GS US Semi & SPE - Takeaways from AEA
Conference; beware of the seasonal trade
premium
We spent the last two days meeting with 22 companies at the AEA Conference in San
Diego. While it is difficult to generalize takeaways from such a diverse group of
companies, our main conclusion is that business trends remain steady but there is a
significant disconnect between fundamental reality and Street expectations. Many stocks
are pricing in a robust seasonal/cyclical recovery while most company managements see
steady but most certainly unspectacular near-term trends. Managements remain hopeful
that business will improve during 2006 but many companies with whom we met expressed
some reservations about a weak consumer holiday season. We believe the market is
overemphasizing seasonal trading patterns and underemphasizing fundamentals, which
could prove dangerous as we get closer to year-end as the seasonal trade premium comes
out of the stocks.
AEA CONFERENCE HIGHLIGHTS STEADY IF UNSPECTACULAR BUSINESS
TRENDS ACROSS A DIVERSE GROUP OF COMPANIES. At the AEA Financial
Conference in San Diego, CA on Monday and Tuesday, we met with many companies
across the Semiconductor and SPE segments including Applied Micro Circuits, Atheros,
Cirrus Logic, Lattice, Microtune, Netlogic, Sirf, Zoran, Monolithic Power, Genesis
Microchip, Pixelworks, Trident Microsystems, Infocus, MicroSemi, O2Micro, Silicon
Image, Entegris, MKS Instruments, Advanced Energy, Aixtron, Cabot Microelectronics,
and Lexar. We provide our key takeaways from the two days of meetings at AEA below as
well as detailed write-ups from covered company meetings. Our key takeaways include:
(1) Equipment companies seem aware that the overall capex environment in 2006 is likely
to be flattish although many are hopeful that there proves to be upside to the market as the
year progresses. Regardless, companies continue to be focused on reducing costs and
improving/sustaining margins by manufacturing and sourcing supplies from lower cost
regions, integrating subsystems, divesting lower margin businesses, etc.
(2) In the subcomponent segment of the SPE industry, the impact of recent consolidation
in the industry also appears to be another topic of focus following the merger of Entegris
and Mykrolis and Brooks Automation's acquisition of Helix Technology. Companies
continue to highlight a consolidating customer base as a driver of recent M&A activity, as
larger scale becomes increasingly important as the customer base consolidates. Those
subcomponent companies that have not recently been acquisitive highlight that it is an
area of focus although managements are also noting the importance of making intelligent
acquisitions as opposed to simply being acquisitive because competitors or customers are
consolidating.
(3) SPE companies continue to highlight growth opportunities outside of the
Semiconductor market, which we believe is a function of the slower long-term growth rate
of the semi industry. Target growth markets outside of Semiconductors include flat panel
display, solar cells, fuel cells, medical/biopharmaceutical, etc. Within the Semiconductor
industry, SPE companies appear to be focused on driving solid product offerings in higher
growth areas such as immersion lithography, ALD, and CMP.
(4) Semiconductor content in DTVs remains a fiercely contested market with large unit growth
opportunity but likely continued aggressive price declines. Competitors like Genesis Microchip,
Pixelworks, and Trident Microsystems with image processing strength are integrating up-stream
functionality such as decode and demodulation into their solutions to enable cost and space savings
while retaining dollar content. Image processing remains a key differentiator for these companies,
though we expect competitors like ATI and Broadcom with strong decode/demod capabilities will
become more significant competitors as their image processing quality matures and improves going
forward. Zoran also expects its integrated solutions to be competitive going forward, though its
penetration will likely be concentrated at the low end of the market in the near-term.
(5) We went to presentations by a number of analog companies, including Monolithic Power
Systems, Advanced Analogic Tech, Power Integrations, MicroSemi, and O2Micro. With their initial
success, these small, mainly fabless companies are expanding the diversity of analog products they
are bringing to market, and we expect these companies will be a competitive presence going
forward. That said, we still see the larger analog companies as well positioned, including Linear,
Maxim, Analog Devices, National, and TI. We continue to think analog revenue growth is primarily
gated by new product introduction, which in turn is directly correlated to the number of analog
design engineers, a notoriously scarce resource.
