Wall Street often asserts that there's a new paradigm in a sector only to be proven wrong. Albeit, when it comes to semiconductor capital equipment the cyclical boom and bust cycles may be a thing of the past. The companies that provide the machinery to manufacture ever more sophisticated circuitry in chips are now growth stocks rather than the traditionally perceived cyclicals of the past.
Wednesday, in a decidedly bullish analysis, Jefferies identified a "tectonic shift to growth plus expanding P/E" for the group. They initiated "buy" recommendations with price targets 20-25% above the current market for KLA (KLAC) , Lam Research (LRCX) , and Applied Materials (AMAT) .
Jefferies posits that the old cyclical semi-cap equipment cycle that has occurred since the 1990s ended in 2015. Since this inflection point in 2015, the industry has compounded at 12% through 2020; now it's set to grow even faster with visibility out to 2025. The stock valuation of the industry leaders lags the market multiple by 10%. Jefferies asserts that the opportunity is for the earnings to grow faster than Wall Street currently expects, along with higher multiples reached as a growth multiple overtakes a cyclical one.
The firm notes several factors that have altered the chip manufacturing industry. Since 2015, chip manufacturing has grown increasingly complex, with process steps accelerating to 27% per node from a previous 5%. The tens of billions of IoT devices coupled w/ years of under-investment in trailing nodes have lead to catch-up build-outs. Plus, datacenter processors have doubled in size, requiring 3x the wafers.
The semiconductor sector is critical to the manufacturing sector and is powering a technology revolution. Computing power is at the heart of autonomous driving, cloud computing datacenters, and the metaverse. Governments are funding incentives and subsidies for semiconductor fabrication, eager to ensure supply control over the building blocks of this technology.
Capital of $80 billion annually has been allocated to CapEx, led by China, South Korea, and the United States. A desire to diversify away from production in Taiwan figures into the mix. In response, the largest semiconductor companies have announced CapEx plans amounting to over $110 billion/year.
Supply constraints led to a push out in demand for capital equipment in 2021 and the shortage of chips will extend well into this year. This gives Wall Street confidence in a robust year ahead.
As part of Jefferies' thesis of multiple expansion, they note service revenues are becoming a larger portion of semi cap revenues. The more predictable earnings stream and lower volatility of the business should reflect in a higher P/E. Double-digit service growth is expected in KLA, Lam Research and Applied Materials through 2023, approaching 25% or higher of revenues.
The capital equipment leaders are producing sizable cash flow after years of industry consolidation. Buybacks amounting to 2-4% of outstanding shares are expected this year. In recent earnings calls and conferences, management of these companies seem assured that over-ordering of semiconductors is not a factor in this demand cycle.
These three semi-cap equipment makers -- KLAC, LRCX, and AMAT -- can be bought on tech weakness with confidence that business visibility is high, demand is robust, and valuations are reasonable.
(Applied Materials is a holding in the Action Alerts PLUS member club. Want to be alerted before AAP buys or sells AMAT? Learn more now.)
