Description

“Now let me provide just a few comments on industry consolidation. The industry has definitely experienced consolidation, from a customer standpoint, through equipment, and more recently in the materials area. We have participated in the consolidation with our recent acquisition of NexPlanar and in 2009 when we acquired Epoch, a slurry provider. As we have indicated in the past, we feel confident with our position, but also believe that there are certain advantages to scale. With the continuing trend of consolidation, we are always monitoring opportunities to strengthen our business, through a variety of means, that could provide additional value to our shareholders.”

– CCMP CEO David Li at the CCMP Annual Meeting of Stockholders (March 8, 2016)

Thesis: Risking ~$5 to make $20+ over next 3-6 months on takeout and/or buyback (net cash) in context of fundamental inflection to $4+ EPS by FY18E

The presence at CCMP of activist Hudson Executive Capital (founded by the former Global Head of JP Morgan M&A Investment Banking, Douglas Braunstein), Lead Director Rick Hill (a semiconductor industry luminary who sold Novellus to LRCX, created substantial shareholder value at TSRA, and was recruited by Starboard to the boards of both YHOO and MRVL), and director Geoffrey Wild (who joined CCMP in late 2015 having sold electronic materials player AZEM LN to MRK GY) has been overlooked by the market. This is surprising given escalating semiconductor M&A (over $100b in deals) and a series of upcoming mergers and spins that stand to transform the fragmented $5+b semiconductor consumables market, which supplies chipmakers including TSM, Samsung, and INTC with the specialty chemicals, gases, and systems (i.e., filters, vacuums) used and exhausted on a recurring basis during the chip-making process (much less cyclical than capital equipment players AMAT and LRCX).

To date, most of CCMP’s true peers (besides perhaps ENTG) have been buried deep inside larger industrial/chemicals conglomerates such as APD and DOW/DD – $30-60+b TEV companies for whom acquiring subscale yet best-in-class CCMP did not much move the needle. This dynamic is about to change: APD has said it plans to spin Versum no later than September and DOW/DD is merging before splitting into three more focused businesses in 2017. On the line is leadership of the $5+b semiconductor consumables market which will go to the most diversified player of best-in-class solutions with the strongest leading-edge R&D capabilities and closest customer relationships.

APD’s planned spin of Versum by this September will introduce to the market a larger, gating, more appropriate peer to CCMP with a highly synergistic portfolio and no observable antitrust risk (Versum is stronger in copper chip polishing technology and lacks a pads business while CCMP is stronger in tungsten and has a pads business). This dynamic introduces the under-appreciated possibility of CCMP being acquired for a premium either before or concurrent with the Versum spin – a scenario that seems more likely when one considers the presence of APD’s former Chairman/President/CEO John McGlade on Hudson Executive’s Advisory Board (http://www.hudsonexecutive.com/our-team), Versum CEO Guillermo Novo’s comments on wanting to “play a very active role in the consolidation of the industry” at the recent Deutsche Bank Global Industrials & Materials Summit, the opportunity to bring CCMP’s mid-20%s EBITDA margins up to Versum’s mid-30%s level using APD’s playbook, and the businesses’ complementary balance sheets (CCMP is net cash while APD is targeting 3.5-4.0x leverage at Versum). An acquisition of CCMP could take the form of a cash deal to strengthen the Versum SpinCo, or a Reverse Morris Trust whereby APD would spin the larger Versum (about $1b sales and $330m EBITDA) which would then acquire the smaller CCMP (over $400m sales and $100m EBITDA). Versum is logically incentivized to move for CCMP soon in an attempt to gain competitive ground while DOW/DD is distracted with its restructuring over the next 12-18 months.