(6) Limited data points related to comms from meetings with Applied Micro Circuits, Netlogic,
Atheros, and Lattice. Overall, business trends were characterized as mixed depending on end market
and product opportunities. Also, companies continue to work to diversify revenue and product
portfolios. Applied Micro Circuits continues to expect tepid trend in comms as declines in
de-emphasized areas will offset growth in processors and transport products; diversification efforts
in storage and embedded processors are the key to intermediate term growth. Netlogic highlighted
growth of Knowledge Processors with diversification opportunities as they expand their customer
base; management also noted an expectation for strong contribution from products for the
Layer2/Layer3 switch market in 2006, which would sit next to switch solutions from Marvell and
Broadcom. Atheros reiterated Q4 guidance for 10-15% growth as WiFi shipments are seasonally
strong and pricing declines not as severe as traditional rate; diversification efforts continue to
progress with PHS solution, including at lead customer UTStarcom. Lattice's Q4 guidance is for
revenue growth of 1-3% Q/Q, which is contingent on turns in the high-40% range versus typical
turns in the 60s; the company is encouraged by new product design momentum and has enacted
additional restructuring, which the company hopes will enable return to profitability in 2006 and
operating leverage going forward.
(7) DVD-recorder shipments are increasing, but the rate of growth continues to be disappointing
relative to expectations. We attended presentations from Zoran and MIPS, which both indicated that
trends in DVD-recorder market were below expectations. Zoran expects the DVD-recorder market
will approach 17.9M units in 2005, up from shipment of 11M in 2004; Zoran's projection is
consistent with LSI's estimate of 15-18M units for 2005, which had been revised mid-year from an
earlier projection of 15-20M. However, companies are still optimistic about opportunities in 2006
and ahead as chip integration (Zoran now marketing single-chip DVD-recorder solution) will help
drive overall system costs towards consumer sweet spot.
ENTG (OP/C): MEETING FOCUSED ON MYKROLIS MERGER AND OUTLINED THE
MAJOR DRIVERS OF THE COMBINED ENTITY. Our meeting with Entegris at AEA focused on
the company's merger with Mykrolis, which closed on August 6th. The company highlighted that
the primary driver behind its merger with Mykrolis is a consolidation in the Semiconductor
customer base, as customers are becoming fewer and larger. The company believes that in order to
be a successful player in the market, it needs to have scale and market share. The combined
company has annual revenues of about $600M, and management highlighted its goal to become a
$1B+ company through both organic growth and strategic mergers and acquisitions. Entegris
intends to realize about $20M in annual cost synergies from the merger, with about $10M in savings
coming from finance and marketing, $5M in IT, and $5M in sales function and office
rationalizations and facility consolidations. The integration is expected to be completed by
mid-2006.
In conjunction with the merger, the company is divesting three non-core, unprofitable businesses
(gas delivery, life sciences, and tape-and-reel). These divestitures will lower annual revenues by
about $50M per year (revenues from the non-core businesses are excluded in the annual $600M
revenues number we quoted above) and drive about 100-200 basis points in operating margin
improvement.
The combined company is about 65% unit-driven and 35% capex driven. The post-merger Entegris
will be focused in four primary product areas: (1) Wafer - which includes wafer shippers (FOSBs)
and wafer carriers (FOUPs) and will represent about 30% of sales. Competitors include Shin-Etsu
Polymer and Miraial. Entegris estimates that it has 80% share in carriers and 50% share in shippers.
(2) Liquid - which includes filters, valves, tubing, pumps, LFCs, and containers and will represent
about 50% of sales. Competitor
s include Pall, Parker-Hannifin, and St. Gobain. Entegris estimates that it has 50% share in filtration
and is a leader in fluid handling. (3) Gas - which includes purification systems and will account for
about 10% of sales. Competitors include Donaldson, SAES, and Mott. And (4) components - which
will include disk shippers, disk carriers, and component trays and will represent about 10% of sales.
Entegris' major customers include MEMC, SEH, Siltronic, SUMCO, Applied Materials, DNS,
Tokyo Electron (a large Mykrolis customer), Chartered, Inotera, Micron, TI, Samsung, STM,
TSMC, UMC, Komag, MMC, and Seagate. No customer represents more than 7% of total sales.
The company discussed three sources of growth, including: (1) Continued growth in wafer
production (we would note that IC units have grown at a 9% CAGR historically and management
commented that third-party researchers are calling for about 4-7% wafer-start growth in 2006), (2)
expanding the company's "ownership" of materials integrity management in the fab (growth areas
inside of the fab include immersion lithography and CMP), and (3) new untapped materials integrity
management markets (including fuel cells where the company is not yet generating significant
profits but has a product offering).
On the near-term environment, management indicated that it has not yet seen signs of a meaningful
build in Semiconductor inventories at its customers. There is no change to our OP/C rating on the
shares as we expect the stock to outperform the SPE group given our view that the combined entity
will have improved secular earnings potential and a less volatile and solid growth revenue stream
given higher exposure to IC units as opposed to capex.
