The semiconductor and memory equipment space is one of the most interesting today. While long-term demand drivers for semiconductors should be robust, Mr. Market has sent many of these stocks down significantly in 2018. Rising interest rates and trade war fears have sent investors fleeing, with virtually all of these stocks trading at bargain-basement valuations.
However, the recent earnings release from equipment maker Lam Research (LRCX 2.40%) defied many skeptical analysts. Lam Research sells etch-and-deposition equipment and services, mostly to NAND and DRAM memory producers. The company also has a smaller segment in logic and foundry, which make finished chips. Despite declining NAND and DRAM prices, Lam delivered a better-than-expected quarter. Here's how management pulled it off.
Nothing to fear but fear itself
The problems with Lam were articulated roughly three months ago, when management revealed a slowdown in customer investment. While Lam had said its first fiscal quarter would be a tough quarter, indicating this is more of a short-term pause, investors took the slowdown as a potential sign of a much scarier downturn.
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The quarter's results seemed to back up management, with Lam posting revenue of $2.33 billion, along with non-GAAP earnings per share of $3.36. While both declined year over year, they were much better than analyst expectations.
More importantly, Lam's guidance was also ahead of expectations. Next quarter, management projects revenue ranging from $2.35 billion to $2.65 billion, compared to analyst estimates of $2.35 billion, and earnings-per-share guidance was $3.45 to $3.85, compared to consensus estimates of $3.45.
Diversification pays off
Management projects the first half of 2019 will grow over the second half of 2018. While NAND-related projects (roughly half of Lam's revenue) will moderate as expected, the smaller segments in DRAM, logic, and foundry should all grow in 2019. While foundry (17% of revenues) and logic (6% of revenues) are still relatively small parts of the business, they are larger parts relative to Lam's past, and their growth will help offset the volatility of memory investment. (Read a transcript of the company's most recent conference call on fool.com here.)
Services steady the ship
Another significant component of the outperformance was Lam's emerging services business. Since 2014, Lam's installed base has grown from 36,000 units to 55,000 units. The good thing about the larger existing base is that if customers decide to hold off buying the latest generation of equipment, they tend to utilize older equipment at higher rates, which means more services and replacement parts revenue for Lam.
That's led services to grow at twice the rate of unit growth, according to management. So, the services segment is a nice counterweight to the volatility of equipment sales.
China will buy
While large memory manufacturers in the U.S., Korea, and Japan may be cutting back, there's at least one other global player likely to continue buying semiconductor equipment no matter what: China.
As part of China's "China 2025" plan, the country hopes to supply 70% of its high-tech demand through domestic manufacturers by that time. That's a far cry from the roughly 13% China supplies globally today. It's a hugely ambitious target that definitely includes lots of semiconductor and memory investment. Making leading-edge memory and semiconductors is very, very difficult, and so domestic Chinese players will be buying lots of equipment going forward.
Despite the ongoing trade war, Lam is bullish on the Chinese market, which made up 25% of sales last quarter. Two-thirds of these sales went to domestic Chinese manufacturers, with the rest going to factories of non-Chinese corporations. China was second only to Japan in terms of of geographical sales last quarter.
Management is really confident
Despite a more stable services business and growing revenue base in China, the market has bid down Lam Research shares to just 8.8 times forward earnings estimates. Still, Lam's management seems very confident, exhausting its $2 billion share repurchase program last quarter (at higher prices), and last spring the company more than doubled its dividend, which now yields a hefty 3.2%.
All in all, I'm siding with management over the market. They've hit their targets and seem to be realistic about the current state of the industry, so I take the buybacks (in the first quarter, the company committed roughly $1.7 billion toward repurchases) and recent dividend hikes (the company approved a quarterly dividend of $1.10 per share in late August) as positive signs. Plus, at these valuation levels, a lot of bad news seems to be priced in. Lam Research is definitely worth a look for investors who aren't afraid of some volatility.