CCMP’s business is heavily moated with 45% share (triple the next largest competitor) of the chip polishing chemicals or “slurry” market used by chipmakers including TSM, Samsung, and INTC during chemical mechanical planarization (“CMP”). CMP is the mainstream chip polishing procedure where, after metals and other electronic materials are deposited on the wafer, the wafer is carefully flattened and excess materials removed through a combination of slurry-induced chemical reactions and mechanical abrasion from a rotating polishing pad. By ensuring a flat defect-free chip surface, CMP prepares the wafer for photolithography during which a specific pattern is imprinted onto the wafer. In so doing, CMP helps manufacturers optimize ROIC on their substantial capital equipment investment which benefits chip throughput and yield while reducing total cost of ownership. CMP has become essential as the manufacturing process has become ever more complex with smaller, denser, more intricate chips which at 10nm are pushing the physical limits of INTC co-founder Gordon Moore’s “Law” (that the number of transistors per chip should double every 1-2 years).

Realizing they are less able to cost effectively manufacture much smaller chips from here, chipmakers are instead moving from planar 2D chip architectures to even denser, skyscraper-like 3D chip architectures: in memory from 2D to 3D NAND (memory comprises 37% of CCMP sales) and in logic from 2D transistors to 3D FinFET (logic comprises 18% with the remaining 45% foundry). This megatrend has three key implications. First, it is increasing demand for slurries, particularly tungsten slurries where CCMP has 80% market share and which comprise 44% of total CCMP sales (tungsten is a key metal deposited during 3D NAND/FinFET). Overall wafer starts are projected by Gartner to grow at a +LSD CAGR through 2020 amidst more muted smartphone growth and PC demand partially mitigated by stronger growth in emerging end market applications such as IoT. But offsetting this, 3D is driving more process steps per wafer (in the case of 3D NAND, twice as many) which is resulting in a higher aggregate demand for slurry, especially tungsten slurry. LCRX's Chief Technology Officer has spoken to this: "There is a challenge in the metal deposition area. We're seeing a lot of customers backfilling it with tungsten. And that's a tricky deposition, because you are doing a non-line-of-sight deposition. So you basically have these caves and tunnels in there. You have to go back in there after the fact and put in tungsten metal. If you don't engineer the process right, you may put in this pre-cursor that wants to plate out metallic tungsten. Given its own way, it could plate out right when it gets into the hole. So you have a lot of ways to create voids" (http://semiengineering.com/how-to-make-3d-nand/).

Second, 3D is increasing demand for best-in-class, leading-edge slurry R&D as nodes change every 1-2 years (CCMP has more R&D dollars invested than any peer). Finally, 3D is more deeply entrenching prized materials suppliers like CCMP in top customers’ supply chains due to the need for longer lead times and more customized solutions (CCMP has three-year visibility into design wins via joint development with customers and process of record protocols). Taken together, switching costs have materially escalated, even putting aside the historical realities of intensive 6-12 month prequalification processes and supplier-chipmaker co-location. In this way, 3D is pushing chipmakers to place a greater premium than ever before on high-performance materials technology suppliers like CCMP with leading-edge R&D capabilities to continually create new, more advanced slurry formulations and pad structures. Close collaboration between chipmakers and materials suppliers is critical in a world where technology nodes change every 1-2 years, yield becomes harder to optimize when dealing with multiplying process steps at an atomic level, and even newer chip architectures may be on the horizon. CCMP’s supply chain is highly integrated (and sometimes co-located) with its top customers in an environment where chipmakers are requesting customized, longer-lead-time solutions – even putting aside the historical reality of intensive 6-12 month pre-qualification processes.

Beyond tungsten (44% of CCMP sales), another key trend is dielectrics (23% of sales) where CCMP is commercializing a new family of premium products across technology nodes targeting $100m of new business opportunities (double CCMP's current dielectric sales bucket). Dielectric insulating materials separate the conductive layers within logic and memory chips and polishing becomes more complex in advanced nodes. CCMP is specifically targeting the premium Interlayer Dielectric or "ILD" space which includes shallow trench isolation, "stop on poly" isolation, bulk oxide polishing, and advanced transistor polishing.

