Description

Thesis

SK Hynix (Ticker: 000660 KS) is a USD 32.5b market cap manufacturer of DRAM and NAND chips which are used in handsets, PCs, servers, and several other end markets. About 80% of revenues and 100% of earnings come from DRAM. The DRAM industry is consolidated and will be more stable and have higher sustainable gross margins. The stock trades at 6.7x P/E and 3.0x EV/EBITDA on 2015 estimates. Fair value is 9 to 10x P/E on 2015 EPS of KRW 6,600 which is KRW 59,400 to 66,000, 32% to 47% upside.

Industry Consolidation

Over the last 10 years, the DRAM industry has consolidated to three players (Samsung, Micron, and Hynix) controlling 95% of industry capacity. The tipping point for the industry was when Elpida, who was the least rational competitor, filed for bankruptcy in 2012 and was acquired by Micron. Each competitor in the oligopoly has stated they plan to focus on profits, margins, and ROE over market share growth and so far has acted accordingly. Barriers to entry are high and include decades of R&D and billions of dollars of capital for a greenfield fab.

Slowing technological migration (becoming more difficult and costly to lower cost per bit) is causing supply growth to slow. Migration adds around 15% to bit supply annually versus 25% demand growth driven by unit and content growth primarily in handsets and servers. Thus, net wafer adds need to be around 10% annually in order to keep the industry balanced. Incremental wafer adds are becoming more expensive and the industry is being more disciplined on only adding capacity to meet demand, not to take share, which should result in a more profitable and more stable DRAM industry.

Over half of Hynix’s business today has some additional component beyond just a chip including attached to a custom device, specific form factor, etc. As the industry continues to specialize its product offerings for servers, handsets, etc, customers will become more sticky which will result in more stable prices and more stable gross margins.  

Gross Margin Expansion

Hynix’s gross margin is 43% (semi peer average is 52%) and may rise to the mid-to-high 40s over the next 1-2 years driven by stable to modestly declining DRAM prices and declining cost per bit. Given the industry dynamics in which the industry needs to add roughly 10% net wafer adds each year, as long as the companies are not earning adequate returns on capital, the gross margins will continue to rise until MU, Hynix, or Samsung adds capacity.

In a stable gross margin environment, Hynix will benefit from topline growth through ~20% annual bit growth and stable to modestly declining bit prices. This can drive 10-15% topline growth and similar EPS growth over the long-term once gross margins have reached their normalized level. The secular growth trends include growing need for high speed servers to process big data and smartphones having 2-10x the DRAM content of feature phones.

Attractive Valuation

Hynix trades at 8.6x 2014 P/E, 6.7x 2015 P/E, 4.0x 2014 EV/EBITDA, 3.0x 2015 EV/EBITDA, and 2.2x P/BV. At a 45% gross margin in 2015, Hynix will earn KRW 6,600 in EPS and a fair multiple is 9 to 10x P/E (versus semi peers 15x) which drives a fair value of KRW 59,400 to 66,000, 32% to 47% upside. 

Risks

• Samsung is more aggressive in bringing on supply given their weak handset business. The company announced a new $15b fab with first wafer outs in late 2017. Samsung also announced line 17 will be converted from LSI to DRAM in 2015 which will likely be 40k wafers per month or 4% of industry supply. However, given memory is Samsung’s only good business, it seems unlikely that they want to ruin the market. The chairman put out a statement recently that there will not be a market share war, indicating that they will behave. Small capacity additions are needed to keep the market balanced and not choke out demand so for now, the risk seems manageable. 
• SK C&C is an affiliated company with the SK Group and plans to enter the memory module business which entails sourcing memory chips from Hynix, Micon, or Samsung and packaging them as memory modules for distribution and merchandising. Hynix does not have a meaningful module business so it will not represent completion; however, the risk is that SK C&C buys chips from Hynix at a discount to market, transferring earnings from Hynix to C&C. No details about the agreement have been disclosed.
• Slowing global growth which could impact server, handset, and PC demand. MCHP’s earnings pre-announcement has negative read-throughs for industrial and automotive, but not necessarily for handsets, servers, and PCs, though the entire chip space was hit on the news.

Catalyst

• Strong earnings on Nov 14^th (MU beat and raised a month ago and expect same from Hynix).
• Stable DRAM prices which drives gross margin expansion.
• Potential for capital return in 2H15.