To recap, Lam Research is a global leader in the semiconductor manufacturing equipment and processing industry, specifically in wafer fabrication equipment. The company supplies equipment used in the process steps of etch, deposition and cleaning and provides equipment for a broad variety of manufacturing and testing capabilities. The company’s core specialty markets include Dielectric and Metals, ALD/PECVD, Etch and Wet Clean.
Before we continue with the analysis on Lam itself, it’s worth diving into some near-term tailwinds that will drive increased spending in the industry as a whole.
One trend that’s been gaining traction recently is silicon reshoring. Between pandemic-induced supply chain disruptions and the ongoing Russia-Ukraine war, governments around the world are now increasingly focused on deglobalizing and building semiconductor manufacturing capabilities within their borders. This “reshoring” to regain control of a critical competency should support wafer fab equipment (WFE) spending and potentially offset some of the decline as the current cycle rolls over.
The U.S. has a low double-digit market share in semiconductor manufacturing today, compared to more than a third in the 1990s. Taiwan Semiconductor Manufacturing Company (TSM, Financial) has a dominant 50-55% share in global foundries and is a near monopoly in leading-node manufacturing. More governmental subsidies and funding through legislation, such as the CHIPS for America Act or FABS Act, can support wafer fab equipment even in a downturn.
What Lam does differently
With impending market tailwinds, Lam Research is better positioned than most to take advantage. Lam's manufacturing operations mainly consist of assembling and testing components, sub-assemblies and modules that are then integrated into finished systems prior to shipment to or at the location of their customers. The assembly and testing of their products are conducted predominantly in clean room environments on site, and the company has agreements with third parties to outsource much of their manufacturing, production warehousing and logistics functions.
This outsourcing model allows for Lam to shift the burden of manufacturing and other non-core functions to their outsourcing partners. This protects them from cyclical scaling issues and the inherent volatility that’s part and parcel of the semiconductor industry.
The outsourcing model isn’t free of long-term risk. Outsourcing increases the relative bargaining power of their suppliers (outsourcing partners) and poses a potential future risk.
In the present, Lam Research maintains a competitive edge in its services provided. This is best illustrated by the fact that Lam serves all the world’s leading semiconductor manufacturers, as they operate as sole providers of equipment in their niche.
The company derives a particular competitive advantage in its equipment for atomic layer deposition (ALD). Lam’s Sense.i ALD system allows for industry-leading efficiency and accuracy in atomic layer deposition, helping maintain Lam’s leadership position in the market.
This niche is not permanently secure, however. In the future, Lam expects its competitors to continue to improve the design and performance of their current products and processes and introduce new products and processes with enhanced price and performance characteristics. The possibility of competing services rendering Lam’s offerings obsolete drives competition and poses a risk for the company. As such, Lam’s most important competitive advantage remains the continued and timely development of new products and ongoing enhancements to its existing product line.
In the last five years, Lam’s R&D spending has been between 10% and 12% of revenue. The company’s large size and industry expertise allows for efficiency and greater expenditures in research and development, allowing the company to defend its leadership position and keep its products and services ahead of the competitive curve.
Increasing recurring revenue
The company’s revenue segments include Systems and Customer Support Business Group.
Systems includes the sale of leading-node equipment in etch (conductor, dielectric, through-silicon via), deposition (metal, dielectric) and clean (wet clean, dry plasma clean) process steps of semiconductor fabrication. In 2021, Systems revenue grew 47% year-over-year and comprised roughly 67% of total revenue.
Customer Support Business Group is an annuity-like revenue stream rising from increased utilization of the installed base. CSBG includes spares, customer service, technology and productivity upgrades and a specialty product line for new and refurbished lagging-node equipment. In 2021, CSBG revenue grew 42% year-over-year and comprised the remaining 33% of total revenue. With CSBG service revenue being a recurring revenue stream, the company’s financials have become increasingly resilient over time.
With a market capitalization of $59 billion and a price-earnings ratio of 13.35, Lam is well positioned for growth at the forefront of a growing industry. It employs modest leverage, enjoys high returns on incremental invested capital and does not dilute its equity. Overall, my intrinsic valuation estimate is $650 to $700 for the stock, representing upside potential of 64% in relation to its current price of around $427 per share
In the context of a volatile market with seemingly no bottom, investors should stress their models for different scenarios given macro uncertainty and semiconductor supply chain issues. Lam traded at a price-earnings ratio as low as 8 January 2019. Given a fundamentally more resilient business model with increased focus on wafer fabrication equipment, along with higher recurring revenue, I believe a price-earnings ratio of 12.5 is a reasonable worst case for valuation, while my worst case earnings per share estimate is $31 for 2023.
At current levels, a $680 price target (price-earnings ratio of 15.5 combined with my 2023 EPS estimate of $31) could support an attractive asymmetric reward/risk set up with ~80% upside vs. ~20% downside.