Cash-Rich And Into Chips
Mark Mowrey, The Prudent Speculator, 02.01.05, 1:01 PM ET
NEW YORK - When it comes to out of favor sectors, you can't find too many that fit the bill as well as semiconductors. In 2004, iShares Goldman Sachs Semiconductor Index ( IGW) fell 15%, making it the worst performing of all exchange-traded funds outstanding. Longtime subscribers of The Prudent Speculator already know that "out of favor" and "long-term value" often go hand in hand. Indeed, as patient investors like many names in the sector. One of our favorites is semiconductor equipment manufacturer Varian Semiconductor (nasdaq: VSEA - news - people ) is one such name.
Varian Chief Financial Officer Robert J. Halliday recently gave an investor presentation at investment bank Needham's Growth Conference in New York. Here are some of the highlights of my notes on the meeting. Varian Semi sits at the "front end" of the semiconductor capital equipment spectrum. In that part of the chip manufacturing process, various types of equipment take raw silicon wafers and "print" the chip structure onto the silicon using chemical or lithographical (light-based) processes. Also, within front-end processing, negatively and positively charged ions are implanted into the silicon in order to enable transistor functionality. The latter is Varian's specialty.
According to research firm Dataquest, ion implant revenue totaled $754 million in 2003 and $1.2 billion in 2004, about 4% to 5% of the front-end total. Varian said it had a 31% share of that market in 2003, a stake it maintained in 2004. The ion implantation group can be further segmented based on two inversely related characteristics of the layers of ions deposited by specific types of implantation equipment--how deep the ions penetrate the silicon and how thick they are laid on. Depth is determined by the energy level, the thickness is determined by current, and one trades off for the other. The industry can thus be divided into high energy/low current products, medium energy/medium current products and low energy/high current products. The fastest growing category, high current, accounts for 50% of total industry revenue, medium current accounts for about one-third of the total and high energy is about 17%. Varian sells in all spaces, and their tools cross the segments, use common parts and software tools, affording valuable cost saving opportunities.
It is in high current where Varian competes with Applied Materials (nasdaq: AMAT - news - people ) and Axcelis Technologies (nasdaq: ACLS - news - people ). This is the area that the company thinks it has its greatest potential for market share gains. That's because the company believes the market is moving to a production process that it has used exclusively over the past five years, and Varian's competitors, while moving closer to Varian's processes, won't be able to match them spec for spec.
In the past, ion implantations were completed using a spinning wheel on which several silicon wafers were placed. These wafers were in turn bombarded with ions as the wheel spun around. Long story short, the process took advantage of the rotation to create uniformity in the implantation of ions. Today, the process lacks the specificity required of larger silicon wafer sizes, smaller feature lengths and higher yield requirements. Instead, Varian has perfected a process that uses one beam of particles to implant ions on one wafer at a time. According to the company, the process has several benefits, one of the greatest of which is less damage to the silicon during the implantation process.
From what we understand, Varian's single-wafer process filters out bad particles in the ion stream. These bad particles are prone to damage the silicon. Further, the spinning disk used in batch processing adds velocity, which can increase the damage caused by any unfriendly particles. This is especially important as production sizes shrink since any individual area of damage will have a more significant impact on the silicon in terms of its yield (more individual chip area will be affected).
Varian's CFO believes batch processing will go away. And given that Varian is the leader in single-wafer technology right now, it stands to benefit the most. The company has been shipping single-wafer machines since 1999, and it has over 110 installed and in production at 13 customers. According to Varian, Applied Materials has shipped a few (Varian is not sure whether they are in production), and Axcelis Technologies has shipped none.
The real reason we like Varian, of course, is its financial performance and fundamental underpinnings. First, there's the cash. Varian started its life in the public markets with about $100 million in cash, a figure that is now nearly four times as large, due almost exclusively to the internally generated excess cash from operations--the company has only seen one unprofitable quarter since Q2 1999. Operating leverage is high for these folks as well. Sales grew 46% in fiscal 2004 (ended Oct. 1) to $530.1 million, while adjusted earnings grew by 460%, from $10.8 million (31 cents per share) to $61.1 million ($1.65 per share).
As for valuation, the stock is cheap, even in non-tech terms. When one excludes the $10.66 per share in cash and equivalents (net of debt) Varian maintains on its balance sheet, the shares trade at 1.5 times trailing 12-month revenue and less than 13 times earnings. Our current target price for Varian is $64, and we are buyers all the way up to $37.03. |