While CCMP's polishing pads business is currently only 12% of sales pro forma for NexPlanar, with only 5% share of a $600+m market, the bundling opportunity with slurries provides long runway for growth versus incumbent market leader DOW/DD (85% share). CCMP has a window here through 2017-2018 to take share in pads and is targeting up to $90m sales by 2018 which may prove conservative. It is worth noting that Versum would logically be eyeing not only CCMP's core strong tungsten and dielectric businesses but also the potential to take material share from DOW/DD in paids in one fell swoop. Versum is also stronger in cooper than CCMP and weaker in tungsten so their portfolios seem quite complementary.

CCMP stands to disproportionately benefit because it has the highest concentration of leading-edge customers: CCMP’s top customers – TSM at 18% of sales, Samsung at 15%, and INTC – are paving the way in 3D NAND/FinFET and dielectric with a greater appreciation for the best pads. For example, Samsung was the first-mover in 3D NAND (it recently said it is spending $2b to add another 40k wafer starts per month capacity to 3D NAND through conversion of 2D) while INTC is ramping production (CCMP has repeatedly won INTC’s top supplier award, 1 of 11 chosen out of thousands). Anyone can mix together lower-end chemicals to formulate lower-ASP commodity slurry serving lagging-edge customers – but only CCMP has the integrated supply chain infrastructure and adaptive, leading-edge R&D capabilities to serve the demanding, higher-ASP premium segment across every CMP application, customer type, and geography. The upcoming SEMICON West event in mid-July (including the July 13th CEO Investor Summit) should serve as a positive catalyst for CCMP highlighting these trends, the benefits of which should begin to accrete more pronouncedly to CCMP’s earnings starting this July quarter and beyond through 2017.

It is difficult to decide which part of CCMP’s P&L consensus most materially mis-models looking to 2018: the top line, where CCMP is not given adequate credit for 3D NAND/FinFET transition despite its 80% share of the tungsten category plus attractive dielectric and pads backdrop; the cost structure, where Street simplistically assumes the status quo despite the presence of an operationally-inclined activist with an Advisory Board of 14 CEO Partners; or the balance sheet, where Street refuses to imagine what CCMP’s EPS power could look like if it levered from current net cash to ENTG-like (not to mention Versum-like) levels (on consensus numbers, a leveraged recap analysis suggests $58 per share).

To frame the fundamental earnings opportunity at CCMP, these developments stand to blend a +MSD to +HSD top-line CAGR through 2018 versus consensus assuming +LSD (the stock is thinly covered by Citi and Needham; UBS chemicals analyst John Roberts used to cover CCMP but now covers APD). ~90% of CCMP’s business is slurry (45% market share) while ~10% is polishing pads (5% share versus DOW/DD at 85%; note that from an antitrust perspective, the pads business could be divested if DOW/DD acquired CCMP). Consensus models approximately $2.70 EPS power for CCMP in fiscal 2018 (September year-end) on an earnings algorithm of +LSD top-line growth, ~50% gross margin, and ~20% EBIT margin. Consensus assumes little operating leverage or controls on fixed cost line items flowing R&D ~14% of sales, S&M ~6%, and ~G&A 12%. Further, this $2.70 FY2018E EPS is unlevered: CCMP has ~$3 net cash per share versus ENTG levered 2x and APD targeting fully 3.5-4.0x at Versum post spin. CCMP is not averse to returning capital to shareholders ($15 special dividend in March 2012) and instituted an annual $0.72 dividend earlier this year (perhaps prodded by Hudson Executive). Assuming moderately higher top-line growth, moderately tighter cost controls, and conservative leverage to 2x pro forma Net Debt / EBITDA suggests EPS power at CCMP of $4.30 in FY2018E on which the stock would currently trade 10x versus ENTG at 14-15x (note ENTG is December year-end). This would box to a 10+% FCF yield given CCMP’s inherently low capital intensity (~5% of sales). Capitalizing CCMP’s $4.30 in EPS at 14-15x suggests a stock price of $60+. This is laid out in the high-level model below.

