Semiconductor Equipment Manufacturers Slide Amid Supply Fears

Semiconductor equipment manufacturers are taking a hit today on negative commentary from a bullish analyst.

Evercore ISI analyst CJ Muse noted Lam Research (LRCX, Financial) – the manufacturer of semiconductor equipment for integrated circuit fabrication – is facing short-term headwinds as memory players are delaying equipment procurement, which is likely to affect the company's second and third-quarter results. Muse, however, expects the slump will be short-lived. The analyst holds a $300 price target on Lam Research, an upside of 60% over Thursday’s opening price.

According to Muse’s channel checks, Samsung (SSNLF, Financial) is pushing out the purchase of memory equipment amid delays in its NAND memory production, which means a 7% trim off Lam’s bottom line over the next couple of quarters. Other reports say there are delays in dynamic random-access memory (DRAM) production.

In response to the news, semiconductor equipment manufacturers tumbled on Thursday; Lam Research was down 6%, Applied Materials (AMAT, Financial) – the provider of transistor and interconnect fabrication tools – fell 3.23% and ASML Holding (ASML, Financial) – the extreme ultraviolet lithography specialist – slipped 2.4%. Memory players, including Micron (MU, Financial) and SK Hynix (HKSE:000660, Financial), were not affected.

Memory players are set to benefit from the trend

Despite strong demand in DRAM and NAND, the slowdown in Samsung's production indicates supply isn’t going out of control anytime soon. Prices will remain stable, or even rise, as a result of the decline in production. According to IC Insights, “The memory market is forecast to increase by a CAGR of 5.2% through 2022."

As only a few major players command most of the memory industry, a production delay from Samsung will reflect positively on NAND and DRAM prices, benefiting Micron and SK Hynix in the process.

Look out for regulatory scrutiny

Nonetheless, this will raise eyebrows in the regulatory community and can potentially lead to litigation as Samsung deliberately throttles production in a market that is set to witness double-digit growth. China has already launched a price probe to look into the possibility of foul play from Samsung, Micron and SK Hynix in DRAM pricing. In addition, Reuters reported Beijing is investigating price-fixing allegations amid a sharp rise in DRAM prices.

Law firm Hagens Berman also recently filed a price-fixing lawsuit against Samsung, Micron and SK Hynix in the U.S. The point is hesitation in production might add to price-fixing concerns, leading to hefty fines for memory giants.

The market is reading too much into Evercore commetary

It is worth mentioning that supply constraint headlines are purely based on the commentary of the Evercore analyst. Samsung is actually planning to increase capacity. The company recently announced it is planning to double its NAND memory output capacity in China by 2020; it is also planning to invest $7 billion over a three-year period to achieve this goal.

While it can be argued Samsung won’t aggressively reduce supply amid regulatory concerns, the company's initiative to increase its NAND capacity in China is one of the examples. Moreover, "new capacity for flash memory and, to a lesser extent for DRAM, should bring some relief from fast-rising ASPs [in 2019]”, noted IC Insights in a semiconductor spending forecast.Â

To review, memory players will benefit from the slowdown in NAND and DRAM supply, if any. However, regulatory scrutiny might increase in reaction, leading to fines.

Back to Lam Research

Lam's wafer fabrication equipment spend will remain on the softer side over the next year or so. Gartner expects the water fabrication expenditure to be around $40 billion in 2019, down 7.3% on a year-over-year basis, before registering 2% growth in 2020. Hence, the comments of the Evercore analyst are not completely out of line; the industry is set to slow down.

But the market reaction was uncalled for. Lam Research is expected to post earnings per share of $17.52, translating into a price-earnings ratio of 10.6 times 2018 earnings. Moreover, the market has already priced in the slowdown in equipment spending as earnings are expected to decline to $17.4 a share in 2019. As the stock declined approximately 7% on the analyst’s comment, it creates a decent buying opportunity.

Valuation also confirms there is a buying opportunity in Lam Research amid negative market sentiments. After adjusting for the 7% decline in earnings as a result of potential delay from Samsung, Lam Research is still trading at a discount, according to the economic-value-added approach.

The valuation reveals a price target of $223, which translates into an upside of around 20%. Note the valuation is based on the assumption that earnings will grow 2% per annum from 2020 to 2023. Gartner’s base forecast of 2% growth in wafer fabrication equipment spending is used as a proxy for earnings growth. However, analysts’ consensus for earnings growth stands at more than 20% per annum for the next five years. Based on analysts’ consensus, the stock is extremely undervalued.

Takeaways

The decline in wafer fabrication equipment expenditure, as forecasted by the Evercore analyst, will be short-lived at best. Samsung is set to increase NAND capacity in 2019. Gartner is also forecasting a supply-intensive 2019. In short, the long-run thesis for semiconductor manufacturers like Lam Research is intact.

Memory players might benefit from the short-term supply bottleneck created by Samsung, which can catalyze Micron’s stock price in the short run. However, supply is expected to stabilize or increase in 2019, pressuing DRAM and NAND prices along with Micron’s stock price. Moreover, reduction in NAND supply can also create regulatory issues for memory giants, at least for the time being.

Disclosure: I have no positions in any stocks mentioned and have no plans to initiate any positions within the next 72 hours.