Description

Cymer is the technology and market share leader at “the bottleneck” in path forward for semiconductor performance, and is showing signs of being about to distance itself from its one and only competitor.

 

After aggressively completing a $300MM share BB in 2007, CYMI ended the year with $357MM in cash & eq and only $140MM in debt ( 3.5% convert @ $50, due 2/15/09). It generates over $25MM FCF/Q. 

 

Unlike in past market downturns, over half of its revenues now come from spares, upgrades and other non-system sales to support an installed base of over 3250 light source systems.

 

Cymer is the clear leader in the design and production of light sources for photo lithography used in semiconductor wafer production. These light sources are used in scanners and steppers produced by ASML, Nikon and Canon. (Photolithography is similar to film development. The silicon wafer is polished and then light sensitive material is applied. It is then masked and exposed to UV light, which alters the material that was not masked. The mask is removed, more chemicals applied to remove materials and leave the desired pattern. This is repeated hundreds of times to create between 28 and 43 layers for most microprocessors.) As circuitry node sizes have decreased, more precise light pulses (wavelength, wattage, duration, among other measures) are required. Cymer emerged as the leading producer of light sources based on its understanding of excimer lasers, leading the way from a krypton-fluoride (KrFl) based process to a dual-chamber, argon-fluoride (ArFl) system. With the demise a few years ago of Lambda-Physik, only one competitor remains. GigaPhoton is a JV between Komatsu and another Japanese company. As chip makers look to advance from the 65nm to 45nm node size and beyond, the industry is counting on CYMI to produce the light sources that can deliver to evermore exacting tolerances and at lower total operating costs. CYMI has made initial production shipments of ring-based “immersion” technology, which will extend ArFl technology to the 32nm node size. The next step will be accomplished with a technique called double-patterning. Beyond that, the likely final step will be Extreme Ultra-violet (EUV). CYMI has been working on EUV since 1997 and in late 2007 received initial orders from ASML for EUV light sources. This is a steep technological curve, and it has been rumored that Komatsu is not sure it wants to fund spending to keep following CYMI.

 

Besides delivering leading edge technology for the critical layers on next generation wafers, CYMI also disclosed in its latest conference call that they have re-tooled some of their older KrFl product, where their competitor has been able to gain some market share with aggressive pricing (customers will always support a reasonably competent second source). Many of the layers in microprocessors can be done with these non leading edge technologies. It is likely that while KrFl is no longer leading edge, it can be enhanced to take share from i-line systems (the technology that preceded KrFl) for many of these non-critical layers.

 

In addition to what appears to be a widening lead on the new product front, Cymer is in the midst of re-engineering its aftermarket offering to a model that is more fixed price. Called OnPulse, it will provide 24/7 support based on the number of pulses the customer gets from the equipment. As photolithography is very messy as things go in the fab world, light sources generate relatively high parts & service revenues over their typically very long lives. It is management’s expectation that OnPulse will move the margins on this part of the business, which has been somewhat below the corporate average, up to that present average. 

 

Revenue Growth?  CYMI’s revenue growth correlates with the growth in demand for wafer fab equipment (WFE), but when you look at units and ASP it gets complicated. Over time, the productivity improvements that CYMI has been able to introduce has translated into a downward trend in the number of light sources but an even more powerful uptrend in ASP. This has been described in terms of “If a KrF light source was priced at 1X, think of the ArFl we introduced a few years ago as 2X, the immersion systems as 3X, and double-patterning systems as 4X.” ASP grew at a 9% CAGR 2002-2006. Lately, the initial shipments of immersion (as opposed to dry) ArF systems is pushing ASP up (25% in 2007) while restrained capex is weighing on non-leading edge (KrF and i-line) lithography spend. These trends are expected to persist well into 2008. For Units, I started out assuming that they maintain a 65% share of forecasted demand. (The industry unit forecast is flattish, 370 in 2011 v 355 in 2007.) Cymer’s market share is more like 90% at the high end (immersion ArF at $1.6MM/unit) and 50% in KrFl where the competitor can compete on price. They have addressed share loss at the low end with a product refresh first mentioned on the Q3 07 conference call. The next “bump” in ASP will be double patterning light sources, which is expected to ship in 2009.

 

I believe my revenue assumptions, which grow revenues from $526MM in 2008 to $682MM in 2012, are conservative because Cymer is so dominant at the high end of the price and they have a credible game plan for regaining unit share at the low end. (Offer a product that can so obviously produce more through-put with less space, power and/or downtime that you can charge a premium for it.)

 

Revenue growth also comes from growth in consumables & spares for the installed base. This revenue has grown at a 20%+ CAGR since 2002. I am assuming high single-digit growth going forward. CYMI is changing its aftermarket model with OnPulse. It sounds like an improved value proposition for the customers and if CYMI correctly estimates the improved durability they are engineering into their systems it will be more profitable for them to charge what amounts to a fixed rate for uptime.

