Anyone invested in the semiconductor sector knows that the industry is headed into a down cycle. Huge demand during the pandemic led to chip shortages, but now that central banks are tightening up their fiscal policies to tamp down on inflation -- and economic growth -- demand has slumped, suppliers are loaded with inventory, and prices are falling for memory chips worldwide. Despite a rally this week, the iShares Semiconductor ETF (SOXX 2.09%) is still down 39% on the year.
And yet, the semiconductor industry is going to grow over the long term, and likely at a much faster rate than the overall economy. Today, many chip stocks trade at bargain levels, setting up those who invest in them now for potentially outsized gains once the market recovers.
One under-the-radar company in this space that looks like a terrific buy today is equipment supplier Onto Innovation (ONTO 3.12%).
Exposure to the most attractive parts of the market
Onto Innovation is relatively small by semiconductor equipment standards, with a market cap of just $3.3 billion. However, it has put forth some powerful technology in some of the more attractive parts of the market: leading-edge metrology and advanced packaging.
Even though a semiconductor slump may be in the cards, chipmakers will still invest to compete on the most advanced nodes. Samsung and Intel (INTC -0.38%) look set to invest heavily through this cycle, as they aim to build alternatives to compete with Taiwan Semiconductor Manufacturing (TSM 2.84%), which pulled ahead of both of them a few years ago and now dominates leading-edge chip production. In fact, Samsung just announced a bold plan to produce 2 nm chips by 2025 and 1.4 nm chips by 2027, with a goal of tripling its advanced node capacity by that time. Intel has announced it aims to transition through four nodes in just five years -- an ambitious timeline.
Onto Innovation makes metrology solutions for leading-edge logic and memory chips. Metrology, to put it simply, is the science of measurement. And in the specific context of manufacturing chips, it refers to the quality-assurance tools and techniques used to calibrate the machines and scan the chips they produce for imperfections at nearly every step of the process. As chip geometries get smaller and smaller and manufacturing execution becomes more difficult, the need for quality metrology solutions intensifies.
The company's other segment focuses on wafer inspection and advanced packaging lithography -- two areas that should also grow in the years ahead. As foundries struggle to shrink transistor distances further, chipmakers are now turning to advanced packaging solutions and chiplet architectures to keep Moore's Law valid. Advanced packaging is also growing with the ascension of electric vehicles and edge-computing devices.
Equipment sales account for 83% of Onto Innovation's revenue, split roughly evenly between the leading-edge and advanced packaging segments; software and services make up the remaining 17%.
An exciting growth catalyst
Onto Innovation also has a particularly important catalyst coming up. The semiconductor industry is transitioning from FinFET transistors (in which gates surround each transistor on three sides) to Gate-All-Around (GAA) transistors. As the name suggests, that new architecture has gating material on all sides of the transistor, which also enables vertical transistor stacking. Samsung is already beginning production of GAA chips at the 3 nm node, which is just ramping up as we speak. TSMC is staying with FinFET for 3 nm, but will transition to GAA at 2 nm, likely in 2024.
Onto Innovation is in a great spot here, as its new Atlas 3D metrology system looks to have the lead in performance capabilities, especially when it comes to the 3D-modeling capabilities needed for GAA-based chips. According to reports and industry blogs, it appears as though Atlas machines outperform even KLA's (KLAC 2.30%) metrology solutions in GAA nodes. Given that KLA dominates the metrology industry with a market share of more than 50%, a competitive win by Onto Innovation could make a meaningful dent in the balance of power.
In July, the Atlas machine won the Best of West Award at the SEMICON West trade show. Management also said on its August conference call that it has already received orders for Atlas on both 3 nm and 2 nm node buildouts. That gives management great visibility, and it expects advanced node revenue to rise by 40% this year.
In addition, it forecast that advanced packaging revenue will rise by 20%, so both of its segments are growing faster than the 9% to 10% growth that the broader semiconductor equipment industry is experiencing in 2022. Even though Onto Innovation is small, it appears fiercely competitive in its high-growth specialty niches.
The market downturn has made this growth stock a bargain
The semiconductor sector's swoon has brought down Onto Innovation's valuation to a quite reasonable 17.7 times earnings. However, the company also has an excess $545 million ($10.98 per share) in cash on its balance sheet and no debt, which brings its price-to-earnings ratio ex-cash down to just 15.
Meanwhile, revenue grew by 33% last quarter. Although margins took a hit due to supply chain issues and inflationary pressures, management expects those headwinds to diminish as the supply chain becomes unkinked.
Onto Innovation doesn't pay a dividend and hasn't bought back stock -- qualities that may turn off some investors. However, it's hoarding cash for potential acquisitions, and its big cash balance could be a huge asset if the market becomes stressed next year. In that scenario, it could make some opportunistic purchases at bargain prices.
With its rock-solid balance sheet, a multiyear catalyst ahead in the Gate-All-Around transition, and a cheap valuation for its growth rate, Onto Innovation should be on every tech investor's radar.
