Ultratech Knocked Back, Not Knocked Out

By Stephen D. Simpson, CFA | May 23, 2013 AAA

For all of the times I lament stocks that got away, I've been lucky enough over the years to benefit from second chances as well. Semiconductor equipment supplier Ultratech (Nasdaq:UTEK) appears to be offering just such a chance right now. While there are certainly risks regarding the adoption of the company's advanced packaging and laser annealing technologies, to say nothing of competition from much larger companies, Ultratech's strong position at leading chip manufacturers like Intel (Nasdaq:INTC) and Taiwan Semiconductor (NYSE:TSM) argues that this company is still in the early stages of a significant revenue ramp.

SEE: The Industry Handbook: The Semiconductor Industry

First Quarter Earnings Weren't Great, And Guidance Was Much Worse
The problem with Ultratech is that it's small enough where a lost or delayed order or two can have a major impact upon results. To that end, I do not believe that the company's fairly severe downward revision for second quarter revenue and earnings is so much of a long-term competitiveness issue as a timing issue.

As it was, first quarter revenue rose 22% from the year-ago level, but fell 9% sequentially. That was about 5% to 10% below many analysts. Gross margin weakened both annually (down about two and a half points) and sequentially (down almost two points), but was a little better than most estimates. Operating income rose 17% from last year, but fell almost one-quarter sequentially, and the operating margin was a little disappointing.

Because of customer uncertainty (usually code for order delays and/or an inability to get customers to sign on the dotted line), management lowered guidance for the second quarter by about one-third while projecting roughly breakeven operating earnings.

SEE: Can Earnings Guidance Accurately Predict The Future?

FinFET Driving More Laser Spike Annealing – When Or If?
One of the bigger near-term opportunities for Ultratech is the adoption of the company's laser spike annealing to manufacture FinFET chips. FinFETs generally refer to multigate (usually, but not always, double-gate) transistor architectures where the gate wraps over a conducting silicon “fin”. Some engineers have pointed to this as one of the biggest moves forward in chip design in decades, and it promises significantly better performance/power trade-offs.

It's still early, but it appears that laser annealing offers considerably better performance over traditional annealing technologies from companies like Dainippon Screen and Applied Materials (Nasdaq:AMAT). What's more, the migration to even smaller chips will increase the number of annealing steps, which means more opportunity for Ultratech. Should LSA take off with FinFETs, that could go a long way towards growing a $100 million market towards $500 million or even $1 billion in a matter of years, and Ultratech is currently estimated to have about 70% share in this market, not to mention strong IP and chip partners like Intel, TSMC, and Samsung (OTC:SSNLF) -- all of whom use Ultratech for 100% of their LSA tools at 28nm.

As I believe LSA adoption in FinFETs is a when-not-if proposition, so too do I believe greater spending from Ultratech's core customers is a question of timing. Intel appears committed to establishing its fab operations, but won't be spending in earnest until later in the year (and may delay further if chip demand doesn't improve). On the other hand, TSMC recently increased its full-year capex target by $500 million to $1 billion, suggesting that Ultratech investors simply need to be patient.

SEE: A Primer On Investing In The Tech Industry

The Bottom Line
A large part of the Ultratech story revolves around chip companies changing their practices, and that certainly adds risk to the story. There are compelling arguments for companies to switch to “flip chips” that require Ultratech's advanced packaging tools and to laser spike annealing, but it's certainly risky to just assume that a company is going to see a many-fold increase in its addressable markets in just three to five years. Likewise, the company's efforts to challenge KLA-Tencor (Nasdaq:KLAC) and Nanometrics (Nasdaq:NANO) in metrology are bold, to say the least.

Even so, I'm a believer. I think Ultratech could see 9% long-term revenue and free cash flow (FCF) growth, and that's conservative relative to most of the analysts who cover this stock. Said differently, if the advanced packaging and LSA markets grow as forecast, Ultratech could conceivably generate $500 million or more in revenue from these businesses alone in 2017 (my estimates are more modest than this). On a cash flow basis, that works out to a fair value of close to $42, and valuation likewise seems undemanding on a price/tangible book compared to other equipment vendors. I don't actually believe that Ultratech will stay independent long enough to test those 2017 assumptions, but I am seriously considering adding these shares to my account today.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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