year for many companies in the semiconductor equipment space. With guidance from major players like Applied Materials (NASDAQ:AMAT) and ASML (NASDAQ:ASML) suggesting that dawn is breaking and the merger between Lam Research (NASDAQ:LRCX) and Novellus (NVLS) hinting that business is getting back to normal, investors seem to be willing to consider risky stories again.

That could set up the right sort of one-two punch for investors in FSI International (NASDAQ:FSII). Like many other small equipment vendors, FSI was hit hard by the downturn in equipment spending. Unlike some of those small peers, though, FSI is coming into a cyclical upswing with a new product and the potential for some real sales momentum. Couple that with the fact that this stock is barely followed and has about 10% short interest, and it may not take much for this stock to do even more in 2012.

The Right Tool And The Right Time?

FSI is in the business of surface conditioning equipment -- basically products that clean, strip, and condition wafers used to make chips. It's a critical part in the chip manufacturing process, and one that is dominated by big-name competition from the likes of Dainippon Screen (OTC:DINRF), Tokyo Electron (OTCPK:TOELY) , Lam Research (LRCX), and Applied Materials (AMAT).

There is no question that FSI is a small fish in this pond. Dainippon basically dominates the market with roughly 70% share in single wafer cleaning and over 50% share in batch cleaning. Lam is a distant #2 in single wafer (and doesn't compete at all in batch), while Tokyo Electron holds a strong #2 spot in batch but is a more distant #3 in single wafer. Applied Materials is mostly an afterthought from a global share perspective, as is FSI.

Nevertheless, FSI is hoping that its new product platform (Orion) can change this. First released in 2010, Orion offers single wafer wet process cleaning that is usable all the way down to 28nm manufacturing (basically the state of the art). Already qualified at four customers, the system is in the qualification process with two more, and the company reports that the Orion is already being used in 22nm chip development.

Challenges And Opportunities

FSI will certainly have its work cut out gaining any ground on Dainippon -- a company that has already moved towards 450mm wafers (the Orion processes 300mm wafers) and advanced methodologies that can allow for speeds of up to 1,000 wafers per hour (about triple what I believe Orion can handle). But it is not as though FSI is not used to competition nor completely helpless, as the closed chamber design of the Orion has some perks of its own and overall productivity and defect rates are attractive.

It's also worth noting that this is not a one product company. FSI has other product lines like Antares to sell through to customers.

Speaking of customers, FSI has recently reported follow-on orders from a foundry and management has commented that current product order visibility is the "best" it has been in "some time". Given past customer patterns, I would suspect that FSI is seeing more interest from Samsung (OTC:SSNLF) -- one of the world's largest chip makers and a big FSI customer in the past.

The good and bad about FSI, though, is that one customer (or even just one system) can make a big difference over a quarter or a fiscal year. So while getting past customers like Samsung, GlobalFoundries, and Hynix on board with the Orion is indeed important, so too would be penetrating a new customer like Intel (NASDAQ:INTC), Taiwan Semiconductor (NYSE:TSM) or Texas Instruments (NYSE:TXN) (the first two of which are Dainippon customers).

That said, investors should keep in mind that there have generally been higher switching costs for cleaning equipment relative to other types of equipment. That could put pressure on FSI to demonstrate that it, too, is ready for the migration to 450mm wafers and other advanced processes.

As it stands now, the company is reporting not only follow-on orders (meaning that the customers liked what they saw and want more systems), but multiple orders from multiple parties. The end result of all this activity is that revenue is expected to double sequentially to over $30 million in the February quarter. While data from Dainippon and Tokyo Electron confirms the basically directionality of the market (orders are improving), FSI's small size leaves it with proportionately more to gain.

The Bottom Line

Any time an investor looks at a company as small as FSI, the risks go up significantly; large rivals like Dainippon and Applied Material have the resources to out-spend them in the R&D lab, and chip companies are often unsure of trusting critical processes to smaller players. By the same token, FSI has a history of at least staying in the game and the Orion could be a catalyst for real share growth.

It's hard to say that FSI is a great takeout candidate. The company has to demonstrate that its technology can bloody a few noses among the big boys before it would make any real sense for a company like Lam or Applied Materials to consider it. Still, successful small toolmakers in this space don't tend to stay independent.

The question is whether FSI can get enough business to be a success. Support from a company like Samsung certainly doesn't hurt, but this is very definitely a David vs. Goliath battle (or Godzilla, if you prefer) and Goliath wins the vast majority of those.

If you believe that FSI can get back to bubble-era sales (about $200 million in revenue) and achieve "industry standard" free cash flow conversion, these shares are cheap enough to consider today. More to the point, if the company can do all of that, these shares could come close to doubling again, despite already more than doubling off the 52-week low. Just don't fool yourself about how easy that goal will be to achieve -- this is a pretty standard high-risk / high-reward small-cap tech story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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