citi: The Problem With The Back-End - Semi Cap Beat Vol. 89 March 17, 2006 SUMMARY
* Following our downgrade several weeks ago, commentary this week from KLIC supports a more cautious NT view on sector. We continue to see peaking chipmaker capacity utilization and 2H:06 tool orders weighing on equipment stocks - therefore, focus new money on defensive names like NVLS/ENTG.
* Despite recent flurry of market activity in test sector (two IPOs (EGLT, NEXT) + A's test spinoff (Verigy)), secular gap b/w front and back-end is widening.
* In the five years prior to C2000, back-end R&D efficiency exceeded front-end (~12 % revs versus~14% for front-end) while return metrics such as ROE were comparable. Since C2000, a dramatic reversal has occurred and rising front-end capital intensity in post-300mm era should only exacerbate the gap.
* While a valuation gap (sales) has developed,
it is surprisingly not dissimilar to past cycles, suggesting the market has yet to fully discount these diverging secular trends.
OPINION
This week our analysis focuses on the diverging fundamentals of the front-end
and back-end segments of the equipment industry. Historically, R&D efficiency
has been somewhat similar between the two groups, with the back-end actually
exceeding the front-end on this metric (~12% of revs versus ~14% for front-end)
during the five-year period leading up to C2000. Since C2000, however, this
trend has experienced a strong reversal as back-end R&D levels as a % of sales
are much higher than historic levels, while the front-end -- after a temporary
uptick in 2002-2003 -- is now back to historical levels. Figure 1 depicts this
reversing trend, while Figure 2 shows that most back-end suppliers maintain
inflated operating cost structures relative to historic norms.
Figure 2. R&D Efficiency: Front-End vs. Back-End
Note: Back-end group comprised of CMOS, LTXX, TER Note: Front-end group
comprised of AMAT, KLAC, LRCX, NVLS
Source: Company information, Citigroup Investment Research
Figure 3. Back-End Opex Efficiency
Source: Company information, Citigroup Investment Research
Similarly, returns metrics between the two groups in the five years prior to
C2000 were fairly comparable, but we show in Figure 4 that this relationship
deteriorated post-C2000 as the back-end suffered a far more rapid decline in
profitability and has still yet to fully recover. And while a valuation gap
(sales) has developed, it is surprisingly not dissimilar to past cycles,
suggesting the market has yet to fully discount these diverging secular trends
(see Figure 5).
Figure 4. Return on Equity: Front-End and Back-End vs. S&P 500
Note: Back-end group comprised of ATE, CMOS, LTXX, TER Note: Front-end group
comprised of AMAT, KLAC, LRCX, NVLS
Source: Factset
Figure 5. Front-End to Back-End P/S and P/B Valuation Ratios
Note: Back-end group comprised of CMOS, LTXX, TER Note: Front-end group
comprised of AMAT, KLAC, LRCX, NVLS
Source: Factset
FIGURE 6. GROUP PERFORMANCE RELATIVE TO NASDAQ COMP (3-MONTH)
Source: Factset
FIGURE 7. SEMICONDUCTOR EQUIPMENT VALUATION
Source: Company reports, First Call, Factset, Reuters, Citigroup Investment
Research estimates
Note: all P/S analysis for KLAC, NVLS, and LRCX is based on SHIPMENTS and not
REVENUE
Note: Adj. P/E calculated w/stock price stripping out net cash, EPS excluding
net interest income
B=Buy, H=Hold, S=Sell, NR=Not Rated, N/A=Not Available
*ASMI covered by Navdeep Sheera and Katherine Thompson
*ASML covered by Paraag Amin
VALUATION AND RISKS
Novellus Systems (NVLS--$24.58; 1H)
Valuation
We rate NVLS Buy, High Risk (1H) with a $32 price target.
With sharply reduced manufacturing cycle times at equipments OEMs allowing
swift corrective action by chipmakers in response to excess inventories, our
analysis suggests that the semiconductor equipment industry downturns will be
shorter and shallower than in the past. As our analysis suggests that most
front-end equipment companies are thus unlikely to lose money at any point in
the downturn, we believe that investors should focus on a metric that
accurately captures cross-cycle earnings power. We thus focus on "normalized"
earnings on the notion that the downturn will be more muted than any such
downturn in recent memory. If we average peak rolling four quarter EPS of
$1.94 (FQ3:07) and trough rolling four-quarter EPS of $0.92 (FQ1:06), we arrive
at a normalized full-year EPS estimate of $1.43.
