Governments around the world are responding to fallout from the chip shortage of the last few years by pouring billions of dollars into semiconductor manufacturing. Even the U.S. and the European Union, which account for small portions of the global chipmaking market (Taiwan and South Korea have come to dominate the space), are getting serious. The U.S. CHIPS Act will dole out $53 billion to support manufacturing and research, and the European Chips Act will aim to rekindle semiconductor manufacturing with 43 billion euros in funding.
This legislation is only going to foot a small part of the bill to build new fabs and update existing ones, though. A new high-end chip fab, where the manufacturing of semiconductor designs is executed, can cost tens of billions of dollars. That's why I've recently focused my investment dollars not on chipmakers themselves like Intel or Taiwan Semiconductor Manufacturing. Instead, I am putting my money into fab equipment companies -- the businesses that build the machines needed to actually make silicon wafers and package the chips from those wafers into a computer.
Because of global economic uncertainty in 2023, many of these fab equipment company stocks have been sold off hard, but they could be trading at a deep-value share price. Two small-cap names you should keep on your radar are Onto Innovation (ONTO 3.15%) and Kulicke & Soffa Industries (KLIC -1.22%). Here's why.
Advanced metrology for the next generation of high-end chips
The long and complicated semiconductor manufacturing process begins with the creation of a crystalline silicon boule -- think of it like a cylindrical loaf of bread. Once made, those boules get cut up into wafers (like cutting slices of bread); picture those shiny discs you see workers in bunny suits holding. Those wafers are then subjected to an intricate process of creating microscopic patterns on their surface (this shows up as reflective squares on the wafer) that govern how the chip that eventually gets cut out of the wafer operates.
Like any complex manufacturing process, chipmaking requires machines to measure the accuracy of the results -- metrology, in industry speak. That's where Onto Innovation comes in. Onto is a small company with some advanced metrology capabilities for high-end chipmaking (think semiconductors used in top-of-the-line smartphones, data centers, AI applications, and the like).
Onto competes in this space against metrology juggernaut KLA, but it's holding its own thanks to its focus on advanced measurement tools. Sure, revenue in Q1 2023 fell 17% year over year to $199 million as management said it would, but that's coming off of a record year in 2022. A new generation of chips made with mind-bogglingly complex equipment and ever-smaller features are in need of Onto's machines, and the company could return to growth before too long. In fact, the company is forecasting a slight sequential increase in revenue in Q2 to $204 million.
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More importantly, even during this downturn, Onto is profitable. Free cash flow was $42.2 million last quarter, about even with where free cash flow was last year in spite of the decline in sales, equating to a healthy free cash flow margin of 21%. The balance sheet is also in exceptionally good shape, with $583 million in cash and short-term investments and zero debt.
Onto currently trades for 22 times trailing-12-month earnings, or 37 times free cash flow (the latter an elevated valuation metric that could improve later this year if business continues to pick up steam). The average consensus on Wall Street is that Onto will grow sales at a mid-teens percentage again starting in 2024. For a small company with in-demand machines for advanced chipmaking, the current valuation could be a long-term value.
Don't forget chip packaging technology
Once a wafer is complete, it's time to cut it up into chips, which then get packaged together on a circuit board with other chips and electrical components to make a computer. Over the last couple of decades, a great deal of technological advancement has been made in wafer manufacturing. However, existing packaging technology has been, by and large, good enough along the way and ignored by many investors.
Kulicke & Soffa's particular focus is on chip packaging, as well as equipment for assembly of LED displays and automotive and industrial applications. Kulicke & Soffa was one of the first companies involved with chip equipment development in the 1950s, getting tapped by Bell Labs (at the time, AT&T's research and development arm) to devise an automated system for connecting this new thing called a "semiconductor" to the rest of an electrical package with tiny wires.
However, early packaging technology eventually got eclipsed by wafer manufacturing, leaving Kulicke & Soffa with a highly cyclical, overall low-growth business.
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But something changed in the last few years. Automotive and industrial markets, in particular, have become new secular growth arenas, driven by electrification and automation. Kulicke & Soffa's "old" tech is suddenly en vogue again. And as more advanced chips (like Onto's specialty described above) keep shrinking, manufacturers may be in need of new innovation from packaging experts like Kulicke & Soffa once more.
Like Onto, Kulicke & Soffa's sales surge has given way to a slump as customers manage their spending amid tough times in 2023. During the first quarter of calendar year 2023, the company's revenue was down a whopping 55% from the year-ago period to $173 million. Net income was $15 million, and free cash flow dipped into the red (negative $8.8 million). Such is life for a cyclical industrialist.
But Kulicke & Soffa is already sensing a bit of a reprieve. Management expects a sequential increase in sales in the next quarter to $190 million. Wall Street analyst estimates also predict a return to year-over-year double-digit sales growth in 2024. A squeaky-clean balance sheet is a plus, too, with $734 million in cash and short-term investments and no debt at the end of last quarter.
Make no mistake, even a new period of sustained growth for chip packaging from the electrification of vehicles isn't going to eliminate this company's cyclicality. Expect some steep peaks and valleys in revenue and profitability going forward. However, if Kulicke & Soffa does enjoy some revitalized growth trends in the next few years, shares could be cheap. Amid a nasty downturn, the stock trades for 13 times trailing-12-month earnings, or 10 times free cash flow. This is another tiny chip stock that could be worth your consideration as the semiconductor market receives renewed interest from investors.