AEIS (U/C): FOCUS ON LONG-TERM GROWTH AND BUSINESS STRATEGY AS WELL AS
COST STRUCTURE. Our meeting with AE focused on the company's intention to grow its sales by
strengthening its position in its core Semiconductor business by being more focused on the
customer, thus driving share gains. Customers where the company hopes to grow its business
include Applied Materials (AE's single largest customer), Lam Research, Novellus, and Tokyo
Electron (where the company sells flow products but has not penetrated its power supply products).
Regarding AE's business at Applied Materials, management saw a reduction in sales to Applied last
quarter. The company attributed declining sales to Applied primarily to an increase in Applied's
200mm business while AE has stronger share in 300mm.
The company also intends to grow in new emerging markets where it can transfer its technology,
like the solar cell market which currently represents only about $5M in annual revenues for AE.
Management also highlighted opportunities to grow its business in the flat panel segment. Note that
AE sells flow products to AKT but has yet to penetrate its power supply products.
In regards to the company's move to lower-cost Asian based manufacturing and sourcing,
management indicated that more than 80% of its products are being produced in China currently
and the move to an Asian based supplier base is about 70% completed. The company currently has
about 500 employees operating in China and noted that the labor supply in the region is still not
tight. Management also indicated that the facility has received very high quality ratings from
customers. Importantly, AE believes that if revenues are flat next year the company can still
generate about 300-500 basis points of margin improvement driven by several factors including
product design cost reduction, supply agreements, warranty performance, and smarter logistics.
While the company is paying careful attention to consolidation taking place across the
subcomponent segment, management believes that it is more important to ensure that the company
has a strong cost structure and a solid financial model. On the near-term environment, the company
sees a flattish overall environment in 2006 but believes that there is more likely to be upside than
downside to the market in 2006. Management doesn't expect significant sequential growth of
10-15% per quarter in 2006, but noted that some customers are running at high utilization rates
which may be driving some pent-up demand.
There is no change to our U/C rating as we expect an overall flattish capex environment in 2006 but
the Street is modeling significant Y/Y EPS growth for AE of +133% in 2006. Further, the stock is
very expensive at 43x our 2006 EPS estimate.
MKSI (IL/C): CONTINUED FOCUS ON GROWTH DRIVERS AND MARGIN
IMPROVEMENT THROUGH INTEGRATED SUBSYSTEM SALES. Our meeting with MKS
focused on how the company is driving growth and margin improvement. Management indicated
that it is focusing on driving growth by expanding its presence in markets outside of the
semiconductor industry by applying its semiconductor technologies to other markets (i.e. thin-film
(FPD, optical/data storage, architectural glass), biopharm (high purity manufacturing), medical
equipment (MRI equipment, sterilization equipment), analytical (mass spectrometers), government
(high energy physics, mission control, chemical agent detection), energy (alternative energy
research, including solar cells and fuel cells). Within the semiconductor business, management
expects growth to be driven by increasing device complexity (including more layers and thinner
layers in chips), more process steps, and the continued migration of the installed base to 300mm
(22% of the installed base was at 300mm in 2004), all of which are expected to drive the need for
more process monitoring and control.
Regarding the company's efforts in driving gross margin improvement, management is focused on
continuing to drive down costs by sourcing less expensive materials (45 - 50% of materials are
currently sourced from low cost areas) and by manufacturing in lower cost regions (the company
manufactures in China and Mexico in addition to the US). MKS has a 103k square foot facility in
China that is ISO certified and has been qualified for production by customers. The company does
believe, however, that it is important not to rely entirely on manufacturing in China, particularly
because savings are mostly on the labor side and the manufacturing environment is not particularly
labor intensive. Management also continues to be focused on the sale of integrated subsystems as
opposed to separate subsystem components, which provide the company with higher margins. Sales
of integrated subsystems accounted for just under 25% of the company's business in 2004. Earlier in
2005, management increased its target of integrated subsystem sales to 40% from 30% of total sales
over time.
MKS reiterated its target operating model (assuming quarterly sales of $155 - $160 million) with
gross margins targeted at 44% - 46% of sales, R&D at 8% - 9% of sales, SG&A at 14% - 15% of
sales, and operating income of 21% - 24% of sales.
MKS continued to highlight its strategy of "surrounding the process chamber" with a product
offering that can measure, control materials, analyze data, deliver power, etc. to the process
chamber. Within the semiconductor business segment, MKS is targeting the higher growth ALD
segment.
MKS has about 4,000 customers worldwide with Applied Materials (17% of CQ3'05 sales) the
company's largest customer. Top ten customers account for about 47% of sales. MKS' semi
equipment customers include ASMI, ASML, Lam Research, Novellus, Semitool, TEL, and Varian.
