Select semiconductor design stocks and big tech are feeling optimistic about generative artificial intelligence (AI) services like ChatGPT, but the financial hype hasn't trickled down to the rest of the economy just yet -- or has it?
Chip manufacturing equipment companies critical to the making of AI systems are in a slump this year as their customers try to conserve cash, but it looks like AI is waking them up from their bear market slumber a bit earlier than expected.
At least, that's the vibe top equipment maker Lam Research (LRCX 2.65%) was giving off during its last earnings report. Lam is anticipating a sequential rise in revenue after another nasty year-over-year tumble. Powerful chips and new chip system packaging techniques could provide a significant lift in the coming years. Even after a rally off of multiyear lows so far in 2023, this stock could be cheap.
A horrible quarter, so why all the excitement?
By all counts, Lam's latest quarter ended in June 2023 was not so great. Revenue was down both year over year (by 31%) and quarter over quarter (by 17%) to $3.21 billion. Earnings per share (EPS) fell 32% from the year prior, but fell less than 1% from the previous quarter -- helped by Lam's cost-cutting and its ongoing cash return to shareholders via stock buybacks (total share count shrank 0.7% from March to June 2023 alone).
The stock soared a double-digit percentage after the report anyway, and is now up over 70% so far in 2023. That's impressive, given that Lam's financials have deteriorated significantly the last few earnings updates.
Data by YCharts.
So what's got investors pumped? Lam's outlook, which is finally calling for a sequential rise in financials. At the midpoint of guidance, revenue is expected to be $3.4 billion for the next quarter, which will end in September, and EPS could be as high as $6.57. It looks like the semiconductor market slump is coming to an end for this top manufacturing equipment player.
AI to the rescue
As one might guess for a tech company, artificial intelligence (AI) was given credit for the coming reprieve in Lam's financials. But why? Lam is, after all, a tech manufacturing outfit -- not a business touting some special benefit from a generative AI software service.
Chalk it up to a wave of new servers (the computing units used inside data centers) that are training and operating AI services. CEO Timothy Archer said on the earnings call, "Advanced AI servers have significantly higher leading-edge logic, memory and storage content versus traditional servers, and every incremental 1% penetration of AI servers and data centers is expected to drive $1 billion to $1.5 billion of additional [wafer fab equipment] investment."
This is significant money because Lam Research is one of the "fab five," what I call the five companies that make up the vast majority of the semiconductor fab equipment industry: ASML, Applied Materials, Tokyo Electron, KLA, and of course Lam.
Data by YCharts.
Lam won't scoop up all of this expected $1 billion to $1.5 billion in new equipment expenditures for every 1% of AI server market share growth, but it could nab a few hundred million dollars of it. The company has announced several new machines in the last year aimed at crafting more powerful chips, as well as more advanced packaging of those chips into a larger compute system.
As a result, while Lam's traditional skew toward the memory chip market hasn't been a good thing as of late (memory has been absolutely clobbered by the downturn), the company's pivot has it increasingly focused on logic chips and third-party foundry businesses (those that manufacture chips for semiconductor designers).
And here's what's really wild about AI servers: According to one research report from TrendForce, AI server market share is poised to go from 9% currently to 15% by 2026. This growth seems to jibe with what the world's largest third-party foundry, Taiwan Semiconductor Manufacturing, said in its latest earnings report, too. If this pans out, and Lam's estimate is correct, that implies up to $9 billion in additional revenue (6 percentage points of market share, each point multiplied by $1.5 billion) is up for grabs for the "fab five" in the next few years from AI servers alone.
Time to buy Lam Research stock?
Lam is very early on in its business rebound, and so it's difficult to assume how high the next run in chip manufacturing upgrades will carry revenue and earnings. However, based on a consensus of Wall Street analyst estimates for next year's earnings, Lam Research (as well as Applied Materials and KLA) trades for about 20 times earnings. As fab equipment makers dig themselves out of the chip industry downturn, shares are starting to look attractively priced again.
I've been cautious on Lam Research this year as the stock has soared, and my caution was (at least over the last nine months or so) unwarranted. I continue to call this one a cautious buy, owing to its still large reliance on memory chip manufacturing and a lack of robust rebound in that part of the industry. Keep Lam Research on your radar, at the very least.
