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Leading Independent Investment Research

Morningstar, Inc.

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Thematic (Sector/Industry)

<div class="content-highlight"><h2>Electronic Materials: Soaring Growth, Looming Consolidation, and New Investment Vehicles</h2></div><hr><p>Investors are instinctively on the hunt for well-run companies in under-researched sectors that generate rapid organic growth, possess economic moats, and are poised to benefit from secular trends. We believe the electronic materials industry fulfills these criteria. The EM sector provides the gas mixtures, chemical formulations, specialty materials, delivery equipment, and packaging and handling solutions that facilitate leading-edge semiconductors and other micro-electronics underlying the proliferation of mobile devices, laptops, cloud computing, and the Internet of Things. EM growth is sprinting along at double-digit rates, riding the powerful waves of twin macroeconomic drivers. The first is rising investment in data-rich endeavors such as mobile devices, cloud computing, industrial automation and control, and artificial intelligence. The second driver is the fact that most current and future generation design and manufacturing innovations facilitating advances in miniaturization, chip performance, reliability, and productivity characterized by Moore's law are now inherently more materials-intensive than previous iterations. We think these forces are highly likely to remain in force indefinitely. Consequently, our view is that EM growth will structurally exceed that of the underlying chip industry by a meaningful margin. From an investor's perspective, the creation and emergence of several new pure-play companies leads us to expect that the EM industry's heretofore low profile, a legacy of operating mostly as small units buried deep within much larger companies, is approaching an end.</p><p>The protagonist in the Jon Krakauer book <em>Into the Wild</em> unknowingly seals his demise when he crosses a low Alaskan river one sunny spring day to embark on a wilderness expedition, only to find a couple of months later that the thaw had converted the same narrow river into an impassible torrent, fatally preventing his return. Analogously, today's robust demand environment for electronic materials may obscure the rising competitive risks that most narrowly focused or niche suppliers will face once demand stabilizes and their powerful customer base becomes more concentrated, demanding, and selective. We believe the fragmented sector will ultimately consolidate down to a handful of broad-based suppliers possessing technological advantages, product breadth, global presence, and research and development and technical support with the ability to leverage strong relationships to squeeze out narrower or less committed rivals.</p><p>Equity investors attracted to the rapid organic growth, technological innovation, global presence, and healthy margins that EMs currently enjoy are limited to a handful of small- to mid-cap stocks with somewhat varied track records. However, competitive dynamics and healthy valuations are the catalysts driving the creation of new investment options via consolidation, mergers, and spin-outs. Industrial logic and financial incentives underlie this motivation. Large sophisticated chipmakers increasingly seek highly committed solutions providers as partners to collaborate with on their next-generation designs, an imperative that may not align with the resource allocation priorities of large, diversified companies whose EM activities comprise a small part of overall sales and strategic investment. Semiconductor equipment manufacturers likewise seek collaborators that offer the needed expertise, technical support, and responsiveness to streamline the next wave of innovation in production equipment and process techniques. Within the next year, the looming demerger of <strong><a href="https://www.smartkarma.com/entities/26784" target="_blank" data-smartkarma-citation="entities:26784:1">DowDuPont Inc (DWDP US)</a></strong> into three or more publicly traded companies will cause both current holders and potential new investors to evaluate the investment potential of a new electronic materials industry leader with large-cap equity potential.