- VAT Group's second-quarter earnings exceeded expectations, with a 14% beat on the order line as fabs and semiconductor companies scramble to add capacity and reduce record lead times.
- Not only are fabs scrambling to add chip capacity but leading-edge designs also require even more high-vacuum steps, driving even more sales for VAT Group's core products.
- Keeping up with demand could be a more significant near-term challenge, with supply chain and labor limitations and the need to add more capacity sooner than expected (2022).
- Valuation arguments are pretty much moot now with high-end semi capex plays like VAT Group, but embedded expectations are not at all conservative.
When it comes to evaluating the performance of Swiss semi capex component maker VAT Group (OTCPK:VACNY) (VACN.S) since my last update, the closest I can come to criticism is that a very few stocks (like Applied Materials (AMAT) have done better, but the roughly 100% increase in the share price has nevertheless been way more than I expected back in October of 2020.
VAT Group has continued to see strong order inflow for its vacuum valves, and the biggest near-term challenge for the company is likely to be keeping up with demand. Adding too much capacity in the good times has long been an issue in the semiconductor space, and a source of cyclical volatility for the equipment makers, but this cycle could be different. Fabs are scrambling to add capacity, but equipment vendors can only do what they can do, pushing some demand off into 2022. Beyond that, new sources of demand like autos and IoT and more intense production processes (requiring more tools/equipment at each step) could drive better long-term growth with less cyclicality than in the past.
Much as I have liked VAT Group for some time, I didn't expect this blazing run over the past 10 months, and I'm not going to pout and take an Eeyore-like stance that the market is just being unreasonable. That said, a forward revenue multiple of around 10.5x on FY'22 revenue isn't exactly conservative (about a 12% discount to ASML (ASML), and neither are the revenue, EBITDA, or FCF growth expectations built into the share price now.
From Strength To Strength As Fabs Scramble To Catch Up
It's no secret that underinvestment in capacity during the pandemic and exceptionally strong demand coming out of the pandemic has led to soaring lead-times across the semiconductor sector, leading many fabs and semiconductor companies scrambling to add capacity and meet this demand. That, in turn, has driven exceptional demand for VAT Group's vacuum valves.
VAT Group is due to report its final second quarter / first half results on August 5, but the company has already previewed the quarter and management's initial comments usually match up to final results pretty closely.
Revenue rose 29% year over year and 17% quarter over quarter in the second quarter, and valves for the semiconductor industry are going to be the overwhelming driver of that growth. Not only is demand for equipment very strong, advanced chips require more high-vacuum steps, leading to more vacuum valve sales across the production process. In other words, VAT Group is benefiting not only from increasing investment in overall chip production capacity (# of chips), but also increasingly vacuum-intense processes (more valves require to produce a given # of chips) that are leading to 25% to 30% more equipment at a given production step.
Better still, orders were up 43% yoy and 5% qoq, and again I expect this to be overwhelmingly driven by orders from semiconductor customers. That order figure was a 14% beat to sell-side expectations, and works out to a book-to-bill of 1.13x.
A "Good Problem" Is Still A Problem
Given the recent commentary and outlook from equipment companies like ASML, Lam Research (LRCX), and Tokyo Electron (OTCPK:TOELY), there's really no sign of flagging momentum in the short term. Moreover, the commentary from major fabs like TSMC (TSM) and Samsung has remained very constructive for the group, and I think there's a plausible argument that VAT Group could see double-digit growth for some time as orders are pushed into 2022 and at least some semiconductor companies try to get ahead of the curve.
In the near term, that does create some challenges for VAT Group. First, management is already have some labor challenges at its Malaysia facility, and staffing and supply chain challenges may crimp growth to some extent in the short term.
Second, these high order levels are cutting into the 20%-25% capacity buffer that management likes to maintain so that it can respond quickly to high-volume orders from its core clients. VAT Group currently has capacity to support around CHF 1.2B in revenue, but include that buffer and VAT Group is already going to be short on capacity in 2022 relative to its targeted level. This is going to drive earlier reinvestment in capacity than expected, and management would prefer to expand in Malaysia if it can.
I'm not concerned about the capex/FCF impact of capacity additions; companies like VAT Group don't really trade on FCF and certainly not in the up-cycles. Likewise, the company can easily afford to reinvest in the business. My concern is more about whether the company can scale up when, where, and to the extent it wants to given those supply chain and labor challenges. Those issues should resolve over time, but I don't know if "over time" falls into the time frame in which VAT Group needs to add that capacity.
These are very good days for this well-run company. The company continues to build share in its core semiconductor valve market (around 70% now), and rivals like CKD (6407.T) and MKS Instruments (MKSI) don't really seem to be mounting a serious near-term challenge to VAT's business. On top of that, VAT's share is even higher in more vacuum-intense applications and the company has maintained a strong focus on working with clients on customized products.
In the near term, I have no concerns about semi capex demand, and demand for solar cell production is likewise strong. While display is a weaker market for VAT Group right now, and that's normally a 20% or so contributor to revenue, I believe demand there will improve in 2022 and beyond.
I've raised my estimates, including five-year revenue growth of more than 15% and long-term revenue growth of more than 10%, but even with ongoing margin/FCF leverage improvements to 25% FCF margins, this isn't enough to keep pace with the shares. As I said, FCF-based modeling really doesn't help with stockpicking in semi capex during upswings, but I do still find it a useful tool for gauging where embedded expectations appear to be.
The Bottom Line
I don't think anybody's going to argue that 10.5x '22 revenue is a low multiple for the stock, but VAT Group has continued to execute well on levels of demand that have far exceeded what was expected a year or so ago. I can get comfortable to a point with the "stronger for longer" bull call here, but it's tough to model a scenario where there's still upside from the growth expectations already built into the share price. Those who own these shares aren't likely to be dissuaded by valuation concerns now, but I would suggest that the appeal of these shares in the short term is largely just as a vehicle to play even more momentum in near-term semi capex trends.
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