MKS' semi customers include Micron, Mitsubishi, Motorola, National Semi, NEC, Philips,
Samsung, STMicro, Texas Instruments, Toshiba, TSMC, and UMC. In the data storage and FPD
markets, customers include AKT (segment of Applied Materials), Seagate, Sharp, and Ulvac.
There is no change to our IL/C rating on MKSI, as despite the company's continued solid execution,
we don't see signs of a sustainable upturn in the foreseeable future given a likely flattish overall
capex environment in 2006 and the stock is expensive
at 31x our current full cycle (2003-2006) normalized EPS estimate of ~$0.60.
AMCC (IL/N): PRESENTATION FOCUS ON DIVERSIFICATION, RE-ORG EFFORTS, AND
GROWTH OPPORTUNITIES. We rate Applied Micro Circuits (AMCC) In-Line within our Neutral
semiconductor devices coverage view as we continue to build confidence in recent operational
restructuring and management changes, which we believe will be key to re-establishing sustainable
revenue growth and earnings momentum necessary before becoming more aggressive on the stock.
No new insights from the company's presentation at AEA, which focused on diversification,
reorganization/restructuring, and market opportunities. Near-term revenue trends in communications
semiconductors and storage are impacted by declines in strategically de-emphasized products (in
particular comms/switch and storage/fibre channel). However, Applied Micro remains optimistic
about business opportunities in both segments with key driver being acceleration of converged
networks (voice/video/data), which will leverage the company's core competences in processors
(network, comms, and embedded), transport (high speed, high bandwidth devices), and storage
(focus on low-cost, high performance S-ATA/SAS). New management team has quickly enacted
reorganization and additional restructuring, which keys on driving engineering efficiency with
focused investments in target markets. The company will continue to tightly manage operating
expenses as it looks to drive "20/20" long-term target model, i.e. 20% annual growth and 20%
pre-tax profit, which the company discussed on its most recent earnings call and believes it can
establish over the next couple years as it completes business transitions that are limiting near-term
revenue trends. AMCC trades at 1.7x calendar 2006 EV/S given high cash/share, but 38x calendar
2006 P/E due to challenged margin profile.
MPWR (IL/N): MEETING FOCUSED ON REVENUE GROWTH OPPORTUNITIES;
LITIGATION REMAINS THE KEY RISK. The meeting focused on MPS' strong market share in
cold cathode fluorescent lamp (CCFL) inverters and solid growth in DC/DC converters. Litigation
was also discussed at length, with the Linear suit now settled, the O2Micro litigation ongoing, and
MicroSemi and Micrel trials to begin likely in H1'06. No change to our IL/N rating; we expect the
company will continue to experience solid revenue growth, but the possibility of adverse litigation
outcomes remains a key risk, and litigation expense is the biggest downside risk to earnings. Given
MPWR's discount the analog group despite higher growth, we see litigation risk as fully priced into
shares. Regarding valuation, MPWR trades at 18x calendar 2006 P/E, well below the analog median
of 23x and near the market multiple of 17x despite its significantly higher growth rate, due to
litigation overhang; excluding litigation expense, MPWR trades at 12x calendar 2006 P/E.
CEO Michael Hsing and CFO Rick Neely discussed the company's significant market share in cold
cathode fluorescent lamp (CCFL) inverters and solid growth in DC/DC converters. MPS continues
to see its process technology as a key differentiator vs. competitors such as MicroSemi and
O2Micro in the inverter space and standard linear analog companies like Linear, Maxim, and TI in
the broader analog space. In CCFL inverters, MPS believes it has >50% market share in the
notebook market, and is optimistic on the LCD TV market given design win activity. In the DC/DC
converter market, MPS is being designed into DVD players, LCD TVs, and WLAN access points,
among others. MPS continues to see strong growth in DC/DC products, which grew ~40% Q/Q in
CQ3 to comprise 62% of sales.
Potential adverse litigation outcomes remain the major overhang and key risk to shares, though we
believe the risk is fully priced in. MPS noted that the Linear lawsuit was successfully settled, and
sees limited risk with the O2Micro (OIIM, NC) and MicroSemi (MSCC, NC) lawsuits as both are
related to some CCFL products with limited revenue impact. The Micrel lawsuit is acknowledged to
potentially affect all revenues, though we expect the likely worst-case scenario would be payment of
royalty and/or license fees.
Litigation expense remains the biggest downside risk to earnings, which consumed 20% of YTD
sales and 59% of YTD operating profit. We expect the expense to remain high (>$3M/quarter) in
the near-term as O2Micro litigation continues and MicroSemi and Micrel litigation will likely
commence in H1'06.
Each of the analysts named below hereby certifies... |