 

Earnings Outlook 2008 is looking to be a down year for CYMI. The consensus estimate is presently $1.91, down from $2.50 in 2007. This is due in part the slowing in WFE spending that first became apparent in the industry in Q2 07 but did not register for CYMI until the very end of the year. Due to certain customers’ need for next generation “immersion” systems, the company is confident that H2 will be stronger than H1. This pause in demand will cause reduced fixed cost absorption and so a lower GM (48ish% v. 50%ish) in H1. Additionally, the company has stepped up spending to support the roll-out of OnPulse, and R&D spending, which totaled $81MM last year, or $2.67/share, is expected to trend from just under 15% of sales to almost 18%. Taking all this together, I am expecting the operating margin to decline from 22.8% to 15.5%, and EPS to decline to about $1.80.

 

Once the slowdown that started almost a year ago has run its course and demand for next-gen photolithography kicks in, I am looking for moderate volume improvement to lead to better leveraging of costs. R&D will continue to grow, but at a much slower rate.  I think it is reasonable to expect the operating margin to improve to 21% in 2009 and then trend higher, getting just above 23% in 2012. Below the operating line, we have to consider either an increase in net interest expense as the notes go away in early 2009 and the cash builds, or another reduction in the share count. The $300MM repurchased in 2007 followed $50MM and $100MM in the prior two years, as well as $57MM redemption of the notes.

 

 

Appreciation Potential?  This flexibility in the use of surplus cash presents a challenge in arriving at a likely future valuation based on EPS. At its last peak in 2006, CYMI sold at $56.70, or 23.7 times earnings. At present, it is selling for a little over ten times last year’s earnings despite having net cash of over $7/share. To get around the conundrum of not knowing what the EPS denominator is going to be, I would look at prospective EV/EBITDA assuming the note gets paid and the cash just piles up. EV/EBITDA was 12.29 at the 2006 peak. If we apply that multiple to 2008, AP is $54. If we apply it to my projection for 2011, it is $95. If we haircut this by 20% to 9.83 times EBITDA to allow for how things might change in the next 3-4 years, we still get AP to about $81.

 

In allowing for such contingencies, though, it must also be pointed out that I have not said much about what could go really right for CYMI in terms of the competitor falling further behind or even giving up, or the possibility that they manage the eventual “end of the road for excimer lasers for the critical layers” astutely. (I should also mention that they have a potentially interesting JV with Zeiss called TCZ, that has developed tools for the LCD flat panel industry, and is expected to ship its first production tools in H1 08. I have not figured this into earnings outlook.) I recently had the opportunity to attend Intel’s Investor Day and any fears I might have had that “node shrink” is about to reach the end of the line have been put to rest. Even after we get to where photolithography has reached its limits (I am thinking 6-8 years from now) there will be demand for a couple of decades at least based on serving the installed base and continued unit demand for technology where non-critical layers are done with CYMI light sources. If they recognize “what time it is”, they could actually grow earnings by scaling back R&D and otherwise adjusting their overhead structure. There is the risk that they will go “a bridge too far”, stepping up R&D for a couple of years only to learn that their technology is no longer capable of going to the next level. This is not likely a concern today, but it is something to keep an eye on longer term.

 

The Bear Case There is a bear case going around on CYMI that merits some attention. It revolves around market share loss to GigaPhoton, their Japanese JV competitor. As is often the case, there is a kernel of truth here, but it has been blown out of proportion. When CYMI lead the way from KrFl to ArFl a few years ago, the competitor had a hard time following, and so for a season CYMI had the then-leading edge all to itself. Three years later, the reverse engineering has succeeded, CYMI is focused on moving the leading edge to where the competitor might not even want to go, and not surprisingly, the competitor has qualified some product and is taking market share in unit terms. (You get a different market share picture in dollars, as CYMI maintains a 90% share in the light sources that go for multiples of what the technology that hit the market five years ago goes for.) There is almost no information available from Giga-photon, as they are a JV, but there seem to be sell-side analysts who express grave concerns because their “sources” tell them that Gigaphoton is taking share. CYMI is clearly acting in a way that will address the competitive threat at both the leading and trailing edge of the product mix, but they are adamant that they are not losing share in any sense that really matters. I am more inclined than usual to believe this, because if anyone knows about market share, it’s them. Their equipment is in every fab in the world and their people visit on a regular basis and see what is going on. Giga-photon cannot say this, no customer can say this, and certainly no sell-side analyst has “sources” who can say this (with a straight face). We should expect that as in any business, customers want to avoid depending on a sole source and will do what they can to help a second source along. There is some possibility that CYMI’s profitability benefited for a period from an effective monopoly on something its customers needed badly, which would mean that earnings on that product will revert from that unnatural level as the alternative becomes available, but this will have little bearing on how leading edge equipment and replacement parts for the 3250+ CYMI light sources that are in place get priced over the time period we are concerned with.

 

I recommend CYMI at this time because of its leadership position enabling the likes of Intel and Samsung to get where they want to go, its impressive financial flexibility, its minimal downside risk and an odds-on likelihood of reaching or exceeding its 2006 peak price of $57 sometime over the next 2-3 years.

Catalyst

I recommend CYMI at this time because of its leadership position enabling the likes of Intel and Samsung to get where they want to go, its impressive financial flexibility, its minimal downside risk and an odds-on likelihood of reaching or exceeding its 2006 peak price of $57 sometime over the next 2-3 years.