Growing Niches Should Propel Ultratech Higher

By Stephen D. Simpson, CFA | September 17, 2012 AAA

Niche markets are often spoken of poorly, as they don't typically offer the sort of huge addressable revenue opportunities that tech investors value. In the case of Ultratech (Nasdaq:UTEK), however, I wouldn't be so quick to dismiss the company as just a niche player. With opportunities to expand the utilization of market-leading tools for advanced packaging, laser annealing and LED production, Ultratech could be looking at several years of above-market growth or a takeout offer.

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Not Another ASML
While Ultratech is, broadly speaking, in the lithography business, that doesn't make it a head-to-head competitor with ASML (Nasdaq:ASML). Where companies like ASML, Canon (NYSE:CAJ) and Nikon sell immersion steppers (at over $30 million a pop) for critical features, Ultratech's products are used in the process of fabricating non-critical layers of the circuit.

More to the point, Ultratech's advanced packaging products are used to make flip chips - chips that use conductive bumps instead of wire bonding, leading to smaller assemblies, faster speeds and less heat. Only a relatively small percentage of chips use this technology today, but some in the industry believe it could grow at a double-digit clip through the decade, particularly if memory makers adopt it. While Ultratech's leading share may be hard to maintain against Canon, Nikon, SUSS Microtech and Ushio, it's still a pretty solid growth opportunity.

SEE: A Primer On Investing In The Tech Industry

Strong Share at the Edge in Laser Annealing
Ultratech is also a meaningful player in laser annealing, where it is replacing rapid thermal processing in the activation of transistors on microchips. Traditional RTP systems sold by the likes of Dainippon Screen and Applied Materials (Nasdaq:AMAT) sometimes struggle with millisecond annealing, leading to lower yields and performance with higher-end chips such as smartphone and tablet processors. Right now, Ultratech's gear is the equipment of choice for laser annealing at Taiwan Semiconductor (NYSE:TSM), Samsung and Intel (Nasdaq:INTC) (which make up more than half of the semiconductor equipment market) at the 28nm level. As sizes continue to shrink, Ultratech should have more opportunities to sell high-end LSA equipment.

Not Making LEDs, but Making the Making of LEDs Better
Last but not least, Ultratech has opportunities for growth in the LED business. As LEDs become more commoditized, manufacturing yields are becoming more and more important. Ultratech's tools help improve yields and throughput and seem to be used more often as yield-enhancing tools (as opposed to front-end production capacity). The challenge here is displacing old gear. Ultratech's tools cost about $1 million new, and compete with new contact aligners and used reduction steppers. While reduction steppers are considered obsolete for regular semiconductor manufacturing, a grey market has emerged in taking old Nikon steppers, refurbishing them and repurposing them into LED production. Although these old machines have lower throughput (due in part to higher rework rates) and need more maintenance, the upfront costs (about $500,000) are lower.

Continuing to Build the Business
Ultratech is not just standing pat with its current business. The company recently bought a collection of patents ((including some from IBM (NYSE:IBM)) covering C4 bumping, ball grid arrays, 3D packaging and so on. What's more, the company continues to look at incremental markets such as overlay metrology ((presently dominated by KLA-Tencor (Nasdaq:KLAC) and Nanometrics (Nasdaq:NANO)) that aren't huge (maybe $200 million), but could be meaningful to a company of Ultratech's size.

The Bottom Line
I think the fact that Samsung, Intel and Taiwan Semi use Ultratech's gear is testament to the quality of the machinery and its utility in various parts of the semi manufacturing process. Likewise, I'm impressed with the company's solid share in what today look like niche markets, though they do offer meaningful growth. All in all, I wouldn't be surprised to see this company go the way of FSI International (Nasdaq:FSII) and attract a bid from a larger player such as Applied Materials or Tokyo Electron.

On its own, I think Ultratech works as a stock, even with the strong run seen to date. Growth expectations do look pretty hefty for the next few years, but that's tempered by the fact that Ultratech is one of the few equipment companies to continue growing (and growing profitably) during this difficult stretch in semiconductor capital spending. So, low-to-mid teens free cash flow growth is indeed a demanding target, but the shares could be more than 30% undervalued if the company can hit this mark.

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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