Description

Investment Summary:

Varian Semiconductor is a jewel of a company operating in a viciously cyclical industry going through a wrenching downturn.  The stock is 65% off its high reached in August, 2007, and, while not a conventional VIC name, is now at extremely attractive levels for true long-term investors.  VSEA has a very dominant—indeed, I believe, unassailable--position in the ion Implantation segment of the semiconductor equipment industry.  In a normal year profit margins and returns on capital are high.  The balance sheet is rock solid with almost $4/share in cash and investments (which will grow over the next year) and minimal debt.  I have no idea when the cycle will turn but VSEA should be able to earn over $5-6/share at its next peak.  On that basis, the stock should at least triple over the next several years.  On the downside, VSEA has bottomed out in the past at roughly 2X LTM sales (bear in mind that the company then was much less profitable and dominant than today).  If the current quarterly sales rate is the trough, that would suggest a downside risk to around $14.  Coincidentally or not, this is where the stock reached in the market collapse in early October.

Background:

Casper719 wrote a very detailed and thoughtful analysis of VSEA on VIC last March, which is well worth reading for anyone with interest in the idea.  The most important point he makes is that VSEA has been a major market share gainer in recent years and should continue to gain share going forward.  Management noted on the last conference call that for F08 (9/30), Varian’s market share will be between 68-69%, up from 31% as recently as four years ago.  Applied Materials exited the market in early 2007.  Axcelis, the other major competitor, spurned a takeover bid earlier this year from Sumitomo Heavy Industries (also its partner) and is now a penny stock with significant losses. Importantly, VSEA now has a very competitive product in the High Energy segment, which has been where Axcelis dominated.  In this segment, VSEA’s share rose from 11% in F07 to 26% in F08.  Management believes that this can double in F09 and that overall market share will continue to climb.  Casper projects that VSEA will garner over 80% of the overall market in three years and that is certainly a possibility when one goes through a product and geographical analysis, as he lays out. 

Recent Developments:

Revenues peaked in the 9/07 quarter at $298MM.  The falloff was relatively modest in December and March but then ratcheted sharply downward in 6/08 ($182MM) and 9/08 ($142MM) with minimal profitability in the most recent quarter. During the summer the company stopped its aggressive repurchase program in response to the precipitous business decline. Management expects revenues to decline to the $115-125MM range in the current quarter and incur a modest loss, the bulk of which is restructuring costs to reduce headcount.  The CFO noted at an industry conference last week that the targeted breakeven point is $100MM in quarterly revenues. Gross margins are projected to decline about 500 basis points to the 40% area due to product mix issues but should edge upwards over the balance of this year.  The company is focused on cost reduction with a goal of taking $10MM/quarter, or about 17%, out of operating costs by the March quarter from levels of the prior year.  Notwithstanding the aggressive cost reduction efforts, VSEA is actually increasing R&D on new market opportunities in an attempt to widen its competitive advantage further in the next upturn.  With lower sales volumes the business remains very cash generative (a forecast additional $100MM in F09), but from reductions in accounts receivable and inventory as opposed to profits. 

The Next Upturn:

Varian is poised to do extremely well during the next cycle.  As noted above, market share gains should continue over time.  Management strongly believes that their products not only deliver better throughput in their customers’ fabs, but better devices (for example, less leakage improving battery life in portable devices) and better yields, which is incredibly valuable to semiconductor companies.  Furthermore, smaller and smaller chip geometries require more implant steps. The common platform VSEA employs across its product line produces scale efficiencies and much more productive R&D, enabling the company to cycle its products much faster than its competitors.

Forecasting the timing and scale of a recovery is virtually impossible.  From the trough in 2002 to the peak in 2007 VSEA roundly tripled its revenues.  This, of course, was a period of greater market share gains than are possible going forward.  On the other hand, the company has a much bigger base of service and support today than 6 years ago.  So arbitrarily, I estimate that sales at the next peak should be $1,375MM, or 2.75X what I think will be a four quarter trough of about $500MM.  With somewhat improved gross margins and some leverage on operating costs, a 30% operating margin seems reasonable and consistent with management thinking.  (I believe they think that they can do better.)  With these assumptions and a more normalized tax rate in the mid 20s, VSEA would earn $4.50-5.00. 

But this ignores potential share repurchases.  From late 2005 to mid-2008, VSEA spent over $700MM buying back stock at an average price of about $33/share. I belleve that the company will resume an aggressive repurchase program once management believes that business has bottomed out and the overall health of the capital markets has somewhat stabilized.  If VSEA were to use its accumulated cash flow to buyback stock—without dipping into current cash or levering up—the share count could decline 20-25% further over the next few years and EPS would get to $5-6/share.

Catalyst