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Automotive Chipmakers in the Fast Lane —Destination: High-Speed Growth

We Are Raising Our Chip Equipment Estimates for 2018 as Recent Strength Set to Persist

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Thematic (Sector/Industry)

Colombia Semiconductors and semiconductor equipment / Thematic (Sector/Industry)

<div class="content-highlight"><p style="text-align: center;"><strong>The capital equipment space offers moats and growth at favorable prices.</strong></p></div><hr><p style="text-align: left;">In April 2016, we published a report on the wafer fabrication equipment, or WFE, space, When the Chips Are Down, Bet on Capital Equipment Firms, which highlighted the major equipment providers: <a href="https://www.smartkarma.com/entities/283" target="_blank" data-smartkarma-citation="entities:283:1">Applied Materials (AMAT US)</a>, <a href="https://www.smartkarma.com/entities/1116" target="_blank" data-smartkarma-citation="entities:1116:1">Lam Research (LRCX US)</a>, <a href="https://www.smartkarma.com/entities/21097" target="_blank" data-smartkarma-citation="entities:21097:1">ASML Holding NV (ASML NA)</a>, <a href="https://www.smartkarma.com/entities/1115" target="_blank" data-smartkarma-citation="entities:1115:1">KLA-Tencor Corp (KLAC US)</a>, and <a href="https://www.smartkarma.com/entities/280" target="_blank" data-smartkarma-citation="entities:280:1">Tokyo Electron (8035 JP)</a>. Since then, the average stock price increase for these five players is 60%, even after the market's recent pullback. Over the same period, the S&amp;P 500 has risen 23%. More recently, semiconductor stocks have been mired in a broad sell-off from recent highs stemming from an array of factors including macro-related concerns such as tariffs and the escalating trade war between the United States and China, inventory builds across key end markets such as smartphones, and memory price declines. This has led to concerns about a cyclical downturn that will negatively affect WFE levels in 2019 and beyond. However, we foresee a longer-term recovery in WFE thanks to end-market diversity beyond PC and smartphones for chipmakers, which includes the shift to the public cloud, rise in automotive chip content, investment in 5G, and artificial intelligence. Consequently, our top three picks (wide-moat Applied and KLA and narrow-moat Lam) trade at attractive discounts to our fair value estimates, with an average 41% upside.</p><p style="text-align: left;">For 2019, we anticipate a decline in WFE spending from record 2018 levels ($50 billion-plus) chiefly due to softer memory investments. Nonetheless, we remain positive on the space as stronger service revenue should support the overall top line of each firm, while logic and foundry investments related to leading-edge process technologies will also buttress overall WFE levels. Beyond 2019, we foresee healthy WFE growth as traversing the path prescribed by Moore's Law remains increasingly challenging and requires greater process intensity for advanced equipment, in addition to the aforementioned broader end-market diversity that should help normalize future WFE trajectories. Meanwhile, we believe chipmakers (especially memory customers) are better equipped to navigate "downturns" with greater cash cushions and profitability levels from the recent memory upswing, thanks to more rational behavior from a supply/demand standpoint. Consequently, near-term delays in equipment spending by the likes of Samsung and <a href="https://www.smartkarma.com/entities/13382" target="_blank" data-smartkarma-citation="entities:13382:1">Micron Technology (MU US)</a> in fact validate our view of a healthier, more diverse semiconductor market.</p><p style="text-align: left;">Following a down year in 2019, we forecast average revenue growth of 7.5% for our top three WFE picks through 2023. In contrast, we think current valuation levels imply average top-line growth of just 2.4% following 2019 for these firms. From a forward 2019 price/earnings standpoint, the average for the top three is 9 times relative to our fair value assumption of 13 times. We implore prospective investors to remain vigilant for attractive entry points for these high-quality vendors, which offer an appealing way to play the semiconductor market given that all types of chips are made using equipment from these companies.</p><h2><strong>Key Takeaways</strong></h2><ul>
<li>Leading wafer fabrication equipment firms boast economic moats stemming from cost advantages and intangible assets, in our view, that allow for sustainable excess returns.</li>
<li>2019 WFE growth will be lower than 2018 as memory investments subside, but logic and foundry spending should partially offset this weakness thanks to ramps of the latest process nodes from <a href="https://www.smartkarma.com/entities/16764" target="_blank" data-smartkarma-citation="entities:16764:1">Intel Corp (INTC US)</a> and <a href="https://www.smartkarma.com/entities/11230" target="_blank" data-smartkarma-citation="entities:11230:1">Taiwan Semiconductor Mfg Co. Ltd. (2330 TT)</a>. Growing service revenue derived from large installed bases should also assuage near-term headwinds.</li>
<li>We anticipate healthy WFE growth beyond 2019 as greater end-market diversity and process intensity further mitigate the cyclicality of future equipment spending by the likes of Samsung, Intel, and TSMC.</li>
<li>We forecast a compound annual growth rate of 7.5% for WFE spending over the four years after 2019, thanks to more sophisticated process technologies for both memory and logic, with new materials and structures as well as smaller geometries and feature sizes.</li>
<li>Although PCs and smartphones continue to dominate the semiconductor space, burgeoning trends such as the shift to the cloud, rise in automotive chip content, artificial intelligence, 5G, and virtual reality will collectively support healthy WFE levels as the range of chip types needed will become more heterogeneous.</li>
<li>China remains a substantial upside driver for WFE spending in the coming years as it strives to develop its own national champions for memory and logic semiconductor manufacturing, with NAND flash storage serving as the lowest-hanging fruit, in our view. Recent spending trends from indigenous Chinese chipmakers support our thesis that China will remain a positive upside catalyst.</li>
<li>Our top picks are wide-moat KLA-Tencor and Applied Materials as well as narrow-moat Lam Research, thanks to their powerful combination of attractive valuations, technology leadership, product breadth, and favorable end-market exposure.</li>
<li>We forecast average revenue growth of 7.5% for our top three WFE picks from 2019 to 2023. In contrast, we think current valuation levels imply average top-line growth of just 2.4% following 2019 for these firms.</li>
</ul><p><em>Analysts: Abhinav Davuluri and Nicholas Johnson</em></p>

