- LRCX continues to consolidate after a big run.
- Its leverage to rising WFE spending is a big positive.
- Revenue and margins continue to grow, and the valuation is quite attractive.
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Semiconductor stocks are notoriously volatile, owed to their typically high valuations and cyclical nature. However, that creates opportunities to build positions over time, provided you can stomach the price swings. The key is to find a strong stock in the group that is more insulated from the inevitable swings in demand, and one such stock is Lam Research (NASDAQ:LRCX).
Lam designs, manufactures, refurbishes, services, and distributes semiconductor processing equipment that is used to make integrated circuits. Lam is, in other words, making the picks and shovels in the gold rush that is semiconductor manufacturing. The company is therefore uniquely positioned to take advantage of ever-rising semiconductor sales essentially irrespective of who is actually selling them. So long as long-term demand for chips remains high, Lam stands to benefit.
The stock made its all-time high in May, which also formed a double top at the time. Shares have spent several months consolidating since then, with the bottom of the channel at roughly $555, and the top at the ATH of $670. This consolidation has been very long if you’re holding, but rectangular consolidations like this that follow a massive run higher generally result in upside break outs. When that may happen is anyone’s guess, but I still think that patient holders will be rewarded with an upside break out and a new ATH. That said, if we see the stock fall out of the channel to the downside, all bets are off.
For one feather in the cap of the bulls, Lam’s accumulation/distribution line has remained outstanding during this entire consolidation. It has positively diverged from price action, meaning buyers are continuing to buy dips, which is generally supportive of bullish price action.
Momentum has been uninspiring for Lam for many months, but given we’re in a rectangular consolidation, that’s not surprising. On the plus side, there’s a positive divergence forming right now on the PPO as it has moved meaningfully higher while the stock consolidates. That can often be a sign that the selling pressure is abating, and given we’re at the bottom of the channel, that certainly could mean a bounce is coming.
The bottom line on the chart is that the current setup is heavily skewed towards the bulls from a risk/reward perspective. Downside is about 3% to the bottom of the channel, while upside could be more like 17% to the top of the channel. That doesn’t even include an upside break out, so if you’re into asymmetrical risk/reward setups, Lam is worth a look today.
Industry tailwinds abound for Lam Research
Lam is driving growth opportunities, not only because it is in the right place at the right time with industry tailwinds, but because it has done the work necessary to compete and win within that growing industry spending.
Source: Investor presentation
Lam has greatly diversified its revenue mix over the years, with memory making up about 60% of total revenue, and the vast majority of that in non-volatile memory; the balance is in DRAM. Foundry revenue is ~35%, and the remainder is in its other, very small categories. The point being that Lam isn’t reliant upon a particular segment of the industry succeeding, or certainly, a particular customer. In a segment that is known as seeing volatile results, Lam offers a bit more diversification, and therefore, predictability.
The company’s most recent quarter showed very strong revenue gains once again, and why not? Lam has continued to see strong growth from services and upgrades, as well as spares contracts with very long tails. In other words, similar to a construction equipment manufacturer, Lam not only gets a sale upfront, but can continue to pull in revenue from its customer base for years to come when things break or upgrades are needed.
The semiconductor industry is incredibly complex and becoming more so all the time, but Lam has made the necessary R&D investments to remain relevant, and I believe will continue to do so for the foreseeable future.
This is a look at fab equipment spending, which is what Lam is trying to capture. Forecasts for this year are now actually over the $80 billion mark, as they’ve risen throughout the year. But the point is that we can see just five years ago, total spending was half what it is today, and should be even higher next year. Given the burgeoning demand for chips, it would stand to reason equipment spending should continue to soar in the years to come, driving demand for Lam and its competitors. This is an ideal situation where a company has strong products in a sector that is seeing ever-higher demand.
Perhaps that’s why revenue estimates are so bullish.
Source: Seeking Alpha
We can see revenue estimates have soared in the past few quarters, with this year’s $17.7 billion estimate up from just $11.8 billion two years ago. That is an enormous amount of growth for that period of time, and surely a big reason why Lam shares have flown higher. I expect to continue to see higher and higher revenue estimates in the coming quarters given demand for semi equipment continues to rise, and that Lam continues to invest to make sure it is capturing its fair share of that rising demand.
Another point to consider is that as Lam captures more and more revenue, its operating margins move higher due to costs being leveraged down by volumes. This is a look at trailing-twelve-months revenue and operating margins to illustrate that point.
Operating leverage works both ways, of course, but we’re very clearly in the midst of an upcycle for both revenue and margins. This growth in margins means profit growth will almost certainly outpace revenue growth, which is great for EPS.
In addition, rising revenue and margins mean that Lam is in a position to have ample free cash flow, the components of which we can see below.
The most recent TTM period has Lam cresting $3 billion in FCF, which is money it can use to invest in R&D, keep for acquisitions, or buy back its own shares.
Lam was once a major buyer of its own shares, but the pace slowed down in 2020. Repurchases are creeping back into the fold, and I expect we’ll see the share count decline more as we move into next year and beyond. That juices EPS growth as we have a virtuous combination of higher revenue, higher margins, and a lower share count all contributing to earnings gains.
Lam is set to report earnings on October 20th, which is only a couple of weeks away. You’ll get a preview of what Wall Street thinks heading into the report by the way the stock behaves in the next couple of weeks. My sense is that we’ll see at least a small rally given we’re near the bottom of the channel today, and that guidance for the quarter was quite bullish.
Source: Investor presentation
Admittedly, these ranges are large so it isn’t like we have a prescription we can follow. For example, EPS’ implied range is $7.60 to $8.60, which is a massive range. That variability is something investors don’t like, but like I said, semi companies tend to see large swings in revenue and profits, so it is just something you have to live with if you’re going to invest in this space.
Source: Seeking Alpha
We can see that expectations remain high for Lam as EPS estimates continue to rise. This is an extremely bullish chart and has all the things you want to see from a buyer’s perspective; there’s plenty of up-and-to-the-right action, as well as ample white space between the years, indicating not only upward revisions, but year-over-year growth.
A favorable valuation for LRCX to boot
Lam isn’t just likely to post strong EPS for the foreseeable future, but the valuation has come well off its highs and to my eyes, is a bargain. The consolidation that has been taking place for several months – all while EPS estimates continue to rise – has created a situation where Lam looks downright cheap.
Shares go for just 16.7X forward earnings, which is average for the past three years. But keep in mind that three years ago, semi stocks were also-rans in the market as the current boom hadn’t yet been recognized in valuations. Lam traded for 26X forward earnings a few months ago, and while I don’t expect to necessarily see that anytime soon, a median valuation for a company with revenue, margins and buybacks all pushing EPS higher – along with strong industry tailwinds – simply isn’t enough.
The bottom line is that Lam is leveraged to an ever-expanding semi market, it has rising revenue and margins, is buying back its own stock, and trades for a below-market earnings multiple. We have to watch the bottom of the channel but absent a break down there, I see Lam eventually breaking out to the upside and rallying to new all-time highs once again. The time frame on this one is up for grabs, but it is difficult not to be bullish on Lam today.
This article was written by
Josh Arnold has been covering financial markets for a decade, utilizing a combination of technical and fundamental analysis to identify potential winners early on in their growth cycles. Josh's focus is mainly on growth stocks. His goal is efficient and profitable use of capital, which overly rigid buy-and-hold strategies do not allow.Josh is the leader of the investing group Timely Trader where he focuses on limiting risk and maximizing potential reward. Features of Timely Trader include: real-time alerts, a model portfolio, technical charts, sentiment indicators, and sector analysis to find the best trading opportunities. Learn more.
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