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Introduction
Despite the huge size of the semiconductor market, the industry is still cyclical as evident in lackluster growth in 2022 across the board. However, one area of the market is insulated against the more consumer-facing cyclicality: the semi equipment makers. Despite valuations falling in this sector, financial performance remains strong. Tokyo Electron (OTCPK:TOELY) is one of the leaders in this segment and my choice for sector exposure.
This is for a variety of reasons, and I have discussed the company in depth in a prior article. This article will revisit the key points, and discuss recent indications that mark an opportune time to continue adding shares, despite TOELY rising almost 50% over the past 3 months.
Tokyo Electron Annual Report
Going With A Leader
Rather than speculating on the success of more volatile and speculative semiconductor industry investments, I rather gain exposure through a leader in the Semi Equipment sector. By focusing on a diversified, $50 billion company, I negate risk through the sale of essential components, a moat on those essential products, and general diversification. For Tokyo Electron, or TEL, they are the most diverse manufacturer of semi production equipment. In fact, TEL components are used by ASML to complete their EUV process. Refer to this fact sheet for more on the various steps and processes to make chips. When times are rough, the stalwarts will continue to have sales while innovative, luxury, or unessential companies will face drawdowns.
Tokyo Electron Annual Report
In fact, recent earnings suggests that leading equipment makers are faring well even when consumer and niche peers face sharp declines in revenues. Below, I highlight earnings reports from the past two days from Lam Research (LRCX), ASML Holding (ASML), KLA Corp (KLAC), and Teradyne (TER). The closest peers, Lam, KLAC, and ASML, beat expectations and provided positive growth of 24.8-28.5%.
Meanwhile, niche test equipment maker Teradyne beat expectations, but is still in a sector where growth is negative by over 15%. Then, don’t even get started with the poor earnings from Intel (INTC), with growth falling 28% YoY (a big miss). Although, it is important to note that Intel is still investing significantly in capacity expansions, so Intel's losses are partly going to the well-performing equipment makers.
Compiled by Author. Source: Seeking Alpha Tokyo Electron Fact Sheet
While consumer electronics sales are flushing down the drain, equipment makers are growing as foundries move from China and Taiwan to the US, Japan, and Europe. Issues with Chinese sanctions will always be present, but most issues are focused on only the most advanced logic chips. TEL does have a high proportion of sales to China, but I am sure management is addressing any potential sanctions. As of the last quarter, it seems that China sales have increased rapidly, and this may be in anticipation of any blockages, or a sign that TEL sales will continue despite the geopolitics. We can also see the country is attempting to reopen, and despite the ravages of COVID, should begin to drive economic growth again.
TEL’s saving grace is that their operations are globally diverse, despite the 28% share of revenues from China. The sales mix is also important to consider, as TEL has a strong service and refurbishing unit that can supply older generation equipment that may not fall under trade bans. Also, the majority of the workforce remains in Japan, a clear US-EU ally and operations should not be affected by politics. However, I will look to take advantage of any valuation weakness that arises due to the lack of cooperation of the world’s superpowers. We all know that cooperation is essential and will rise again. Then, with foundries moving away from China and Taiwan, I believe the sales mix will shift favorably to North America, Europe, and Japan.
Tokyo Electron Annual Report Tokyo Electron Investor Presentation
Financials
An investment in semiconductors usually falls in two categories, a speculative bet on a new technology, or a bet on a bull cycle lifting up stalwarts. Neither of these are favorable for buy-and-hold investors. This is because of the inherent cyclicality of the chip commodity. Essentially, these companies are just as cyclical as miners like Rio Tinto (RIO) or Steel makers like Nucor (NUE). If investors can handle the cyclicality of earnings and either invest on a recurring basis or trade the cycles, the returns are still strong thanks to the secular demand for better chips.
With the rising of interest rates in 2022, and coming off a strong bull cycle after the great recession, it is clear that a cool down is necessary. We can already see that most industry constituents are down over 50% over the past year or two, and this trend may continue. Thankfully as I have discussed, equipment makers are one of the insulated sectors that offer higher safety. There is still cyclicality though, and for Tokyo Electron, the downside has yet to occur. Instead, momentum of high growth from 2020-22 continues, and recent earnings by peers supports continued momentum.
Tokyo Electron Investor Presentation
Looking at the historical revenue trends, cyclicality is present. In fact, timing was extremely important as quarterly sales during the great recession fell by two-thirds. Then, they rebounded fast, within a few years, but fell again afterwards. The early 2010s were also a weak period for the semi industry, with stagnant growth until 2016. Then, growth took off for a few years before falling sharply before the pandemic. Then, the last three years have been excellent for the industry. I believe that the cyclicality is over as chips have become embedded further and further into society, especially with data centers supporting the thousands of cloud ecosystems, but consumer facing industries are already in a steep bear market.
