These 5 Semiconductor Suppliers Are Undervalued – Morningstar.ca
When most people think about investing in semiconductor stocks, their usual focus is on big chip producers such as Nvidia (NVDA) and Intel (INTC).
But there is another way to play the latest trends in technology: the handful of major companies that supply semiconductor manufacturers with the tools and equipment they need to make the chips themselves. And with many of these stocks having fallen faster than the broader equity market this year, they offer investors a chance to pick up these names at their lowest valuations in over a decade.
When it comes to 5G, artificial intelligence, and cloud computing “semiconductors are essential for all of it,” Morningstar’s equity sector strategist for semiconductors and technology Abhinav Davuluri says.
“But we’re most excited about the stocks of companies that are supplying semiconductor companies with the materials for production,” Davuluri says. “Instead of having to worry about Nvidia vs. Intel winning a deal, we are focused on the ‘arms dealers’ in that battle. They profit regardless of who wins the final chip design.”
ASML, a global corporation specializing in photolithography machines used to make microchips, has fallen 40.1% this year as of June 17. The company is currently trading at about half of its fair value estimate price. The stock hasn’t been this undervalued at any point since Morningstar analysts began covering the company in 2004.
Microchip quality-assurance testing equipment producer Teradyne is down 45.4% this year, and chip component manufacturer Lam Research has plunged 41.3%, leaving each at valuations cheaper than any time since March 2009.
As equity markets fell into bear territory, semiconductor equipment suppliers were hit harder than most.
The Morningstar Global Semiconductor Equipment & Materials Index, a collection of companies that design, develop, manufacture and market equipment and tools for the industry, has tumbled 38.1% for the year as of June 17. That is more than the broader Morningstar US Technology Sector Index’s drop of 31.3%, and the equity market’s losses of 23.5% as measured by the Morningstar US Market Index.
As of June 15, 10 companies in the Morningstar Global Semiconductor Equipment & Materials Index are trading at five-star discount prices, and an additional 48 companies are close behind at four-star.
Overall, the microchip space is set to grow, and Morningstar analysts expect semiconductor suppliers to profit.
“Our view for the long term is very healthy. The semiconductor market itself is now worth about $600 billion, by 2030 it’s projected to be about $1 trillion,” Davuluri says.
On top of that, “It’s a highly concentrated market. Five major players account for over 70% of all semiconductor equipment spend.” Davuluri doesn’t see these competitive dynamics changing anytime soon.
“Customers will need to buy newer, more advanced tools,” he says. “They’ll always be upgrading to the next-generation technology. And the costs will continue to elevate because the industry is consolidated.”
Over the past five years, ASML rose 313.9%, KLA climbed 268.1%, Lam Research rose 230.7% and Teradyne gained 198%. Each company more than tripled the Morningstar U.S. Market’s rise of 65.9% for the same period. Applied Materials also saw returns of 140.3% over the past five years.
A closer look at the Morningstar Global Semiconductor Equipment & Materials Index reveals five high-quality, undervalued stocks with strong track records. All five companies have earned Morningstar’s wide Economic Moat designation, meaning their competitive advantages are strong enough to fend off competition and earn high returns on capital for more than 20 years into the future.
The companies on our list make up four of the five “key players” noted by Davuluri. The fifth is Teradyne, a company that makes highly-specialized equipment to test the semiconductors for quality, once they’re ready.
“We believe ASML (ASML) has a wide economic moat based on its intangible assets around equipment design expertise in addition to research and development cost advantages required to compete for the business of leading-edge chipmakers. As the leader in photolithography equipment, the company exhibits considerable scale and technological superiority relative to its competitors. Its technical expertise and large R&D budget (US$2 billion) serve as barriers to entry, but competitors do exist (Nikon and Canon), albeit in a substantially lesser capacity (ASML captured 89% share of the US$12.8 billion lithography stepper market in 2020, according to Gartner). We also believe that incumbent tool providers have intangible assets related to equipment design derived from service contracts and customer collaboration during process development and subsequent high-volume manufacturing. Taken together, these two sources of competitive advantage allow leading equipment firms to earn excess returns on invested capital over extended periods.
“Lithography tools account for a significant portion of chipmakers’ capital expenditures, with next-generation extreme ultraviolet, or EUV, platforms exceeding US$150 million each. ASML’s immersion lithography tools have allowed the company to capture and maintain its leadership position in the marketplace, while competitors like Nikon and Canon do not have the scale or resources to compete in EUV. In 2012, ASML’s top three customers, Intel, Samsung, and Taiwan Semiconductor, committed to help fund a portion of research and development for EUV technologies and acquired an aggregate 23% minority equity stake in ASML (though these stakes have come down in recent years).”