We note that the S&P500 is currently trading at a multiple of 15.8x C2006
operating EPS. As semiconductor equipment capital spending is likely to
continue growing in the high single digits % CAGR (or roughly 2x global GDP),
we assign a 10% premium to the market for NVLS, and arrive at a multiple of
about 17x earnings. We note that the semiconductor industry is entering what we
believe is a period of muted cyclicality where operating performance, and thus
earnings, will be experience less fluctuations throughout the cycle. As a
result, we think a 15.8x S&P multiple on C2006 better reflects the current
market condition versus our previous use of the 10-year historical S&P average.
Applying this approximately 17x multiple to our $1.43 in normalized earnings
power, we arrive at a fair value of approximately $24.3. As this is based on
cross-cycle normalized earnings, we consider this to be "fair value" for the
stock.
On a price/book value basis, the ten-year average multiple is 3.78x (ten-year
range from 2x-8x). Applying this multiple to our estimated book value per
share at the end of C2006 of $14.39, we arrive at a price target of ~$54.
As noted above, we prefer to focus on "normalized" earnings on the notion that
the downturn will likely be more muted than any such downturn in recent memory.
However, as many investors are still concerned about the more traditional
price-to-book method of valuing stocks, we do not wish to completely discount
this.
We note the large discrepancy between the implied price targets from book value
and normalized earnings. Although we choose to take book value into account,
we note that it may be skewed due to past bubble valuations, and we believe
that normalized earnings will be the primary driver of the stocks moving
forward.
We assign a weighting of 75% to our normalized earnings method and 25% to book
value and arrive at our price target of $32 and Buy, High Risk (1H) rating.
Risks
We rate NVLS High Risk, primarily due to stock price volatility as well as
earnings volatility and uncertainty in terms of product market share at the
90nm technology node. The following are key risk factors:
1. Our valuation methodology is based on the assumption that semiconductor
capital equipment cycle will exhibit a shallower downturn than in previous
cycles. As fab utilization and capital equipment orders are closely linked to
stock price, any material differences to our supply/demand model (e.g., demand
drops suddenly, or supply increases more rapidly than we predict) may cause our
valuation methodology to be inaccurate.
2. NVLS' primary competitor is AMAT, the industry bellwether. While
Novellus has a long-term track record of share gain, fighting off competitive
pressure from Applied Materials is a daily occurrence. While we are encouraged
by Novellus' early lead and disproportionately high share in copper
electroplating, we recognize the likelihood of share gains by Applied Materials
with the introduction of its 2nd-generation copper ECD tool, SlimCell.
3. Novellus recently acquired Speedfam-IPEC, a manufacturer of CMP
equipment. This acquisition comes on the heels of the acquisition of Gasonics.
While Novellus has been successful in integrating Gasonics and is now gaining
back lost market share, we believe the challenges facing the CMP division are
greater, as AMAT now dominates the CMP market.
4. Novellus has historically had one of the highest margin structures in
the industry, a result of the company's leading edge products and highly
outsourced manufacturing strategy. Particularly given the above-noted mergers,
we recognize some risk to the company's ability to repeat their peak margin
structure. While we still expect Novellus to show industry-leading margins,
investors may be disappointed in the inability of the company to improve upon
previous cycles' profitability.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
Entegris (ENTG--$10.57; 1H)
Valuation
We rate ENTG Buy, High Risk (1H) with a $14 target price.
Because ENTG is a combination of a consumables wafer-start driven business and
an equipment capex-driven business, a sum-of-the-parts valuation seems
appropriate.
In determining the right multiple for the consumables side of the business, we
look to ATMI as a benchmark. Since ATMI is growing revenue per wafer at 15-20%
CAGR and ENTG is growing revenue per wafer at only 7% CAGR, we conclude some
discount is appropriate. To arrive at this discount, we look at underlying
growth rates of ATMI, ENTG, and the S&P500.
* ATMI has grown overall revenue at ~21.5% CAGR from C2001 to C2005E. This
is the combination of wafer start growth and growth in revenue per
wafer.
