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Sell Pickaxes and Shovels During the Gold Rush
🕑 Added 2020-10-03 19:04:32 +0000 UTCSell Pickaxes and Shovels During the Gold Rush
We all know the story of how companies that made out like kings during the gold rush were not those who wallowed in shallow rivers sifting for gold flakes. The companies that did well were those that serviced those folks with pickaxes, sifts shovels, jeans, and other goods necessary for hunting gold nuggets.
Today, the tech industry has its own gold rush. Consumers have a high demand for semiconductors and other computing hardware, and companies compete with one another to fill that demand. In my analogy, these companies are the prospectors, the 49ers, who hunt for gold. Many of them, like Apple and Tesla, serve the investor well. Others, like Palm, GoPro, and FitBit, do not. Choosing a winner can be difficult, and these companies are also highly susceptible to overall market downturns since the companies serve the consumer directly.
Investors can diversify by buying shares of QQQ, which captures tech companies traded on the Nasdaq. But in a broad market downturn, QQQ will perform very poorly because it mostly owns shares of these 49er companies. Likewise, overdiversification into QQQ carries the opportunity cost of not investing heavily into the real big winners.
Can we buy a company that is at least somewhat protected from dropping consumer demand for electronics in a recession, but also capture some of the market's biggest wins during bullish environments? Yes, we can. That company is Lam Research.
tl;dr Lam Research Corporation (LRCX) is fundamentally strong and will almost certainly benefit from the 5G rollout. The company has a track record of increasing revenue and EPS, and will continue rewarding shareholders with increasing dividend and share buyback programs.
Positions: Long 100 shares of LRCX, long 100 shares of SMH (ETF 4.5% comprised of LRCX). Will sell deep OTM covered calls occasionally for premium. Will reinvest premium and dividend into either LRCX or SMH.
The Electronic Hardware Pipeline
Moore's Law states that every two years, the number of transistors on a microchip doubles and the cost of computers is halved. Keeping this vision alive since its origin in 1965 has forced companies to push the limits of physics and chemistry.
Lam Research is one of the few companies that have answered that challenge. Lam Research creates the tools and processes that have enabled semiconductor manufacturers like Qualcomm and Taiwan Semiconductor to create the chips that consumer hardware companies need.
To understand this pipeline, begin with the phone in your pocket. I assume you have an iPhone like the other cool kids. Your iPhone was designed by Apple and manufactured by Foxconn. But Apple did not create most of the components inside it. Apple's chips are produced by semiconductor manufacturers further back in the pipeline.
Prior to the consumer hardware stage is the semiconductor manufacturer. Continuing with our iPhone example, most of those semiconductors (computer chips) are manufactured by Taiwan Semiconductor and Samsung. Other Apple products incorporate chips by Intel, SkyWorks, Qualcomm, and others. But Taiwan Semiconductor is a manufacturer, and manufacturers need equipment to create chips. These chips are provided by manufacturing enablers another step back in the pipeline.
Behind the semiconductor manufacturers are the enablers. These are the companies that create the tools and perform the research that enable manufacturers like Taiwan Semiconductor and Qualcomm to make chips for consumer hardware providers. In our gold rush analogy, they're the ones making the pickaxes to sell the prospectors. Lam Research is among few companies in this niche, and they are outperforming the few companies with whom they compete. The next section will outline Lam's activities from the point of view of the investor.
Lam Research Corporation: irl h4xx0rz
A perusal of Lam Research's activities indicates they are leading the charge in creating faster and smaller electronics.
Creating the tiny, complex chips used in computing devices involves hundreds of individual steps. For successful production, semiconductor manufacturers require sophisticated processes and fabrication equipment. Lam Research is responsible for the research behind manufacturing and creating the tools required to perform the production.
Lam is responsible for 22 families of products designed to, among other things, improve wafers (thin slices of semiconductor material like silicon used in the production of semiconductors), perform doping (adding imperfections to modify semiconductor conductivity), and tools for eliminating debris from transistors. Only a true engineer would understand the specifics. From the investor's point of view, Lam Research is well-positioned to continue providing modern civilization-critical manufacturers like Taiwan Semiconductor, Texas Instruments, and Qualcomm with manufacturing solutions to continue improving semiconductors.
Perhaps the most important of Lam's products is its transistor solutions. Transistors are the "brains" behind chips. They are tiny switches that control the flow of electricity. There can be literal billions of transistors on one integrated circuit, and this number is increasing in accordance with Moore's Law.
Chip fabricators, specifically Taiwan Semiconductor, have announced breakthrough transistor technology that will allow transistors to be built at the 7 and 5 nanometer (nm) level. Atoms are usually between 0.1 and 0.5 nm wide, so these 5 nm transistors will be measurable in atoms. Keep in mind that "5 nm" doesn't literally mean "5 nanometers." It just means "smaller than 7 nm," because physical spaces tend to run into issues with uncertainty at this atomic space where quantum physics takes over. Nevertheless, these transistors are small as fuck.