The capital equipment space offers moats and growth at favorable prices.In April 2016, we published a report on the wafer fabrication equipment, or WFE, space, When the Chips Are Down, Bet on Capital Equipment Firms, which highlighted the major equipment providers: Applied Materials (AMAT US), Lam Research (LRCX US), ASML Holding NV (ASML NA), KLA-Tencor Corp (KLAC US), and Tokyo Electron (8035 JP). Since then, the average stock price increase for these five players is 60%, even after the market's recent pullback. Over the same period, the S&amp;P 500 has risen 23%. More recently, semiconductor stocks have been mired in a broad sell-off from recent highs stemming from an array of factors including macro-related concerns such as tariffs and the escalating trade war between the United States and China, inventory builds across key end markets such as smartphones, and memory price declines. This has led to concerns about a cyclical downturn that will negatively affect WFE levels in 2019 and beyond. However, we foresee a longer-term recovery in WFE thanks to end-market diversity beyond PC and smartphones for chipmakers, which includes the shift to the public cloud, rise in automotive chip content, investment in 5G, and artificial intelligence. Consequently, our top three picks (wide-moat Applied and KLA and narrow-moat Lam) trade at attractive discounts to our fair value estimates, with an average 41% upside.For 2019, we anticipate a decline in WFE spending from record 2018 levels ($50 billion-plus) chiefly due to softer memory investments. Nonetheless, we remain positive on the space as stronger service revenue should support the overall top line of each firm, while logic and foundry investments related to leading-edge process technologies will also buttress overall WFE levels. Beyond 2019, we foresee healthy WFE growth as traversing the path prescribed by Moore's Law remains increasingly challenging and requires greater process intensity for advanced equipment, in addition to the aforementioned broader end-market diversity that should help normalize future WFE trajectories. Meanwhile, we believe chipmakers (especially memory customers) are better equipped to navigate "downturns" with greater cash cushions and profitability levels from the recent memory upswing, thanks to more rational behavior from a supply/demand standpoint. Consequently, near-term delays in equipment spending by the likes of Samsung and Micron Technology (MU US) in fact validate our view of a healthier, more diverse semiconductor market.Following a down year in 2019, we forecast average revenue growth of 7.5% for our top three WFE picks through 2023. In contrast, we think current valuation levels imply average top-line growth of just 2.4% following 2019 for these firms. From a forward 2019 price/earnings standpoint, the average for the top three is 9 times relative to our fair value assumption of 13 times. We implore prospective investors to remain vigilant for attractive entry points for these high-quality vendors, which offer an appealing way to play the semiconductor market given that all types of chips are made using equipment from these companies.Key Takeaways
Leading wafer fabrication equipment firms boast economic moats stemming from cost advantages and intangible assets, in our view, that allow for sustainable excess returns.
2019 WFE growth will be lower than 2018 as memory investments subside, but logic and foundry spending should partially offset this weakness thanks to ramps of the latest process nodes from Intel Corp (INTC US) and Taiwan Semiconductor Mfg Co. Ltd. (2330 TT). Growing service revenue derived from large installed bases should also assuage near-term headwinds.
We anticipate healthy WFE growth beyond 2019 as greater end-market diversity and process intensity further mitigate the cyclicality of future equipment spending by the likes of Samsung, Intel, and TSMC.
We forecast a compound annual growth rate of 7.5% for WFE spending over the four years after 2019, thanks to more sophisticated process technologies for both memory and logic, with new materials and structures as well as smaller geometries and feature sizes.
Although PCs and smartphones continue to dominate the semiconductor space, burgeoning trends such as the shift to the cloud, rise in automotive chip content, artificial intelligence, 5G, and virtual reality will collectively support healthy WFE levels as the range of chip types needed will become more heterogeneous.
China remains a substantial upside driver for WFE spending in the coming years as it strives to develop its own national champions for memory and logic semiconductor manufacturing, with NAND flash storage serving as the lowest-hanging fruit, in our view. Recent spending trends from indigenous Chinese chipmakers support our thesis that China will remain a positive upside catalyst.
Our top picks are wide-moat KLA-Tencor and Applied Materials as well as narrow-moat Lam Research, thanks to their powerful combination of attractive valuations, technology leadership, product breadth, and favorable end-market exposure.
We forecast average revenue growth of 7.5% for our top three WFE picks from 2019 to 2023. In contrast, we think current valuation levels imply average top-line growth of just 2.4% following 2019 for these firms.
Analysts: Abhinav Davuluri and Nicholas Johnson

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