Description

Kulicke & Soffa is a market leader in the highly cyclical semiconductor capital equipment space. I believe that the company lacks due market recognition given its solid secular growth trend. At the current price of $10.88, I believe the company is significantly undervalued at roughly 2 times earnings and free cash flow after adjusting for what will be large cash balance of $6.50 per share on Dec 31, 2012. In the coming quarters the company will demonstrate its performance over its peers.

Business Description

Kulicke & Soffa specializes in bonding machines that connect integrated circuits to printed circuit boards, a process used in approximately 85% of the world’s semiconductors. Founded in 1951, the company has been publicly traded since 1961. It has over 3,200 employees globally and is headquartered in Philadelphia. The company's fiscal years ends September 30 which means they will be reporting fiscal fourth quarter earnings tomorrow. (Source: Management conversation; Industry interviews; KLIC Investor Presentation 1 Aug 2012)

Opportunity

Historically, bonding was completed using gold filament, but high and volatile gold prices are convincing manufacturers to move to copper for bonding. Kulicke & Soffa is the proven technological leader in copper bonding equipment with 70% share in the overall wire-bonding market and about 90% market share for copper-capable machines. The company has held this leadership position for several years and the competition has been unable to unseat KLIC in any of its core product categories.

While the overall semiconductor capital equipment space is highly volatile and cyclical, Kulicke & Soffa is seeing a powerful secular demand trend for their products that will buck the cycle for years to come. The company projects the number of copper ball bonders in production to increase 2012-2016 at a 26% CAGR as long as gold prices remain over $1,000 per oz. (Source: KLIC Investor Presentation 1 Aug 2012)

The company has shown good strategic direction by focusing marketing efforts on the outsourced semiconductor assembly and test (OSAT) industry. OSATs accounted for 88.4% of ball bonder sales 3FQ12 and 75% of all bonders shipped since 2008. While large OSATs may be reaching 50% adoption in the next 3-4 years , management believes they are only about 1/3 of the way through the conversion cycle and have the clear technology leadership position. The company’s competitors, ASM Pacific and Shinkawa, were very slow moving on the copper conversion trend and have subpar products, leaving them only to compete with Kulicke & Soffa on price, which I believe is an ineffective strategy in this space. Industry experts forecast OSATs will grow at nearly 2x the overall semiconductor space, as measured by revenue, and Kulicke & Soffa is in unique position to win their business. (Source: 1FQ12 earnings call; 3FQ12 earnings call; KLIC Investor Presentation 1 Aug 2012; Gartner)

Financials and Valuation

By the end of this calendar year I expect the company to have over $6.50 per share in cash and no debt, for an enterprise value just under $4.40 per share. Kulicke & Soffa has made over $2.00 per share in earnings the past two fiscal years and I expect their dominant share in copper bonding equipment will allow them to produce at this level for the next few years. Furthermore, the company’s FCF has typically trended closely in-line with EPS. Adjusting for cash the company trades at just over two times earnings.

*CapitalIQ Consensus
**CCM Estimate

The company has done a good job managing debt and is currently debt-free as of 3FQ12. At the same time, management is looking to the future and investing in other technologies to keep the company in pole position without sacrificing cash flow. As shown below, the deleveraging has had a remarkable effect on the balance sheet, and I believe it will only get stronger from here. The company has stated it is open to share repurchases and they are looking to return excess cash to shareholders in the near-term.

Conclusion

In a space often fraught with volatility, Kulicke & Soffa has generated several years of strong cash flow from the secular switch to copper and I believe this will continue for the next few years. While the transition period has a definite life, the company will be in an excellent position to ride the replacement and parts/service annuity for a long time to come, and management is looking to the future and investing in other technologies to keep the company in pole position within packaging and assembly. I believe that the stock is worth over $16 today based just on their existing products.

Risks 

• Management spends cash on bad projects or value-destroying acquisitions
• ASM Pacific may build a good copper wire bonder and increase competitive pressure
• Greater than normal cyclicality could take hold of buying patterns of IDMs and OSATs overwhelming secular copper bonding equipment demand trend

Catalyst

1. Continued execution, demonstration of the secular copper transition (perhaps in contrast to a “pause” or cyclical downturn)
2. Consistent cash generation and announcement of return to shareholders via share repurchase or dividend
3. Resurgence in LED lighting and other niche applications that heavily use bonding equipment
4. Due to customer buying patterns, Kulicke & Soffa’s revenues and earnings are typically strongest in fiscal Q3 and Q4 and weakest in fiscal Q1 and Q2. However, smart semicap investors tend to invest in front of the heavy sales season, buying before the company discusses the weak fiscal Q1 on the one hand, and its strong initial full-year outlook on the other. If you bought the stock the day before the Q4 release and held until the fiscal Q2 call you would have seen a 42% return in 2011-2012 and 59% in 2010-2011. I believe this pattern will continue.