Description

I am recommending a long position in Ultra Clean Holdings (UCTT), a subsystem supplier to the global semiconductor capital equipment (semicap) industry. I find the current setup quite compelling, as I’ll explain. For the few of you that aren’t already completely turned off by a semicap name, please do read on. I believe a confluence of factors here have come together to present this unique opportunity. 

My bullish thesis is predicated on 4 key points:

1. UCTT is cheap and likely to beat numbers against a favorable industry backdrop

2. They are led by “rock star” CEO Jim Scholhamer, who in his 7 years at the helm has turned UCTT from a largely irrelevant microcap into an important and impressive $2.5B Revenue company

3. They have the scale & leadership to continue to accretively roll up smaller players

4. Due to recent events, UCTT is well-positioned to take share at their largest customer

What does UCTT do?

UCTT is a subsystem & services supplier to the semicap industry servicing industry heavyweights like LRCX and AMAT, as well as increasingly ASML, Samsung, and INTC. Their business mix is roughly:

1. 1/3 ‘legacy’ gas panels, or gas delivery subsystems, which are large components that are key inputs into tools such as LRCX’s Deposition and Etch tools

2. 1/3 major model integration, which includes tool assembly, but increasingly includes the “plumbing” of new fabs

3. 1/3 valves & fittings – higher IP/margin “veins & arteries” within whole tools

In CY21, LRCX was 40% of UCTT Revenue, while AMAT was 24%. 

1. UCTT is cheap and likely to beat numbers against a favorable industry backdrop

On current consensus estimates for CY22, UCTT trades at 8x EPS, a hefty discount to most semicap comps. 

While UCTT already sits at the bottom of the peer group EPS multiples, I believe estimates for UCTT are also materially too low:

Note here that UCTT reports (and the street models) non-GAAP EPS that excludes SBC; if I include the SBC expense in my estimate, $5.79 in EPS goes to $5.48, making it basically comparable to the way LRCX and others report that do not back out SBC.

The main source of differentiation between my estimates and the street has to do with my adding in the benefit of a faster ramp of UCTT’s new large manufacturing facility in Malaysia. The street numbers, erroneously in my view, do not model much, if any, incremental Revenue/EPS from this additional capacity.

So, I have UCTT at 7.3x rather than the street’s 8.5x (apples-to-apples excluding SBC). If I hit them for SBC expense, my multiple is 7.7x on CY22 EPS.

Malaysia Facility

UCTT is building out a factory in Malaysia that ultimately will be a $600M-$800M Revenue facility. They’ve recently subtlety pulled forward how much Revenue will be coming out of that facility and when:

On the Q321 UCTT call (August 2021): “So the ultimate capacity is $600 million, but roughly 1/3 of that is -- will be -- is available right now, and we expect to have that kind of filled out by the end of next year.

At January Needham conference: “Within 2-3 quarters we’ll be at a $200-250M run-rate out of that factory”

So between August 2021 and January 2022, the goal posts have moved from hoping to reach $200M of annual Revenue generation out of Malaysia by YE22 to now expecting to hit $200M-$250M of annual Revenue generation out of Malaysia by closer to mid-2022. Doing the math on that update implies about an extra $100M of Revenue expected out of Malaysia during CY22 versus prior expectations. This incremental ~$100M of expected CY22 Revenue explains I believe why I’m a bit over $100M higher than the street for CY22 UCTT Revenues. They’ve also made clear that they expect Malaysia to be a couple hundred bps higher on GMs due to the low-cost geography. 

Interestingly, on UCTT’s recent Q421 call (February 23), they gave no such specificity on the timing of the Malaysia Revenue ramp timing. Had Jim given the same level of specificity that he gave out at the financial conference in January, I have a feeling that the street estimates for CY22 might well be closer to mine. 

Industry Cycle Outlook

I’ve compiled the relevant quotes from the big 3 US semicap players on their near to medium term outlooks for Wafer Fab Equipment (WFE) and they don’t see any cycle concerns on the horizon:

LRCX quotes: 1/26

“Overall, for calendar year 2022, we expect to deliver strong across-the-board Revenue growth.”

“We believe that spending in calendar year 2021 ended consistent with the mid-$80 billion estimate we provided on our last call.”

“Consequently, we expect 2022 WFE spending to be in the $100 billion range with strong growth across all segments.”