</p><hr><div class="content-highlight"><h2>Key Takeaways</h2></div><hr><ul><li>Electronic materials suppliers such as <strong><a href="https://www.smartkarma.com/entities/26484" target="_blank" data-smartkarma-citation="entities:26484:1">Versum Materials Inc (VSM US)</a></strong>, <strong><a href="https://www.smartkarma.com/entities/12493" target="_blank" data-smartkarma-citation="entities:12493:1">Entegris Inc (ENTG US)</a></strong>, <strong><a href="https://www.smartkarma.com/entities/20280" target="_blank" data-smartkarma-citation="entities:20280:1">Cabot Microelectronics Corp (CCMP US)</a></strong>, <strong><a href="https://www.smartkarma.com/entities/26784" target="_blank" data-smartkarma-citation="entities:26784:1">DowDuPont Inc (DWDP US)</a></strong>, and others are enjoying robust growth and widening valuations due to rising chip production, as well as technology transitions that require more intensive use of their products and services.</li><li>The $50 billion in revenue EM industry sits at the intersection of two oft-competing imperatives. One is to continually innovate to boost chip performance, while the other is to steadily reduce customers' production costs. While performance gains result from rising investment and development spending for novel techniques, new materials, and tailored processes, production efficiency often rises with standardization, process optimization, supplier and customer consolidation, and tightly linked regional supply chains. One common theme among EMs is ever-closer collaboration with their major customers.</li><li>Sturdy narrow economic moats are built upon the high returns, sizable patent estates, and history of successful collaboration with key customers. A lengthy and expensive product qualification process raises switching costs and deters new entrants. While ROICs are becoming rather gaudy with soaring demand and naturally low capital intensity, it is their structural dependence on serving large, powerful customers in consolidating sectors that comprises the major stumbling block to a wide economic moat.</li><li>Stock prices have soared and valuations have expanded over the past few years in the wake of double-digit revenue growth and step-change margin expansion. One subtlety aiding valuation may be growing recognition of the sector's secular ability to grow faster than the rate of the underlying chip industry.</li><li>While none of the three pure-play choices seem fundamentally inexpensive, <strong><a href="https://www.smartkarma.com/entities/12493" target="_blank" data-smartkarma-citation="entities:12493:1">Entegris Inc (ENTG US)</a></strong> offers the best relative value based upon a combination of its broader, more specialized product mix, a proven ability to complete and integrate transformative acquisitions, and a more reasonable valuation.</li><li>For the pure plays, medium-term challenges revolve around managing expected rapid growth and adroitly deploying free cash flow to exploit rising chip complexity. Among the dozens of diversified global industrials with electronic materials as a portfolio company or product line, we suspect many may follow <strong><a href="https://www.smartkarma.com/entities/4441" target="_blank" data-smartkarma-citation="entities:4441:1">Air Products &amp; Chemicals, Inc. (APD US)</a></strong>'s lead and seek either tighter focus or greater scale to optimize asset value.</li><li>This remains a fragmented industry ripe for aggressive consolidation. A concentrated customer base will steadily opt to work with fewer, larger suppliers better able to protect their IP and commit the resources necessary to tackle the panoply of tactical operational and strategic technical challenges.</li></ul><p><em>Analyst: David Silver, CFA</em></p>