This puts aside the $100+m or ~$4 per share carrying value of CCMP's land and buildings. In the US (Illinois), CCMP owns a global HQ and R&D facility (200k sq ft), a commercial slurry manufacturing plant and distribution center (175k sq ft), a commercial polishing pad manufacturing plant and offices (48k sq ft), 13 additional acres of vacant land, and a smaller facility (15k sq ft). Outside the US, CCMP owns a commercial slurry and pad manufacturing plant, automated warehouse, R&D facility, and offices in Taiwan (170k sq ft), a commercial slurry manufacturing plant and distribution center in Japan (144k sq ft), and a commercial slurry manufacturing plant plus R&D facility in South Korea (56k sq ft).

While Hudson Executive seems to be assuming a more “constructivist” approach at CCMP so far, there is a clear activist path with the director nomination window running November 8 to December 8, 2016. CCMP would seem to present a compelling opportunity for a more public-facing activist to inform the stock narrative. Notably, CCMP’s second-largest shareholder Shapiro Capital Management was activist in AXLL which was sold to WLK in an auction versus Korea’s Lotte. At the end of the day, the most logical lever here is a sale. Over the past 5 years CCMP has been range-bound between $35 and $50 per share (it paid a $15 special dividend in March 2012). Rather than persisting as what CCMP CFO William Johnson calls “a unique and sort of pure-play, standalone public company leading in this highly specialized field” (Baird Global Consumer, Technology, and Services Conference), CCMP belongs as a best-in-class solution within the portfolio of a larger, more diversified semiconductor consumables supply chain player such as Versum or DOW/DD. We have already seen the initial indications of consolidation in the semiconductor consumables space with ENTG buying materials player ATMI. CCMP’s purchase of leading-edge pad polishing player NexPlanar last year for $140m cash would conceivably only make CCMP that much more attractive to pad-less Versum. Management does not seem entrenched. CCMP founder/Chairman William Noglows stepped down as CEO in January 2015, owns 1% of the company (added to his stake in March 2016 as did director Geoffrey Wild), and would make over $10m in event of a change in control (CEO David Li would make over $8m while CFO would make over $4m).

Asia (80% of sales) and the US (13%) drive CCMP's earnings with European exposure (7%) small.

Three Dealmakers + Versum’s September Spin = CCMP Takeout?

In 2015 two distinguished dealmakers – Douglas Braunstein (former CFO of JP Morgan who earlier served as the firm’s Head of Americas Investment Banking and Global M&A) and James Woolery (former M&A partner at Cravath, Swaine & Moore LLP who earlier served as JP Morgan’s Co-Head of North American M&A) – launched the activist hedge fund Hudson Executive Capital. Hudson Executive states that it draws upon its founders’ extensive M&A transactional experience and a board of 14 hand-picked CEO Partners to “identify undervalued investment opportunities where a meaningful margin of safety exists and value can be created through strategic and operational opportunities” including M&A (http://www.hudsonexecutive.com/investment-strategy). Its most recent 13F lists 6 stocks, 4 of which have either been acquired (HTWR by MDT at a 93% premium on June 27th), have publicly discussed the potential for strategic alternatives (CMA, CIT), or have re-rated upward on M&A headlines describing them as logical consolidation candidates (WWAV). Hudson Executive also recently filed a 13D in EGRX and quickly gained board seats.

The most mispriced and catalyst-rich investment in Hudson Executive’s portfolio is CCMP, which has been overlooked despite its size (over $1b market cap), margins (50% gross), FCF algorithm (capex 5% of sales), strong balance sheet (net cash), and R&D-moated leadership (45% share) of a niche, mission-critical market in the least-cyclical portion of the rapidly consolidating semiconductor supply chain. CCMP’s obscurity among deep-value and event-oriented investors is presumably due to its more limited liquidity and sparse public company peers outside of ENTG – indeed, most other analogous businesses are buried deep inside larger industrial/chemicals conglomerates such as APD, DOW/DD, MMM, Fujifilm, and HON. It is nonetheless surprising that a company whose board members include the likes of Rick Hill (Lead Director) and Geoffrey Wild would be so under-the-radar. Hill is highly regarded in the investment community for his operational and M&A acumen, especially within semiconductors, having grown semiconductor equipment player Novellus from $100m to over $1b in annual sales before selling the company to LRCX for over $3b in 2012. Since then Hill has created substantial shareholder value as Chairman of semiconductor IP player TSRA and has been recruited by activists to high-profile board seats, including by Starboard to the boards of YHOO and MRVL and by Sachem Head Capital to ADSK. Meanwhile, Geoffrey Wild was recruited to CCMP’s board in September 2015 having served as CEO of AZEM LN when it was sold for $2.6b to MRK GY, which itself is a logical potential buyer of CCMP.

