ASML - Disco: Standout Niche Market Leader With Sustainable Long-Term Growth

2023-03-24 04:32:18 ET

Summary

• Disco is the market leader in slicing and dicing machines used in the preparation of semiconductors, with around 70% market share.
• It has a solid track record of sustained growth, high profitability, continued investment in R&D and development of strong customer relationships.
• Current valuations appear fair versus 5-year historical average, but on balance we believe the shares are attractive on a long-term view.

Investment thesis

Disco (DISPF) (DSCSY) is a high-quality franchise with a solid track record, and a leader in a market with high barriers to entry. Valuations appear fair versus the 5-year historical average, but on balance, we believe the shares will outperform over the longer term. We rate the shares as a buy.

Quick primer

Established in 1937 in Hiroshima prefecture, Disco Corporation is a global leader in grinding and dicing machines used in the back end of the semiconductor production industry. Grinders are used to thin and prepare wafers from silicon ingots; dicing machines are used to cut wired and prepared chips on the processed wafer itself ( see diagrams from Disco ). Operating in a niche market, Disco is estimated to have around 60%-70% market share in grinders, and around 70%-80% in dicers. Although traditionally strong with physical blade technology, Disco has in-house expertise in lasers and plasma technology. The business model aims to increase the installed base of machines and provide recurring sales of consumables and maintenance parts which make up around 35% of total sales.

Asia made up the largest geographic market with 86% of FY3/2022 sales, with overseas firms operating in China being the largest customer base. Over the last 10 years, R&D spending has averaged 10% of sales (please refer to 'Consolidated Financial Information XLS' ).

Key financials with consensus forecasts

Our objectives

Disco is a relatively unknown niche Japanese precision industrial business, despite having a market capitalization of USD11.6 billion and a high representation of overseas institutional investors ( over 40% of total holdings ). We want to assess what makes the company so competitive and look into its recent track record.

Competitive edge

The company has a strong heritage in the semiconductor industry, starting the production of ultra-thin blade equipment in the 1970s. Initially focused on manufacturing abrasive wheels for third-party machines, the company began to develop and manufacture its own precision equipment that would fully utilize its in-house cutting technology. The company began to scale and made considerable progress in the US market during the 1980s, becoming the market leader and collecting accolades from the likes of Texas Instruments ((TI)) (TXN) in 1981.

We believe the following indicates Disco's competitive moat. Firstly, the consistent investment in R&D has allowed the company to steadily increase its market share with quality technology - its market share has increased from around 60% a decade ago, beating lower-priced peers from China as well as other Japanese companies such as Okamoto Machine Tool Works (6125) and Komatsu ( KMTUY ). There were historic concerns over how Disco's mainstay blade technology could be superseded by laser, but this has turned out to be unwarranted as the company effectively applied this technology. We see a similar pattern now as the company adapts plasma dicing.

Secondly, customers want to develop a close working relationship with a reputable firm. Semiconductor manufacturers (like TSMC ( TSM )) fabricate chips on individual wafers which cost millions of US dollars and hence require high accuracy and reliability from all of its equipment to ensure a high level of yield. Disco has a solid track record and a reputation for working closely with its clients on the ground with skilled engineers showing versatility in addressing multiple needs and problem-solving. Strong customer relationships and effective technology, therefore, act as major barriers to entry, and the value-add provided is evident in the high levels of profitability - operating margins reached 36% in FY3/2022.

A closer look at track record and outlook

We look at Disco's historic 5-year track record to assess how sustainable its growth profile has been. The results highlight a high-quality compounding business, with sales growth (5-year CAGR) of 13.6% (a quality benchmark is around 5%-7%), with EPS growth at 22.1%. It has strong free cash flows, resulting in no debt and net cash of JPY126 billion/USD0.96 billion in FY3/2022 (around 10% of market capitalization).

However, over the same period, we see that the shares have relatively underperformed their larger peers such as ASML ( ASML ), Taiwan Semiconductor Manufacturing, and Applied Materials ( AMAT ). On the other hand, it has not experienced a major drawdown as some of these names, such as Lasertec ( LSRCF ). Disco is impacted by capex for the semiconductor cycle, but the delta in earnings is not as volatile as some of the front-end SPE makers.

5-year share price performance

We note over the last 12 months, Disco has been outperforming in a similar way to Advantest ( ATEYY ). A common theme between the two is their focus on the back-end in semiconductor manufacturing, and their increasing exposure to power devices (as opposed to conventional IC chips), with Advantest's acquisition of power device specialist CREA in August 2022.

12-month share price performance

Despite the current correction in the semiconductor industry, the outlook for Disco is relatively sanguine with consensus forecasts penciling in a single-digit decline into FY3/2024, followed by a recovery in FY3/2025. Whilst earnings may not continue to climb in a straight line, we believe the company has both qualitative and quantitative strengths to grow as a stand-out market leader.

Valuation

On consensus forecasts, the shares are trading on PER FY3/2024 23.7x with a free cash flow yield of 4.3% - the 5-year average PER multiple is 23.1x, and the FCF yield at 5.0%. From this perspective, the shares do look fairly valued. However, taking into account the sustainable growth profile the company has demonstrated, we believe that on a longer-term horizon, valuations look attractive particularly as FY3/2024 multiples are from a down-cycle period. With continued growth, we believe there is a high likelihood of future multiple expansions.

Risks

Upside risk comes from positive developments for the power devices market/SiC (silicon carbide) chips where Disco appears to have an edge with new technologies.

Company guidance for FY3/2024 may be more positive that current market expectations. Disco will announce FY3/2023 results on April 20th, 2023.

Downside risk comes from a larger-than-expected decline in demand for new machines from IC chip makers (for both memory and logic) and OSATs, although this is likely to be temporary.

There is also risk from a sudden recovery in demand which the company may not be able to cater to, as traditionally Disco does not aim to formulate future plans for shipping equipment, but rely on maintaining a steady level of inventory.

Conclusion

Disco is a high-quality franchise with a solid track record, high profitability, and a strong market position. The current correction in the semiconductor market appears to be priced in, and the outlook remains firm for this business both as a market leader, as well as exposure to growth areas such as power devices. Valuations appear fair versus 5-year historical averages, but on balance, we believe the shares are attractive on a longer-term basis. We rate the shares as a buy.

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