- Between increased semiconductor volume, driven by significant chip content growth in multiple markets, and increasing capex intensity, Tokyo Electron is looking at strong underlying market growth over the next decade.
- TEL enjoys strong market share in several key markets, but also has share growth opportunities in clean, etch, and deposition, as well as leverage to growing adoption of EUV lithography.
- Margin performance has been less than exemplary, and management really needs to buckle down on finding ways to improve gross margins.
- Double-digit revenue and FCF growth can support a mid-single-digit long-term annualized return, and the music may not stop for a while in the space, but the shares aren't cheap.
I had a finance professor as an undergrad who liked to say “math works”, and when it comes to the math on semiconductor capex, the math still works for Tokyo Electron (OTCPK:TOELY) (8035.T) (“TEL”). New demand from end-markets like autos, consumer, data center, industrial, medical, and wireless is likely to drive at least mid-single-digit chip volume growth over the next decade, and increasing production complexity means ever-higher capital intensity.
TEL also has credible opportunities to continue gaining share in its core semiconductor production equipment (or SPE) markets, while also driving further progress in margins, with management targeting 30%-plus operating margins when it reaches JPY 2T in revenue.
Where the math stops working for me is valuation. I realize we’re in a bullish cycle for SPE capex spending and that drives higher multiples, but the stock really doesn’t work on a GARP basis. That’ll be fine for some investors, and I do certainly understand using Tokyo Electron as a play on ongoing capex spending growth, but I’ve too many cycles in this sector to want to play the game of musical chairs.
Market Growth, With Market Share Growth On Top Of That
While demand has certainly accelerated in this post-pandemic recovery, it’s not as though the semiconductor or semiconductor equipment markets had been suffering in recent years. Between overall increased consumption (“more stuff”), increasing chip content in a number of markets (“more chips per stuff”), and increasingly capex-intense production methods, the market for SPE has grown at a mid-teens annualized rate since 2015.
As one of the leading players, TEL has benefitted from this strong underlying market growth, and the company has helped its own cause – leveraging R&D to modestly outgrow the market by around 1% to 2% a year, depending on whether you include lithography.
I don’t see any of the major drivers of TEL’s success changing anytime soon.
The electrification of passenger vehicle power trains will be a significant driver of increased chip content in that sector, but not the only one – increasingly advanced ADAS, instrumentation, connectivity, and infotainment will all drive higher chip content (page 10). Likewise in a range of other markets including consumer, industrial, medical, and wireless, with the added opportunity of new growth from IoT device proliferation. All told, I think chip volume could easily grow at an annualized rate in the mid-single-digits over the next decade, and that may well prove conservative.
As customers demand ongoing improvements in chip performance, capex intensity is likewise going to continue to grow. TEL management has estimated in the past that producing logic chips at the 14nm/16nm node at a rate of 100K wafer starts per month requires around $12.5B in SPE. At 10nm that rises to more than $15B, and at 5nm it is around $20B. While the increases haven’t been as dramatic in memory, the basic principle still holds.
TEL also still has opportunities to drive share growth on top of that underlying market growth. While the market shares between Applied Materials (AMAT), Lam Research (LRCX), and TEL haven’t changed that much over the years, Tokyo Electron has picked up a little market share, and the company’s new offerings in wafer cleaning, etch, and deposition could drive further share gains.
In clean, TEL has made the case that its supercritical dry technology avoids the residues of surface tension alcohol solutions and offers better pattern collapse performance than Screen’s (OTCPK:DINRF) sublimation drying. With Screen still holding significant share, that could be an opportunity for TEL, as pattern collapse becomes more of an issue with advanced nodes. Management is looking to sell its Cellesta SCD equipment into the 3D NAND and logic markets in the coming years, and that’s worth watching.
In etch, TEL is staying focused on opportunities in patterning, interconnects, and High Aspect Ratio Contact (or HARC), and has also been designing equipment with more flexible layout options – a potentially important differentiator as etch steps increase.
Last and not least is deposition, where management is looking to drive increased acceptance of new systems outside of its batch CVD business.
While not a share growth opportunity, I also want to note TEL’s leverage to increased adoption of extreme ultraviolet lithography (driven by ASML (ASML)) – with 100% share in EUV coaters/developers, TEL is leveraged to the ongoing adoption of EUV at advanced nodes.
Margins Need More Work
While TEL has done well from a revenue/market share standpoint over the last five or so years, the company has not done as well with margins. TEL, Applied Materials, and Lam all started around the same place with gross margin in 2012 (38% - 39% on a calendar-adjusted GAAP basis), but while AMAT has improved to around 45% and Lam to 47%, TEL is still around 40%.
It’s important to note that J-GAAP requires some R&D expenses to be counted in COGS, but I estimate that’s likely not more than a 200bp headwind, so TEL still comes up short.
Management has also targeted 26.5% operating margins at JPY 1T in revenue, but hasn’t gotten there yet and likely won’t until FY’23. Likewise, targets for 28% margin at JPY 1.7T and 30%+ at JPY 2T are attractive, but the company is going to have to step it up to get there.
Improved scale and debottlenecking efforts could help, but TEL management may need to consider a more comprehensive margin improvement plan to reach those targets. Optimizing the portfolio might help, as could restructuring the manufacturing cost base – AMAT has shifted to a more flexible operating footprint and management there has attributed at least some of the 460bp improvement in operating margin since 2016 to this.
I’m expecting double-digit revenue growth from TEL over the next decade – not quite on par with ASML, but still strong in its own right, with growth driven by the aforementioned factors – increasing chip production volumes, increasing capital intensity for leading-edge production processes, and modest share growth.
On margins, I give TEL some benefit of the doubt and I do model a long-term improvement in FCF margins into the mid-to-high teens, but I need to see more evidence of real progress (particularly on gross margins) before getting more bullish. That does still support low double-digit FCF growth, though, which is hardly bad.
I do also want to note that the odds of my year-by-year estimates proving accurate are almost nil beyond a few years out. The semiconductor and SPE businesses are still cyclical, but trying to predict the cycles is a fool’s errand, and I believe it makes more sense to focus on getting the longer-term trends right.
The Bottom Line
Discounting those cash flows back, TEL shares seem priced for a long-term return in the mid-single-digits, which is not all that appealing to me. Other valuation approaches (margin and return-driven EV/sales and price/book models) likewise don’t suggest compelling undervaluation.
Stocks like these rarely look cheap during cyclical upturns and the shares can go quite a bit higher. A quick look at the chart, though, will also tell you that buying in at the wrong price can lead to long stretches of underperformance. I won’t say that the SPE up-cycle is over or that these shares can’t go higher, but I won’t be chasing them with my own cash.
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