Lam Research: AI, IoT, 5G, And Gaming Tailwinds
Summary
- The Wafer Fabrication Equipment [WFE] market is growing from $57-59 billion in 2020 to $67-$70 billion in 2021 itself as opposed to earlier expectations of achieving this in CY2023/CY2024.
- By 2024, Lam Research is targeting to increase market share from 20% to 25%; i.e. revenue of $14-$17 billion and FCF of $4-$5 billion.
- Enterprise value of $78 billion and past FCF of $2.4 billion give an FCF yield of 3%, while the targeted FCF of $4-5 billion could yield 5% to 6.4%.
- Even the past decade's 6-7% industry growth puts it into double-digit total returns. Lam Research has grown at twice the rate of the industry in the past decade. With Cloud, AI, IoT and 5G coming together, future growth rates could be much higher for the industry and for Lam.
- This is a cyclical business with a secular growth tailwind. The FCF and revenues, and thus, share price will go through volatility.
Wafer Fabrication Equipment Industry In Growth Mode
Artificial Intelligence [AI], Internet of Things [IoT], and 5G are driving demand for memory and processor chips. This demand is getting pushed upstream towards Wafer Fabrication Equipment [WFE] capital investments by the semiconductor manufacturers in anticipation of future demand for chips. Lam Research (LRCX) being one of the top 3 wafer fab equipment [WFE] manufacturers directly gains from this WFE capex.
The WFE market was averaging annual revenues of $30 billion during 2010-2016. During 2017-2020 it was averaging around $50 billion. From 2021 to 2024 it is expected to average around $60-$70 billion. This a cyclical industry and there is a cadence to capital investments which makes it more relevant to have a moving average perspective rather than a year-on-year growth perspective.
Over a 10-year period the revenues have nearly doubled, making the long-term growth in the 6-7% range. However, driven by the secular growth in movement to the Cloud supported by 5G, Internet of Things [IoT] and ultimately the need for using Artificial Intelligence [AI] for business, the future growth rates are likely to be much higher.
Lam Research is a key player in the WFE industry
Lam Research is one of the top 3 players in the industry with nearly 20% market share. It targets to grow that to nearly 25% market share by CY2023-CY2024.
Lam Research serves 3 main markets, viz. Memory, Foundry and Logic/integrated device manufacturing [IDM]. Memory is the largest revenue contributor with 60%-70%, followed by Foundry with 20%-30%, with Logic/IDM contributing the rest.
Source: Company 10-K (FY2020) and investor presentation (Dec. Q2020)
Geographically, recent data shows that China contributes 30%-35% to company revenues, with Korea contributing 20-24%, followed by Taiwan at 17%-19%, Japan at 9%-10%, USA at 4%-8%, South East Asia 6%-10% and Europe at 3%.
Source: Company 10-K (FY2020) and investor presentation (Dec. Q2020)
Lam Research-Scientific Investing Framework And The Financial Model
The opportunity for the WFE industry looks attractive, and LAM Research looks well-placed to benefit from the same. We apply OmniScience Capital's Scientific Investing framework to it to explore if the company is worthy of investment. A company worthy of investment would be able to survive a difficult environment in the future and also have the resources to thrive on opportunities which are, or might become, available in the future.
The first step in the Scientific Investing framework is to understand if the company has the resources to survive or is it a capital destroyer. This involves assessing the balance sheet strength and the earnings and cash flows to support the non-discretionary expenses of the company.
Balance sheet strength
According to the latest 10-Q (Dec. 2020), the company has long-term debt, lease obligations and income-taxes payable of nearly $6 billion. The net free cash, i.e. cash left over after using all current assets other-than-cash to compensate for all current liabilities, on the balance sheet is slightly more than $6 billion. In summary, there is no net-debt on the balance sheet. The company has the resources to fully pay-off all its debt using cash on the balance sheet itself. This checks the first criterion, i.e. debt is not a threat to the company's survival.
It also shows that the firm has $6 billion of cash resources to deploy if any interesting opportunities appear which could help it thrive. These could be M&A or organic investment opportunities, including capital investments or R&D investments or acquiring intangible assets.
Operational strength
Revenues
The average revenue over the last 3 years (FY2018-FY2020) has been $10.3 billion, ranging between $9.7 to $11 billion.
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Gross margins
The COGS has been around 54% delivering a gross margin of nearly 46%, translating to average gross profits of $4.7 billion.