The paths of these accomplished dealmakers – Hudson Executive, Rick Hill, and Geoffrey Wild – cross at CCMP at a time when semiconductor M&A activity is already elevated and when conglomerates like APD and DOW/DD are finally splitting into smaller, more focused businesses for whom an acquisition of CCMP would be hugely needle-moving, if not outright transformational. When considering a potential combination of Versum and CCMP, it is interesting that John McGlade – the former Chairman, President, and CEO of APD from 2007-2014, who joined APD back in 1976 – is listed among the 14 CEO Partners on Hudson Executive’s Advisory Board (http://www.hudsonexecutive.com/our-team). Another sign that APD may be dual-tracking the Versum spin process: APD’s Performance Materials Business was initially supposed to be part of Versum, until it was sold to Evonik in May for 15x EBITDA. The high multiple mitigated the tax leakage and the Versum spin – now a pure-play Electronic Materials Business – was left a much cleaner comparable to CCMP.

Industry

Since its introduction in the 1980s and initial inclusion in the 1992 Semiconductor Industry Association Roadmap, the chip polishing procedure known as chemical mechanical planarization (“CMP”) has become firmly cemented as a mainstream, mission-critical component of the overall chip manufacturing process. Device manufactures including TSM, Samsung, and INTC use CMP in the production of increasingly intricate chips powering consumables including smartphones, tablets, standard PCs, digital TVs, set-top boxes, servers, wireless networks, cars, and IoT. During the chip manufacturing process, transistors and other electronic components are built onto a circular silicon wafer and then wired together using conducting materials such as aluminum and copper in a specific functional sequence. Insulating materials are deposited onto the wafer to prevent electrical signal interference among the various parts. The chip-making process entails hundreds of precisely controlled steps which result in numerous patterned layers of different materials stacked one on top of the other. The finished wafer is then cut into dies and packages into chips.

CMP is a chip polishing procedure whereby a series of chemical reactions enable the targeted removal of excess deposited electronic materials from the wafer in order to flatten  or planarize the wafer. This creates a uniform surface free of defects and unwanted residual metals while maintaining the integrity of the underlying circuitry. The flattening technique is essential for subsequent steps in the chip-making process which require a precise wafer topology, particularly high-resolution photolithography during which a specific pattern is imprinted onto the wafer. During the CMP process, the wafer is held in a rotating carrier while a polishing pad is pressed against it and a liquid chemical mixture called “slurry” is continuously applied. The slurry causes a series of chemical reactions at the atomic level which catalyzes the removal of unwanted materials from the wafer structure, with the polishing pad providing mechanical abrasion. The slurry is held in a day tank at the device manufacturing facility holding ~300 gallons to ensure interrupted supply to the CMP tools with a typical flow rate of 5-15 gpm.

CMP polishing slurries and pads, which are non-recyclable, represent a small recurring operating expense to the device manufacturer while enabling the manufacturer to maximize its ROIC on its much more substantial investment in property, plant, and equipment. CMP allows chipmakers to produce smaller, faster, more complex chips and extend the life of lithography tools while optimizing both throughput and yield. All slurries are not created equal. They contain unique engineered micro-abrasive particles and acidic or basic chemistry designed to remove certain electronic materials from specific parts of a many-layered wafer mere nanometers in size. Current CMP polishing applications include tungsten, dielectrics, copper, barrier, and aluminum. Technology advances and emerging applications such as FinFET and the shift from 2D to 3D structures require the continual innovation of new slurry formulations as well as more CMP steps. Chipmakers work closely with suppliers well ahead of the production process to ensure seamless functioning and an intensive pre-qualification process can take over six months.