KLAC quotes: 1/27

“As we begin the new year, our view is that the WFE market will grow in the high teens, topping $100 billion off a baseline of approximately $86 billion for 2021. WFE demand is still constrained by the industry's ability to supply.”

AMAT quotes: 2/14

“We think this is a good approximation for industry growth in calendar 2021, which would put WFE in the mid-$80 billion range.

 Demand is very strong and continues to grow. We believe wafer fab equipment spending could reach $100 billion in 2022. And since we are already close to being sold out for the year, we also have a positive growth outlook for 2023.”

“If you look at electronics spending in 2025, it's about $780 billion. So if you take 15% of that, you're about $117 billion WFE in '25. So I think kind of sustainable growth rate is high single digits for WFE”

The three largest US semicaps seem to have coalesced around a high teens % growth rate for WFE in CY22, with AMAT indicating that the supply constrained environment in CY22 is leading them to believe that CY23 is looking like it has a “growth outlook” as well. AMAT even seems to suggest that they see WFE growth through 2025!

Simply put, these don’t sound like statements that indicate the WFE cycle is anywhere near topping or rolling over. 

2. They are led by “rock star” CEO Jim Scholhamer

Jim took over as CEO of UCTT in January 2015 and the company’s performance since has shown stellar improvement under his leadership. 

Jim’s experience prior to UCTT had been 16 years in various leadership roles at AMAT, most recently leading the Components and Systems Group for 11 years.

Under Jim’s leadership, UCTT grew Revenue by over 4x and roughly quadrupled operating margins, while share count is only up approximately 40%. It’s been impressive. 

Note that the acquisitions have been almost entirely cash/debt financed, and entirely so subsequent to the two smaller 2015 acquisitions. In each case, UCTT’s acquisition model has been to take on some debt to make the acquisition and subsequently pay down said debt through internal cash flows. This has allowed for substantial inorganic growth, while keeping shareholder dilution to a minimum. 

UCTT’s Revenue growth has outpaced overall WFE growth by approximately 1000bps annually during Jim’s tenure, an outperformance which Jim credits equally to both organic share gains & M&A.

Source: UCTT Spring 2022 Corporate Presentation

3. They have the scale & leadership to continue to accretively roll up smaller players

The universe of smaller subsystem/component/service companies is quite fragmented and provides fertile hunting ground for UCTT to continue making acquisitions.

UCTT, at its current ~$2.5B Revenue run-rate, is now the largest subsystem supplier in the industry. With the largest manufacturing and distribution footprint, UCTT makes for the most natural partner for many smaller players looking to sell. 

For those very familiar with the space, you may be thinking that MKSI (also a subsystem supplier) is slightly larger at ~$3B in Revenue, but I am intentionally excluding them here due to their margin profile. MKSI has a very different mix that results in a much higher margin profile. MKSI, with their mid-high 40%s GMs, actually have higher GMs than LRCX, just to emphasize how different they are versus UCTT. Thus, an acquisition that would make sense to UCTT and be margin accretive for them would likely be quite margin dilutive to MKSI. Simply put, the two would not consider the same set of acquisition candidates. To put a finer point on this, each of UCTT and MKSI made one large acquisition in 2021. MKSI paid $5B to acquire a 48% GM/18% EBIT margin business (Atotech), while UCTT acquired Ham-let ($348M paid, LSD EBIT margins when acquired)

4. Due to recent events, UCTT is well-positioned to take share at their largest customer

There are two distinct situations that have UCTT very well positioned to take share, particularly with UCTT’s largest customer LRCX:

1. During LRCX’s earnings call in January, the company made a point of saying that a specific subsystem supplier failed to deliver at the end of December costing LRCX $200M of Revenue in the December quarter:

LRCX: “These delays, primarily from 1 supplier for critical parts, meant we were unable to recognize Revenue for tools that we actually ship to customers totaling more than $200 million.”

“As we mentioned, the December issue was primarily critical parts, what we call them -- I've called them probably subsystems, pretty large critical components that goes into our tool.”

