Bright Days Ahead for Semiconductor Capital Equipment and Testing, From Cyclical to Secular

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Get ready for the semiconductor capital equipment segment to be less cyclical ahead. That’s the message from Merrill Lynch’s semiconductor team. The firm just reinstated coverage on several chip capital spending leaders with Buy ratings, and the team sees solid upside ahead.

The driving force behind this call is secular demand and a growing complexity, all adding up to an extended cycle versus the very cyclical PC-driven days of the past. Merrill Lynch’s Vivek Arya and the team see the capital equipment stocks in chips on a structurally stronger path of 11% to 15% in annual sales and EBITDA growth. That is nearly 1.7 times last decade’s 7% to 8% trajectory.

There are some additional driving forces and points worth noting here. Newer and more diversified markets are at work, and valuations of 12 to 13 times forward earnings are lower than the 19 to 20 times forward earnings values in the broader semiconductor space.

Additional drivers are China and cloud computing revenues, and there are higher margin business opportunities in the services for spares, upgrades and refurbished equipment. Merrill Lynch even noted that the recurring revenues alone are sufficient to cover all or most of the dividend payouts.

Applied Materials Inc. (NASDAQ: AMAT) was reinstated as Buy with an $80 price objective (versus a $59.23 prior close) at Merrill Lynch. The firm sees 35% upside now with its secular chip demand growth migrating into a less cyclical industry.

Merrill Lynch sees Applied Materials as the most diversified of the capital equipment names and the industry leader. Its $800 price objective arises from the following:

Applied Materials is the largest semi-cap vendor with a solid 11% to 15% sales and earnings growth trajectory. Our $80 price objective is the street-high. The dividend yield is somewhat lower than Lam Research at 1.4%, but Applied Materials is more diversified across memory, logic, foundry and display. We see display as a diversifier, but a possible additional volatility factor given reliance on mature smartphone and TV markets.

Applied Materials shares were last seen trading up 2.2% at $60.57 on Wednesday. The stock has a 52-week trading range of $37.41 to $62.40 and a consensus analyst target price from Thomson Reuters of $69.90.

KLA-Tencor Corp. (NASDAQ: KLAC) was reinstated as Buy with a $140 price objective in the Merrill Lynch call. This represents close to 35% upside from the $117.19 closing price. The firm sees a highly profitable defensive position and an underappreciated enabler of new technologies looking less cyclical than peers with best-in-class returns.

KLA-Tencor is considered to be the most defensive and most profitable of the names mentioned. The report said:

KLA-Tencor dominates the process control/yield enhancement industry and as such is more of a technology purchase rather than (volatile) capacity enhancement tool that drives Lam Research and Applied Materials. KLA-Tencor’s dominance provides it with margins well above peers (37% EBIT% versus peers 29%). Recent Orbotech deal announcement could potentially add 20% accretion to our 2020 estimate.

Shares of KLA-Tencor were last seen up 1.15% at $118.55, with consensus target price of $127.23.

Lam Research Corp. (NASDAQ: LRCX) was reinstated as Buy with a $305 price objective (versus a $219.13 close) at Merrill Lynch. The firm sees roughly 35% upside and is said to have the highest target among major brokerage firms.

Merrill Lynch sees Lam Research as being the top pick and best exposed to the memory upgrade cycle. The report noted:

We expect cloud computing and artificial intelligence to drive secular growth in memory demand. Lam Research is most levered with roughly 75% of sales exposed to increasing memory complexity which is increasingly dependent on more vertical structures and Lam’s etch capability.

Lam Research shares were last seen up 2.2% at $224.10. They have a 52-week range of $123.96 to $234.88, and the consensus target price is $257.67.

Teradyne Inc. (NYSE: TER) was reinstated as Buy with a $58 price objective in a separate call at Merrill Lynch. Arya and team appreciate Teradyne’s growing exposure to secular robotics, complemented by more stable core semiconductor testing. Another driver is roughly $8 per share in cash.

Merrill Lynch views Teradyne as an attractive way to gain exposure to automation in a world where robots could perform 45% of the manufacturing tasks by 2020. Robotics represents just 8% of sales today, but it is modeling 45% to 50% compounded growth through 2020. The firm expects this part of the business to become a meaningful driver of sales and earnings ahead.

The Merrill Lynch investment rationale for Teradyne said:

We view Teradyne, with its rapidly growing collaborative robot (cobot) business, as an attractively valued stock to gain exposure to the secular robotics/automation investment theme. Declining volatility and leadership in the core semi test business provides a stable foundation for the company to grow. We also highlight Teradyne’s strong balance sheet and cash generation which provides optionality for shareholder returns or strategic M&A.

Teradyne was last seen trading up 1.3% at $49.64, and it has a consensus analyst target price of $51.15.

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