For TEL, I believe in the company’s ability to drive growth thanks to their market leadership in innovative, high demand logic chip production, rather than commodity memory and analog chips, but investors must be willing to accept continued downward momentum. Especially in regards to the company's valuation. But, this also means that equipment makers may take a few years before going into a bear market based on: foundries moving to different countries, expanding production in established facilities, and focusing on innovative new designs to keep up with competition (continued investments in EUV, etc).
Koyfin
One aspect of TEOLY is that earnings have performed well over the past 10 years, despite some cyclicality. The revenue drawdown in 2016 and 2019 did not lead to a fall in margins. This suggests that even if revenues fall over the next few years, TEL will still maintain profits. This will reduce downside risk due to insolvency or other financial risks and uncertainty. Perhaps semi industry bulls are correct in the fact that there will be reduced cyclicality in the industry, and equipment makers are just the first to reflect long-term stability of their margins. We just need revenues to remain strong in order to drive meaningful forward momentum, although the risk remains.
Koyfin
Balance Sheet
For now, things seem stable for Tokyo Electron, and a strong balance sheet supports current investors in case the market continues to sour. The company has no debt, and over $3 billion in cash to support operations. However, yearly free cash flows are almost always positive, even in weak market conditions, and investors should not expect losses to accumulate. Upon the resumption of more favorable market conditions, it is likely that TEL will continue buybacks, R&D, and support their higher dividend than peers as a sign of leadership over the sector.
Koyfin
Valuation
Despite the continued financial success, semi industry weakness has led to Tokyo Electron’s valuation falling over the past year or so. I suppose this brings the company back to more realistic valuations, but certainly under-appreciates the strong momentum. One can also consider that foreign exchange influences such as the weak yen and strong dollar continue to support the current valuation. At any rate, investing now at 1-2 year low valuations is favorable in my eyes.
I think it will be important for investors to not get hung up on historical valuation levels, particularly low points in the past, as the company was far more risky then. With increased market leadership, low financial risk, and strong profit generation, TOELY deserves a higher valuation. Therefore, look to the low P/E and EV/EBITDA as a positive signal, rather than the elevated P/S.
Koyfin
Semi Industry Conditions
There is also the factor of the current outlook for the semi industry. While consumer industries are facing declining demand (smartphones, consumer electronics, computers, etc), demand in applications in automotive, industrial, and data center applications remains elevated. To determine the health of the industry, I use data provided by silicon wafer provider Sumco (OTCPK:SUOPY), as discussed in a prior article. As of the last earnings report in November, data continues to look favorable for equipment makers like TOELY as demand is elevated and inventories are low. As per the press release:
During the third quarter of fiscal year 2022 (July 1, 2022–September 30, 2022), the market for 300 mm semiconductor silicon wafers continued to see strong demand, exceeding supply capacity, for both logic and memory applications, driven by expanding data center needs and growth in automotive use.
In the market for 200 mm wafers as well, full production continued, to meet strong demand for automotive and industrial uses. As for wafers of 150 mm and smaller, supply-demand tightness eased, as a correction phase began mainly for consumer use.
Sumco Investor Presentation
This sentiment is also corroborated by outlook data that suggest differing industry demand, consumers vs data centers and industry IoT, will help stabilize this current market weakness. This means that foundries will continue seeking to expand production to meet demand, especially in markets that favor TEL, such as advanced logic chips. It is also important to note, both the wafer demand and inventory data trends indicate that the current period is similar to 2018-19, and this was clearly a great buy point for Tokyo Electron.
If advanced chips and secular growth markets can tamper the drawdown in consumer electronics, the current valuation is favorable for investors. And, it will be quite contrarian in terms of an investment as most investors look at weak consumer sales only, rather than B2B. Once both groups are bullish in tandem, we will once again see great returns.
Looking at the fourth quarter outlook for the 300 mm semiconductor silicon wafer market, production adjustments have begun due to softening of demand in the PC and smartphone end-product markets, whereas strong demand is continuing for automotive and data center needs. As a result, while we may see higher or lower orders depending on the customer, full production is expected to continue. Full production is forecast to continue also in the 200 mm wafer market, as automotive and industrial needs remain solid. On the other hand, for wafers of 150 mm and smaller, a correction phase is expected to continue, mainly for consumer needs.
Sumco Investor Presentation
Conclusion
My analysis suggests that semiconductor production equipment companies like Tokyo Electron are well suited as investments as performance will be far greater than more cyclical industry peers. With a pattern of historical success, tons of lingering demand for data center and IoT applications, and geopolitics leading to the establishment of more foundries around the world, I believe that a bullish investment set up is occurring. Investors will still need revenues to maintain positive momentum, but temporary weakness is always an opportunity. Therefore, I recommend investments continue on a recurring basis. Then, look for factors such as a stronger global economy than anticipated, a weakening USD compared to the Yen, and the continued beating of expectations to provide additional upside. For long-term investors, the opportunity is ripe.
Thanks for reading.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