–Abhinav Davuluri, equity sector strategist
“We believe Applied Materials (AMAT) has a wide economic moat based on its intangible assets around wafer fabrication equipment design expertise and research and development, or R&D, cost advantages required to compete for the business of leading-edge manufacturers. These characteristics have allowed it to become the top vendor in the semiconductor equipment market. Applied’s scale and resources allow a research and development budget in excess of US$2 billion to serve cutting-edge technologies and thus benefit from inflections such as fin field-effect transistors, or FinFET, and 3D NAND. Advanced tools in deposition and etch have become critical for multiple patterning that enables leading-edge foundry and logic processes. As a result, these segments have grown faster than the broader market in recent years, and firms such as Applied have directly benefited, as it can outspend smaller chip equipment firms in research and development to develop more advanced solutions.
“When chipmakers operate numerous fabs around the world, maximizing throughput and reducing process variability across their fleet of tools are top priorities. We believe incumbent tool providers, such as Applied, also have intangible assets derived from service contracts and customer collaboration during process development and subsequent high-volume manufacturing. Field service engineers that are on-site at customer fabs help troubleshoot high-value problems to improve yields and output, ultimately driving productivity and reducing cost. We believe a positive feedback loop is subsequently created in which top equipment vendors leverage existing relationships and insights into future customer technology needs to ultimately design and offer superior equipment. Furthermore, the resultant virtuous cycle cannot easily be replicated by potential new entrants. Applied’s installed base of over 43,000 tools is the largest in the industry, which gives us added confidence in our wide moat rating.”
–Abhinav Davuluri, equity sector strategist
“We believe Lam Research (LRCX) has a wide economic moat, thanks to cost advantages and intangible assets. We view the scale and resources required to compete for the business of leading-edge manufacturers as major barriers to entry, with firms such as Lam boasting R&D cost advantages over smaller peers. We also believe that incumbent tool providers have intangible assets related to equipment design derived from service contracts and customer collaboration during process development and subsequent high-volume manufacturing. Taken together, these two sources of competitive advantage allow leading equipment firms to earn excess returns on invested capital over extended periods of time.
“Lam is the market leader in dry etch and a prominent player in the deposition segment of the wafer fab equipment, or WFE, industry. Deposition equipment applies thin-film layers to surfaces while etching selectively removes material. The combination of these two is critical during the chip fabrication process, along with photolithography, which produces the mask that exposes areas for materials to be deposited or removed. Lam provides customers with some of the most advanced tools in these segments, and its leadership position creates scale advantages that fuel research and development spending at levels only Applied Materials and Tokyo Electron can match. At the end of 2021, Lam had an installed base of 75,000 units, up from 40,000 in 2015. This large installed base creates stickiness that helps Lam maintain its leadership position in key process steps for chipmakers’ process flows. It also offers Lam an intimate look into problems faced by chipmakers, providing valuable information it can use to implement solutions and additional capabilities in future tools.”
–Abhinav Davuluri, equity sector strategist
“KLA (KLAC)’s wide economic moat emanates from its comprehensive tools and leading technical expertise that enable its products to be in every major chip-manufacturing facility in the world. The firm’s large research and development budget allows it to stay at the forefront of the process diagnostic and control (PDC) space, with over 50% market share and 4 times the market share of its closest competitor. Also, its database of defects encountered by customers and their respective solutions help chipmakers in troubleshooting endeavors. Through service contracts, customers indirectly have access to this database that can greatly accelerate the time it takes to solve issues in their process flow, thus reducing tool down time and improving yields. The more customers that take advantage of this access by anonymously submitting their own data to the collection, the greater the network effect that benefits all parties involved.
“We also view the growing service revenue component as stickier and less cyclical, which should help the firm better navigate cyclical troughs. Additionally, unlike smaller competitors like Onto Innovation, or the less specialized players such as ASML and Applied Materials, KLA is able to focus considerable resources on aiding semiconductor manufacturers with yield management and metrology issues they experience.”
–Abhinav Davuluri, equity sector strategist
“We assign Teradyne (TER) a wide economic moat rating based on a combination of intangible assets in semiconductor automated test equipment (ATE) and switching costs created at chipmaking customers. We think Teradyne’s proficiency, which has led to a leading market share in ATE, will enable the firm to earn impressive returns on invested capital that will continue for the next 20 years.
“Teradyne’s automated test equipment for semiconductors (71% of 2021 sales) drives our wide moat rating, and we observe similar competitive dynamics at wide-moat-rated wafer fabrication equipment leaders under our coverage. Teradyne’s test equipment is highly capital-intensive and serves a relatively concentrated number of chipmaking customers.
“In our opinion, Teradyne’s ability to design testing equipment for bleeding-edge chips is the biggest driver of its competitive advantage, representing intangible assets that we don’t think are easily replicable. Teradyne provides testing solutions for nearly every semiconductor on the planet during production, both at the wafer level and final device package level.”
–William Kerwin, equity analyst
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