* The S&P 500 has grown EPS at ~13% CAGR during the same time period, but
to compare apples to apples, we need revenue information. Because a
C2005 revenue estimate for the S&P500 is unavailable, we note that
S&P500 revenue (excluding financials) grew at ~6% CAGR from C2001 to
C2004. We assume the CAGR from C2001 to C2005 will be similar to this
rate.
* Lastly, our segment analysis of increasing revenue per wafer combined
with steady growth in the capex-driven business supports a view that
ENTG should be able to grow revenue at ~15% CAGR over the next few
years.
Based on ATMI's forward EPS multiple of 23x (historic range ~15x-28x) and the
S&P500 multiple of 16x (historic range ~16x-23x), we choose a 20x forward
earnings multiple for ENTG. This makes sense in our view, as ENTG's expected
CAGR falls roughly between ATMI and the S&P. This represents an approximately
15% discount to ATMI.
To determine the right multiple for the equipment (capex-driven) side, we use a
combination of AEIS and MKSI -- both competitors in the mass flow controller
segment. AEIS currently trades at ~17x C2006 EPS (historical range ~10x-22x),
while MKSI trades at ~21x C2006 EPS (historical range ~12x-25x). Taking a
mathematical average of these multiples, we arrive at ~19x.
Because we cannot determine how much of the profits are coming from each
business (although we presume the vast majority are coming from the consumables
business), we choose a multiple blended by revenue. Thus, we take 65% of 20x
and 35% of 19x and arrive at 20x. We thus apply a 19.65x multiple to our
earnings power estimate of $0.69 for ENTG to arrive at a ~$13.50 earnings-based
price target.
Taken on a sales basis, ATMI's 10-year average for trailing P/S is 3.5x and has
ranged between roughly ~2x-6x. Taking a similar 15% discount and applying this
to our $678MM average sales estimate following expected divestiture of the gas
delivery business, we arrive at ~$15 price target.
We generally prefer to use our blended earnings-based analysis, but in this
case we take our price to sales analysis into account as well, since ENTG
margins are likely to remain somewhat depressed in the near-term until full
merger synergies are realize. We thus take a 50/50 weighting of our sales and
earnings methodologies and arrive at a target of $14.25. Rounding down to the
nearest dollar, our price target comes to $14, and we continue to rate ENTG
Buy, High Risk (1H).
Risks
We rate ENTG High Risk primarily due to low earnings stability and, with a Beta
of 2.2, high stock price volatility. The following are key risk factors:
* ENTG derives the majority of its revenue from the highly cyclical
semiconductor industry, and has exposure to other volatile markets such
as flat panel display. Although the semiconductor industry currently is
in the midst of an up-cycle, any unexpected drop in semiconductor demand
or delays/cancellations in new fab projects or expansions could
significantly lower demand for ENTG's products.
* Our valuation methodology assumes a CQ2:05 recovery in wafer starts and
capacity utilization, and a continued secular shift towards liquid-based
wafer processing (e.g. chemical mechanical planarization, copper
electroplating) which should drive to higher consumables revenue on a
per-wafer basis for companies like ENTG. As wafer starts, fab
utilization, and to a lesser extent, equipment, are closely linked to
the stock price, any material differences to our supply/demand model may
cause our valuation methodology to be inaccurate.
* The company also is subject to competitive pressure. While ENTG is well
entrenched as the leading supplier of gas and liquid filters as well as
wafer storage pods to the semiconductor market, it has a lower market
share in their mass flow control business (~15%). Within that business,
the company faces significant competition from MKS Instruments and
Celerity. This pressure can result in lost sales and can create pricing
pressure in the mass flow control division. Additionally, as its OEM
customers look to increase the proportion of their outsourced
components, specifically in the form of subsystems, the company faces
the risk of share loss should it not be able to offer its customers a
complete solution.
* Additionally, following the merger, the combined company (ENTG/MYK) may
not be able to recognize cost synergies beyond the stated $20MM in
C2006. Further, the company may choose to remain in some or all of the
current gas delivery businesses.
If the impact on the company from any of these factors proves to be greater
than we anticipate, the stock will likely have difficulty achieving our target
price.
ANALYST CERTIFICATION APPENDIX A-1
I, Timothy Arcuri, research analyst and the author of this report, hereby
certify ... |