So, we know from LRCX that they lost $200M due to one supplier of large subsystems. Given that $200M was ~5% of LRCX’s total quarterly Revenue this had to be a significant supplier. From combing through filings, I estimate that the largest subsystem suppliers to LRCX are (as a % of LRCX COGS):

Out of these 3 large subsystem suppliers, UCTT beat December quarter Revenues by ~2%, MKSI beat by ~1%, while ICHR was an outlier, missing the December quarter top line by 1%+. Additionally, ICHR provided the following commentary noting issues delivering in the December quarter:

Putting all this together, it seems apparent to me that ICHR was the subsystem supplier that caused LRCX to miss out on the $200M in Revenue. This can’t sit well with LRCX regarding ICHR’s ability to deliver for them. And it’s important to note that within gas panels, UCTT & ICHR are the two main suppliers and both serve LRCX. 

2. On the same LRCX call in January, when asked about their own new Malaysia facility, this exchange was particularly interesting:

LRCX sure seems to appreciate suppliers co-locating. 

Lastly, compare the site of LRCX’s own new large Malaysia facility…

…with the location of UCTT’s new Malaysia site:

So, to summarize, ICHR caused a big issue for LRCX recently, while LRCX called out the benefit of suppliers co-locating. And clearly UCTT is the supplier that has co-located in the same Malaysia industrial park with LRCX’s big new facility. This all seems to add up very favorably for UCTT taking share from ICHR with LRCX; importantly, LRCX is the largest customer for both UCTT and ICHR!  

Risks & Pushback

The most common pushbacks I hear on UCTT are 1) customer concentration, and 2) low margins. I’ll address each.

Customer Concentration

First, regarding customer concentration, I truly view this as a non-issue. Given the huge level of consolidation throughout the semiconductor supply chain that has occurred over the years, high levels of customer concentration for many players has become the norm. As one example, the last breakdown I saw was that 3 spenders (TSMC, Samsung, and Intel) alone comprised >60% of overall industry WFE. It stands to reason that whether you’re LRCX or AMAT or Tokyo Electron, you will have very high customer concentration with these few customers (or at least you hope to!). High customer concentration is just what the game is in semiconductors.

As it pertains to UCTT specifically, I was actually pleasantly surprised to hear Jim Scholhamer say recently at the Needham conference in January that each of ASML, Samsung, and Intel are now mid-single digit %s of Revenue, noting that he’d have a 3rd 10% customer by now but for LRCX and AMAT growing so quickly. 

Low Margins

UCTT is decidedly NOT for software investors for sure! I’d say a couple things here:

• Low margins have proven an opportunity for UCTT as I illustrated above, with the very impressive margin improvement the company has achieved. How many companies can ever 4x their operating margins? 

• In the most recent quarter, UCTT reported 12.6% EBIT margins; is this really that horrible?

• I still see ample room for margin improvement from here from UCTT’s supposedly “low” levels, particularly if/when more margin-accretive M&A can be found

Key Risks

• Jim Scholhamer leaves 

• Given the high regard I hold for him and the strong improvements he’s made in his 7 year tenure at UCTT, this would be my biggest worry

• Semicap cycle rolls over 

• See recent comments from LRCX, KLAC, and AMAT above under Industry Cycle Outlook

• Loses a major customer, i.e., a LRCX or AMAT

• I addressed at length why I think UCTT’s getting much tighter with LRCX; I have no similar anecdotes for AMAT; it’s a risk, though one I deem to be low. I’d also note again that Jim spent 16 years in senior leadership at AMAT

Valuation & Price Target

As noted above UCTT’s valuation is extremely low on both an absolute basis and relative to semicap comps…and particularly so given UCTT’s profile of growth and ongoing margin expansion. Below are my annual summary estimates for CY22 & CY23 with SBC expense included for comparability to UCTT’s main customers LRCX & AMAT. I also went fairly conservative on both Revenue growth and margin expansion y/y in CY23. For the sake of choosing a multiple, I’ll take the average multiple of LRCX/AMAT (15x) and apply a 3-turn discount, so 12x for UCTT. Based on CY23 estimates and a 12x multiple, I arrive at my UCTT price target of $73, representing an attractive 70%+ upside. This also assumes no accretive M&A. I do think M&A is likely this year, as UCTT should be net cash neutral/positive by mid-CY22. Again, that’s not assumed here but could be a source of further upside for UCTT. 

Catalyst

- Continued beats

- Accretive M&A

- Upward multiple re-rating that reflects the company's strong long-term track record of growth and margin expansion