Electronic Materials: Soaring Growth, Looming Consolidation, and New Investment VehiclesInvestors are instinctively on the hunt for well-run companies in under-researched sectors that generate rapid organic growth, possess economic moats, and are poised to benefit from secular trends. We believe the electronic materials industry fulfills these criteria. The EM sector provides the gas mixtures, chemical formulations, specialty materials, delivery equipment, and packaging and handling solutions that facilitate leading-edge semiconductors and other micro-electronics underlying the proliferation of mobile devices, laptops, cloud computing, and the Internet of Things. EM growth is sprinting along at double-digit rates, riding the powerful waves of twin macroeconomic drivers. The first is rising investment in data-rich endeavors such as mobile devices, cloud computing, industrial automation and control, and artificial intelligence. The second driver is the fact that most current and future generation design and manufacturing innovations facilitating advances in miniaturization, chip performance, reliability, and productivity characterized by Moore's law are now inherently more materials-intensive than previous iterations. We think these forces are highly likely to remain in force indefinitely. Consequently, our view is that EM growth will structurally exceed that of the underlying chip industry by a meaningful margin. From an investor's perspective, the creation and emergence of several new pure-play companies leads us to expect that the EM industry's heretofore low profile, a legacy of operating mostly as small units buried deep within much larger companies, is approaching an end.The protagonist in the Jon Krakauer book Into the Wild unknowingly seals his demise when he crosses a low Alaskan river one sunny spring day to embark on a wilderness expedition, only to find a couple of months later that the thaw had converted the same narrow river into an impassible torrent, fatally preventing his return. Analogously, today's robust demand environment for electronic materials may obscure the rising competitive risks that most narrowly focused or niche suppliers will face once demand stabilizes and their powerful customer base becomes more concentrated, demanding, and selective. We believe the fragmented sector will ultimately consolidate down to a handful of broad-based suppliers possessing technological advantages, product breadth, global presence, and research and development and technical support with the ability to leverage strong relationships to squeeze out narrower or less committed rivals.Equity investors attracted to the rapid organic growth, technological innovation, global presence, and healthy margins that EMs currently enjoy are limited to a handful of small- to mid-cap stocks with somewhat varied track records. However, competitive dynamics and healthy valuations are the catalysts driving the creation of new investment options via consolidation, mergers, and spin-outs. Industrial logic and financial incentives underlie this motivation. Large sophisticated chipmakers increasingly seek highly committed solutions providers as partners to collaborate with on their next-generation designs, an imperative that may not align with the resource allocation priorities of large, diversified companies whose EM activities comprise a small part of overall sales and strategic investment. Semiconductor equipment manufacturers likewise seek collaborators that offer the needed expertise, technical support, and responsiveness to streamline the next wave of innovation in production equipment and process techniques. Within the next year, the looming demerger of DowDuPont Inc (DWDP US) into three or more publicly traded companies will cause both current holders and potential new investors to evaluate the investment potential of a new electronic materials industry leader with large-cap equity potential.Key TakeawaysElectronic materials suppliers such as Versum Materials Inc (VSM US), Entegris Inc (ENTG US), Cabot Microelectronics Corp (CCMP US), DowDuPont Inc (DWDP US), and others are enjoying robust growth and widening valuations due to rising chip production, as well as technology transitions that require more intensive use of their products and services.The $50 billion in revenue EM industry sits at the intersection of two oft-competing imperatives. One is to continually innovate to boost chip performance, while the other is to steadily reduce customers' production costs. While performance gains result from rising investment and development spending for novel techniques, new materials, and tailored processes, production efficiency often rises with standardization, process optimization, supplier and customer consolidation, and tightly linked regional supply chains. One common theme among EMs is ever-closer collaboration with their major customers.Sturdy narrow economic moats are built upon the high returns, sizable patent estates, and history of successful collaboration with key customers. A lengthy and expensive product qualification process raises switching costs and deters new entrants. While ROICs are becoming rather gaudy with soaring demand and naturally low capital intensity, it is their structural dependence on serving large, powerful customers in consolidating sectors that comprises the major stumbling block to a wide economic moat.Stock prices have soared and valuations have expanded over the past few years in the wake of double-digit revenue growth and step-change margin expansion. One subtlety aiding valuation may be growing recognition of the sector's secular ability to grow faster than the rate of the underlying chip industry.While none of the three pure-play choices seem fundamentally inexpensive, Entegris Inc (ENTG US) offers the best relative value based upon a combination of its broader, more specialized product mix, a proven ability to complete and integrate transformative acquisitions, and a more reasonable valuation.For the pure plays, medium-term challenges revolve around managing expected rapid growth and adroitly deploying free cash flow to exploit rising chip complexity. Among the dozens of diversified global industrials with electronic materials as a portfolio company or product line, we suspect many may follow Air Products &amp; Chemicals, Inc. (APD US)'s lead and seek either tighter focus or greater scale to optimize asset value.This remains a fragmented industry ripe for aggressive consolidation. A concentrated customer base will steadily opt to work with fewer, larger suppliers better able to protect their IP and commit the resources necessary to tackle the panoply of tactical operational and strategic technical challenges.Analyst: David Silver, CFA

Lines in the Sand: Rapid Growth, Looming Consolidation, and New Investment Options

United States

Entegris Inc. provides materials management products and services to the microelectronics industry on a worldwide basis.  The Company provides products such as wafer shippers, wafer transport and process carriers, pods, and work-in-process boxes.  Entegris also provides chemical delivery products such as valves, fittings, tubing, pipe, and containers.

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Lines in the Sand: Rapid Growth, Looming Consolidation, and New Investment Options

Electronic Materials: Soaring Growth, Looming Consolidation, and New Investment VehiclesInvestors are instinctively on the hunt for well-run...

Morningstar, Inc.