Looking at the patents behind Taiwan Semiconductor's 5 nm transistors, we see Lam Research all over it. I counted 26 Lam Research patents behind just one component within the 5 nm transistor. There can be no questions that Lam Research will continue leading the charge in affecting Moore's Law.
Financial Fundamentals
Revenue: LRCX's financial history shows a marked pattern of strength. Revenue is my favorite financial measurement because it demonstrates the company's ability to drive sales, control prices, and maintain strong demand from customers. Others may disagree that revenue is the most important fundamental factor, but it is where I will begin my analysis.
LRCX's revenue has increased year-over-year (YoY) virtually every year except from 2018-2019, owing to 2018's particularly strong performance. 2018 was an outlier year in the most positive way possible. Even with that outlier, revenue expectations are expected to reach all-time highs in 2021, and again in 2022. Analysts expect revenue of $10.04 billion in 2020, $12.44 billion in 2021, and $13.48 billion in 2022. Expectations for a 23.8% revenue increase in 2021 are ambitious, but demand for more advanced equipment amid the 5G rollout makes this possible.
Earnings Per Share (EPS): Strong revenue expectations and a share buyback program will lead to increasing EPS over the next several years. Since 2016, diluted EPS has nearly tripled from $5.22 to $14.85-$15.10, depending on how the rest of 2020 plays out. This trend is expected to continue into 2021 and beyond, with average analyst expectations of $18.91 in 2021 and $21.28 in 2022. Even the most bearish analysts expect an EPS increase to $21.17 in 2022, and the most bullish expecting a remarkable $27.48 EPS.
From analysts, we've seen a number of upgrades and increasing price targets. Stifel and B. Riley FBR, two bearish analysts, recanted their bearish estimates this year and both upgraded the stock to BUY and increased their price targets. DA Davidson, the lone bearish analyst remaining, has a price target of $250 and is currently getting destroyed.
Dividend and Buyback: LRCX's 1.58% dividend yield will not turn any heads, but the company does appear committed to an annual increase since it began paying in 2014. Most recently, LRCX increased its dividend this quarter from $1.15 to $1.30, an increase of ~13%. With a payout ratio of ~25%, LRXC has plenty of room to continue increasing its dividend, especially when considering its expected earnings increases over the next several years.
Beyond dividend, LRCX is also returning capital to its shareholders in the form of buybacks. LRCX announced a $5 billion buyback plan at the beginning of 2019, and that buyback so far has reduced the number of shares outstanding by about 5%. There is still a long way to go on the buyback, and we will more than likely see additional buybacks in the future.
Competition: The world of semiconductor manufacturing equipment and research is quite niche. It is difficult for new players to enter the market and carve market share away from existing companies. In finance, we call this a wide moat. LRCX indeed has a wide moat, and yet it has been carving market share away from other companies at a rapid pace. This is demonstrated in LRCX's market share in wafers front end (WFE), when transistors are patterned to the semiconductor. Although this chart indicates that AMAT still has a larger proportion of WFE market share overall, LRCX has more than tripled its share to over 15% and rising. This indicates LRCX's ability to bring in demand from customers, even at the expense of other companies. This will become important in the next section due to the trade war.
Future developments
The trade war with China was costly for the semiconductor industry. LRCX and AMAT both took hits due to increased difficulty for its customers to reach domestic hardware markets. For example, LRCX suffered because tariffs on microchips made it more costly for US clients to attain chips from Taiwan Semiconductor, and therefore US customers were buying fewer chips. Likewise, Chinese customers were buying fewer US-made chips. This made things difficult for LRCX because its clients required less support from LRCX. However, the trade war seems to be cooling off with Donald Trump requiring less saber rattling against China to drum up domestic support, and with Democrats having less interest in waging a trade war with China. Either way the election goes, we are likely to see cooling off.
Additionally, at least some of LRCX's customers are finding ways around the trade war. Taiwan Semiconductor intends to build a $12 billion manufacturing plant in Arizona through 2021-2024, which will certainly require substantial support from LRCX to prepare the plant with fewer export challenges than they'd face supplying US customers from abroad. Political and social demand for US-made goods may encourage additional chip manufacturers to turn stateside, which would be a tremendous boon for LRCX.
More speculatively, we can make some assumptions regarding the 5G rollout in the US powering the internet-of-things, smart equipment, and other high-end devices. It stands to reason that demand for smaller and more capable microchips will continue on its current trends, and LRCX will certainly lead the pack in delivering on these requirements. When chipmakers need to push the limits of physics and use actual quantum tunneling to achieve its goals, LRCX will be the company to which these fabricators turn.
I expect tremendous things out of Lam Research over the next several years and will continue to hold shares. I may occasionally sell deep OTM covered calls with very low deltas to pull some additional premium. I expect LRCX to perform well at a fundamental level and for the company to continue rewarding investors with increasing dividends and a generous share buyback program.
Comments
Meatball
Great analysis. As someone who works in this industry, I can confirm the excitement behinds a constant push for Moore's law.
Roc Marciano
Another one for the books Thank you Mickey.