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Selling, General & Administrative
The non-discretionary expenses, i.e. Selling, General & Administrative [SG&A] have averaged $715 million, but have consistently been decreasing from $762 million in 2018 to $683 million in 2020. However, in the last 6-months, they are $408 million, which annualizes to $816 million. This works out to 6.2%.
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Research & Development
The Research & Development [R&D] expenses have been around $1.2 billion for the past 3 years. Recent 6-months have an annualized rate of around $1.4 billion.
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Cash Flows
Lam's operating cash flow has averaged $2.7 billion, i.e. the OCF margin has averaged 26%. The capital investments have averaged around $260 million, i.e. 2.5% of revenues, for the same period. The free cash flow has averaged $2.4 billion, i.e. the FCF has averaged 23%.
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Source: Company 10-K (FY2020), investor presentation (Dec. Q2020), OmniScience Capital Research
Lam is Fundamentally Strong
With the strong, net-debt free balance sheet and significant gross profits of $4.7 billion, Lam Research is a fundamentally strong company. The $4.7 billion provides significant coverage for the $800 million SG&A expenses.
Further, there is significant coverage for the $1.4 billion R&D expenses as well. Spending on R&D--a lot of which might be necessary expenditure to stay in business in the long-term--is well within their means. Some portion of R&D would be helping increase the served available market [SAM] and thus adding to long-term growth opportunities. If required, the recurring cash flows are sufficient to fund significant R&D expenses organically or even for acquisition of relevant intangible assets.
The operating cash flow of $2.7 billion provides ample capital for making any capital investments required. The required capex seems quite modest, comparatively, at $260 million to $300 million.
The FCF of $2.4 billion is available for shareholder distributions or other organic or inorganic growth initiatives.
Lam Research can be said to pass the first criterion of being a survivor with a solid balance sheet with liquid cash resources, and strong business operations resulting in significant cash flows.
Lam Research: Persistent Competitive Advantages
The second criterion in the Scientific Investing framework is to assess whether the company has any persistent competitive advantages. The company is a leader in certain technologies, such as, deposition and etching. The competitive advantages can be seen not only in the high gross (45%-46%) and OCF margins (26%) but also in the high returns on capital.
Return on invested capital has been in the 23%-26% range over the last 3 years while the return on equity has been in the range of 35%-46%.
The high profit margins and profitability are a result of a monopoly in the manufacturing of equipment for certain semiconductor processes. There is significant pricing power at the command of Lam Research.
With industry consolidation in place and semiconductor manufacturing technology reaching fundamental challenges near the atomic levels, the competitive advantages are likely to be persistent.
This passes the second criterion of the Scientific Investing Framework. The company has persistent competitive advantages and can compound shareholder capital at high percentage returns, significantly higher than the cost of capital. This means that the company is a SuperNormal company capable of generating supernormal profitability.
Lam Research: Valuation Estimates
The third criterion of the Scientific Investing Framework is whether the company is available at a significant discount to intrinsic value; i.e.is it available at SuperNormal prices?
The company is valued using the past, proven financials first. This is followed by a valuation based on future, targeted financials.
Valuation Based on Proven Financials
Using the FCF of $2.4 billion, growth rate of 6% and a discount rate of 9%, puts the intrinsic value of the firm at $80 billion. This is close to the current enterprise value which is fluctuating between $75-$80 billion. At the current price, the expected returns from the company are 9%, if the company continues growing at 6% in the long run.
Another way of understanding the current deal is that even at a 4% long-term growth rate the company is valued at $80 billion at a discount rate of 7%. This provides a huge margin of safety as well as a significant upside in terms of valuation as higher growth rates are digested by Mr. Market.
In summary, an investment in Lam Research at this price would deliver a 7% return if the long-run growth rate is 4%, 9% return if the growth rate is 6% and 10% if the growth rate is 7%. Proportional increases in actual growth rates would deliver proportionally higher returns.
If Mr. Market reprices the company based on an 8% discount rate instead of a 9% discount rate, the company would be worth $120 billion.
Valuation Based on Outlook & Targeted Financials
Based on the guidance for Q3 2021 (ending March 2021), the revenues are likely to be in the range of $14 to $15 billion for 2021. This also incorporates the information that the WFE market for 2021 is likely to be close to $70 billion or a couple of billion short. During their Investor Day presentation last year, the company expected to achieve this by CY2023/CY2024. However, the accelerated demand for semiconductors due to Covid-19 and other reasons has made this target likely in 2021 itself.
While the company is targeting an FCF margin of 28%-30% in CY2023/CY2024, we use 27.5% which is likely to be achieved for 2021.