The nearly $4b CMP market, which is expected to grow at a 7% CAGR through 2020, consists of (1) capital equipment makers such as AMAT and LRCX which supply chipmakers with CMP tools and (2) consumables players such as CCMP which supply chipmakers with polishing slurries and pads used on a recurring basis during the chip manufacturing process. The distinction between a capital equipment expense and an operating expense sometimes seems lost on the market when it comes to CCMP. The market tends to trade the inherently less-cyclical CCMP (whose earnings stream is recurring as chip production is an ongoing process) as if it were a more-cyclical capital equipment player (which is levered to chipmakers ramping ahead of new production cycles). Whereas capital equipment makers trade with capital expenditure numbers, these numbers do not directly impact the consumables space which is more concerned with wafer starts and volume transitions to 3D NAND and leading-edge nodes.

Business

CCMP plays in the over $1.6b CMP consumables market which is expected to grow mid-single-digits and which comprises polishing slurries (over $1b) and pads (over $600m). CCMP has 45% share of the fragmented slurry market – triple the size of the next largest slurry competitor – which accounts for 90% of its sales. Following its 2015 acquisition of NexPlanar for $140m it has 5% share of the CMP pads market which is dominated by DOW/DD with 85% share. CCMP’s portfolio is unique in that it has products for every CMP application across the spectrum of technology nodes, whereas most of its competitors tend to focus on a particular subset of applications, range of technology nodes, geography, or customer segment (APD’s Versum, DOW/DD, ENTG, Shin-Etsu Chemical, HON, MMM, Hitachi, Fujifilm). CCMP has 80% share of tungsten (44% of sales) which plays a key role during the metal deposition phase of the 3D NAND manufacturing process (http://semiengineering.com/how-to-make-3d-nand/). CCMP also has tailwinds in advanced dielectric and polishing pads.

Intellectual Property

As of October 2015, excluding NexPlanar, CCMP had 1,253 active worldwide patents of which 247 are US patents and 444 pending worldwide patent applications of which 92 are in the US. CCMP states that it does not expect to lose worldwide patent coverage of material patents through expiration within the ensuing two years. CCMP’s CFO has stated that the company’s best-in-class leading-edge R&D capabilities (in a rapidly evolving industry where technology nodes turn every 1-2 years), heavily integrated supply/services infrastructure with top customers, and long customer lead times with three-year visibility into new design wins provide a formidable moat with high switching costs. Anyone can mix together lower-end chemicals to formulate lower-ASP commodity slurry serving lagging-edge customers – but only CCMP has the integrated supply chain infrastructure and adaptive, leading-edge R&D capabilities to serve the demanding, higher-ASP premium segment across every CMP application, customer type, and geography.

Links

Company Presentations: http://ir.cabotcmp.com/phoenix.zhtml?c=120920&p=irol-calendar

Hudson Executive Capital: http://www.hudsonexecutive.com/

INTC 3D NAND Animation: http://www.intel.com/content/www/us/en/solid-state-drives/3d-nand-technology-animation.html

Catalyst

* APD spin of Versum no later than September (CCMP could be acquired by Versum before or concurrent with spin)

* Potential bidding war by year end

* Mid-July SEMICON West event including July 13th CEO Summit which should highlight fundamental 3D NAND/FinFET tailwinds

* Increased demand for leading-edge tungsten slurries on 3D NAND/FinFET transitions (CCMP has 80% share in tungsten which comprises over 40% of sales)

* Increased demand for advanced dielectric 

* Taking share from DOW/DD in polishing pads using NexPlanar platform

* Capital allocation given CCMP is net cash versus ENTG at 2x and Versum targeting 3.5-4.0x