Lam Research Has Memory Problems (LRCX)

By Hans Wagner | July 13, 2007 AAA

Potential value play Lam Research (Nasdaq: LRCX) makes processing equipment for other companies who make semiconductors. Although it doesn't actually produce memory chips or semiconductors itself, it is set to encounter slowing sales due to falling prices for memory chips. These falling prices mean manufacturers are delaying orders for new equipment which will reduce the sales of firms such as Lam Research. The end result is investors may want to avoid buying any company that is even remotely connected to the memory game, at least for now.

A Value Play
Lam Research sports many of the signs that value investors seek in stocks before making a commitment. For example, the company presently has a P/E ratio under 12 and a PEG ratio of 0.60. For fans of Joel Greenblatt's approach to valuing stocks, the company's return on working capital is in excess of 100% and their earnings yield is over 16%.

Cash flow is another key measure used by many investors to analyze their potential investments. For the last four quarters, free cash flow margin, a measure how much free cash flow a firm's sales generate, for Lam Research is 22%. This is very good. In addition Lam's free cash flow yield is 7.8%. Free Cash flow yield is the amount of free cash flow per share based on the current value of the stock. So, Lam is generating a lot of excess cash for now. But what about the next year?

Memory Manufacturers Delaying Capital Expenditures
According to various reports, current pricing for some NAND flash memory is 15% to 20% below production costs. MarketWatch reports that falling DRAM prices are causing memory chip makers to have one of their worst quarters. As prices fall further than expected, the memory manufacturer's finances are put under undue pressure. One of the first actions these companies can take to conserve cash is to reduce their capital expenditures for new equipment.

According to Citigroup, a "funding gap" has developed as memory EBITDA will fall significantly below capital expenditures. If this happens, it will be only the third time in the past 15 years in which this situation has occurred. In the past when this happened, expenditures on new capital equipment fell the following year. This means we can expect significantly lower capital expenditures in the near future by the manufacturers of memory chips. (To learn more, read A Clear Look At EBITDA.)

Sales Likely to Slow
For Lam Research, memory is the largest market segment making up 78% of the company's business as of the end of the quarter March 25, 2007. Any slowing in the number of orders from semiconductor memory manufacturers will hurt Lam Research's sales.

As confirmation of this, on June 28, 2007, Novellus Systems (Nasdaq: NVLS) warned that its second-quarter financial results will come in at the low-end of expectations due to weakening demand for equipment. Shortly thereafter, a report by Caris & Company's Ben Pang states that Applied Materials' (Nasdaq: AMAT) etch division has been notified of a reduction in orders from Samsung for AMAT's fiscal fourth quarter ending in October.

Cation Required
Given these factors, it is reasonable to assume that Lam Research will also encounter slowing sales in the coming months. While the company has performed well recently, and it is guiding toward the high end of the range, investors should be realize that this is likely the peak in sales for this cycle.

Investors should be wary of taking any position in any semiconductor equipment manufacturers such as Lam Research that provide equipment for the memory manufacturers. While Lam possesses excellent value indicators, the company's customers (memory manufacturers) are encountering a turbulent pricing environment. Therefore, it might be worthwhile for investors to delay taking a position until the memory market stabilizes and equipment orders are likely to pick up.

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