Assuming a $14 billion revenue, nearly $400 million in capital investments, the company is likely to generate FCF around $3.6 billion for 2021. The average level of FCF is likely to be maintained at this or higher level based on the company's targeted financial model.
A 6% growth rate and a 9% discount rate lead to an intrinsic value estimate for the firm at $119 billion. The current market value in the range of $75-80 billion is more than 30% discount to intrinsic value.
Even with a more conservative 23.3% FCF margin, which is currently proven, the FCF is $3 billion and at a 6% growth rate and 9% discount rate the intrinsic value is $101 billion. This a 25%-30% upside from the current levels.
It is possible that the actual growth rates and cash flows over the next 10 years are higher, since there is likely to be a growing demand for WFE, albeit with some cyclicality year-to-year, over the next decade or two. Further, the WFE suppliers are now in a consolidated market and hence the focus will be on growing profitability and increasing margins. Further, Lam Research is quite aggressively focused on increasing its market share in this growing market by launching new products and services which increase its SAM.
Investment Thesis
AI, IoT, 5G are driving demand for semiconductor chips. The WFE market is currently around $65-$70 billion and likely to grow at 6%-9% CAGR over the decade, with annual cyclicality inherent in the industry.
Lam Research is a leading player in the industry with a market share of 20% which it is targeting to increase to 25% on the back of new products and services which it has developed and are likely to get established. It also expects to improve its margins significantly over the next 2-3 years.
The current market value of the firm is at a 25%-40% discount to its estimated intrinsic value.
Risks to the thesis
The industry is exposed to the vagaries of the end semiconductor demand. If the demand for semiconductors falters for any reason, the semiconductor chip manufacturers are likely to delay their capital investment plans. This impacts the WFE manufacturers like Lam Research.
The mitigating factor is that while the demand will fluctuate from year to year, and could get postponed in some years, typically, the pent-up demand comes back in the future years.
An investor in this industry and firm should be willing to live with revenue and earnings volatility resulting in share price volatility. Of course, that also gives opportunities to add to the holdings at good prices for the risk-tolerant, long-term, intrinsic value-focused investor.
This article was written by
Analyst’s Disclosure: I am/we are long LRCX. 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.
We are long the stock in client portfolios, since it's part of our Scientific Investing strategies. Continued holding of the stock is subject to fundamentals and valuations not changing substantially unfavorably from the current situation.
Disclaimer: This is not a buy or sell recommendation. Readers should do their own research and analysis or consult a registered investment adviser from their jurisdiction before taking positions in any stocks or sectors mentioned above. Equity markets can cause complete loss of capital.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (13)
Is the chip shortage over ? Geez
As I mentioned in another comment, you are the buy it side just like us.
As Mark Twain said, prediction is difficult, especially about the future. Sell-side has to predict. Buy-side has to analyse multiple scenarios and see the possibilities and probabilities; that too, subjectively. Bayesian probability has to be used, updating as more factual data appears.
While considering investing in an idea one has to see the downside scenarios first - in the long-term. Short term volatility can take a holding down significantly. Once long-term downside on a fundamental basis is unlikely to be too bad, one starts looking at upside possibilities. In this case, there is quarterly guidance and annual discussion on various forums by the management that this year the demand is going to be very strong. This is supported by the narratives from peers. Can they go down in revenue for 2022? That is possible. But clear indication from management that they are likely at a higher base level for the 2021-2024 period. Things have happened much earlier than anticipated.
Please read the whole article carefully. Analyse critically.
I have shared the valuation based on proven financials. Further the upside possibilities based in management outlook and targets.
Risks are laid out. There can be many more. They are well-articulated in the company 10k.
The crux of the thesis is NOT dependent too much on them achieving it this year, which is quite likely though.
The core idea is that for a company in the $14-15 billion revenue range with $3+ billion cash flows annually, it is clearly mispriced. Throughout I have given multiple scenarios and in most scenarios the return is satisfactory to some people.Sell side job is to predict accurately. Buy side job is to accept multiple futures and find opportunities in which they can come out with positive outcomes in most of them and no disastrous outcome in all but the most pathological case.Hope that clarifies. At least that is our framework.
In fact, if I look at Lam's earnings call, CFO Bettinger stated in response to Arcuri of UBS NAND WFE question "Tim, when you look at this, it'll go up, it'll go down, nothing goes up every quarter. It ebbs and it flows and if you go back to '19, it was pretty low. Go to '20, it went up a little bit, '21, flat to up a little bit? Maybe? Yeah, probably."
"Flat to up a little bit" is not 50%. So Lam must be making an acquisition.
