Description

Versum Materials (VSM) $32.49

Summary

Versum Materials (VSM) provides specialty materials and solutions to the semiconductor manufacturing industry. It was spun out of Air Products (APD) on October 1, 2016. The Company has performed well since the spinoff but I believe there is further upside as there is reasonable visibility into the business, it has low capital intensity, strong cash flow generation and benefits from macro tailwinds relating to semiconductor growth.

Background

Versum Materials provides innovative solutions to the global semiconductor industry involving the development, manufacturing, transportation and handling of specialty materials. The business has been operating for over 30 years and consists of two operating segments: Materials and Delivery Systems & Services. The Company has become increasingly focused in recent years and is a market leader in its operating segments. The business rests on technology leadership and strong customer relationships with a concentrated customer base. Versum has a broad and diverse portfolio that serves six of seven key semiconductor process steps. The company supplies customers producing both memory and logic semiconductors.

The semiconductor industry is undergoing transformational change. Historically, semiconductors were primarily used in computing and demand was tied to large corporate spending which tended to be highly cyclical. In recent years, semiconductor demand has been driven by mobility, cloud computing, big data, internet of things and automotive. Consequently, demand is now more closely tied with consumer demand trends which exhibit greater stability. Silicon demand is correlated with global GDP, but advanced production lines (nodes) are growing around 2x GDP and materials is growing about 1.5x – 3x GDP driven by innovation needed to enable advanced nodes. Global GDP for 2017 is estimated to be roughly 3%.

Additional demand drivers include changes in semiconductor design such as the shift from 2D to 3D chips – which requires more process steps – as well as changes in materials technologies used in semiconductor production. Increasing semiconductor production also results in the expansion of semiconductor fabrication plants (fabs) which drives demand for additional materials, equipment and services. Semiconductor industry growth is measured by millions of square inches of silicon (MSI) and is forecast between 4% - 7% in 2017. Global spending on semiconductor capital equipment is expected to be up 13% - 17% in 2017.

Versum’s Materials segment has two operating divisions: Process Materials and Advanced Materials. Process Materials supplies high-purity gases and chemicals used in the semiconductor, displays and LED markets. Advanced Materials services key platforms in fabricating integrated circuits. 80% of advanced materials sales are based on proprietary or patent-protected positions and 40% of sales are based on products introduced in the last five years.

Competitive position as a materials supplier is determined by technological innovation and capability, quality and cost of supply and customer partnerships. Product sales involves being qualified by the customer and becoming a provider of record (POR). In the Process Materials division, there may be a small number of competitors that have been qualified as a POR for a given customer. Versum is generally the second or third position supplier to capture increased marginal profits. In the Advanced Materials division, Versum is typically the sole supplier for a given customer production line giving it visibility 1-2 years out by knowing the expected volume ramp of the customer.

Delivery Systems & Service has two divisions: Gas and Chemical delivery systems, Turnkey and Installation and On-Site Services. Delivery systems develops, designs and manufactures specialty gas and chemical distribution systems that deliver product directly into production tools. These products allow for the safe storage and handling of products at the fabrication plant.

Turnkey and Installation works with new semiconductor plants to design, install, startup and commission the gases and materials delivery systems and provides quality assurance. It is primarily a business that exists to maintain strong customer relationships.

On-Site Services places Versum employees at the customers location to manage their gas inventories and systems.

Versum has over 1,300 patents and over 200 research scientists, technicians and engineers. The Company has longstanding relationships with its customers.

While Versum’s products and services are critical components to their customers’ production lines, they represent a relatively minor portion of the total cost of semiconductor production.

The Opportunity

The semiconductor industry was historically characterized by high cyclicality, which combined with high capital costs often provided low returns on capital which warranted modest valuations. In addition, recently the industry believed that it had approached the limits of Moore’s Law which postulates that every two years the semiconductor industry could innovate towards doubling the number of transistors while halving the price.

New products have increased semiconductor demand while shifting the demand drivers towards consumer demand which is less volatile – and should warrant higher valuations. New materials and designs have resurrected Moore’s Law. Combined, the semiconductor industry should have a strong tailwind behind it for the foreseeable future with moderate volatility. While Versum has performed well since the spinoff, I do not believe that the current valuation fully reflects the quality of the business and the growth opportunity.

The CEO, Guillermo Nova, is well regarded in the industry and has been running the business since 2012. Since then he has refocused the business and has dramatically improved profitability. He made open market purchases of stock last year around $24 and is required to hold any purchases for 6 years.

The Data

Consensus estimates are for 10% revenue growth in F2017 (Sep) and 6% in F2018 resulting in EPS  growth of 8% in F2018. Currently the equity is trading at 12.3x F2017 EV/EBITDA and 18.0x F2017E P/E. Versum incurred moderate leverage of 2.7x Net Debt/EBITDA in the spinoff from Air Products and should generate enough cash over the next 2.5 years to reduce the net debt position by almost half. It is unlikely to delever to a suboptimal capital structure and can be expected to use its strong cash generating capabilities to increase returns through organic and inorganic capital allocation.

My base case is that growth continues rate modestly above consensus. Revenue growth and strong margins combined with margin expansion to 13.0x EV/EBITDA could result in a stock price in the range of  $39 in 2018 and $44 in 2019, representing price appreciation of 22% - 35%.

My downside case shows revenue growth slowing down but remaining in the mid single digits in F2018 and F2019, margins slightly compressing and further multiple compression to 11.0x EV/EBITDA. Downside to $29 or -11% below the current quote is possible.

My upside case has acceleration in revenue growth and slight margin expansion and a re-rating to 14.0x EV/EBITDA (which is below the 15.8x that Air Products sold off part of this business prior to the spin). Upside potential to almost $46 in 2018 and $52 in 2019 for upside of 41% and 61%, respectively from the current quote.

With base upside of 22% - 35% and reasonable downside of -11%, VSM offers a highly asymmetric reward to risk ratio more than 2.6:1 and 4.6:1 when incorporating the upside case. I recommend purchase of VSM at current prices and an increased position on price weakness.

Catalyst

 Catalysts include the additon of capacity in 2018 and 2019 which should drive additional profitable growth, successful deployment of capital towards organic and M&A and the increased profitability from completing the additional spend relating to transitioning to an independent company.