ASML - HOYA Offers Appealing Leverage To Long-Term Growth In EUV And Data Center

Summary

• HOYA is currently muddling through some challenging end-market conditions as hard drive substrate demand is very weak and EUV mask blank demand is about to decline.
• Long-term growth prospects in both EUV lithography and data center capex are quite positive, giving HOYA leverage to leading-edge chip production growth as well as data center growth.
• HOYA is about to ramp its HAMR HDD substrates and still has leverage to aluminum-to-glass conversion, and high-NA EUV should launch in the near future.
• Life Care needs more work, and management needs to decide if they want to commit to expanding the endoscopy business or retreat.
• HOYA shares aren't a traditional bargain but do offer what I believe is reasonably-priced leverage to EUV lithography and data center growth.

Although it has been some time since I've written on the stock for Seeking Alpha , HOYA Corporation (HOCPY) has long been one of my favorite Japanese companies. Management has long been skillful at leveraging the company's core capabilities in precision glass manufacturing to maintain commanding share of semiconductor photomasks, as well as flat panel and hard drive substrates, while reinvesting in diversification into medical devices.

I love the company's leverage to leading-edge chip production, particularly masks for EUV lithography (necessary for the production of the most advanced semiconductor designs), and I still see good growth opportunities in hard drives. I'm also intrigued by what sounds like management's willingness to reexamine the medical device business with an eye toward improving results or narrowing the focus of its operations.

Not unlike the situation with ASML (ASML), the manufacturer of EUV lithography equipment, valuation for HOYA is a little challenging. While there are some multiples-based approaches that suggest upside, and I'm not opposed to the idea of investing in the shares as a valuation-indifferent play on multiple growth drivers, it's not exactly a value stock and investors can certainly debate its GARP credentials on the basis of just how reasonable the price is.

Hard Drives Drive A Weak December Quarter…

HOYA didn't do badly relative to expectations for the December quarter, particularly at the profit/margin lines, but the company is definitely suffering from some challenges in the hard drive market, while growth in the Life Care business remains more stable but less dramatic.

Revenue rose 1% as reported, but declined 7% in constant currency terms.

IT product revenue declined 19% as reported and 24% in constant currency. While revenue from mask blanks used to produce semiconductors rose 17% cc and photomasks rose 7% (with similar growth in flat panel photomasks), sales of glass disk substrates used to produce hard drives declined 66% cc on significant end-market weakness in PCs, more moderate data center capex spending, and inventory management decisions on the part of drive customers.

In the Life Care business, revenue rose 14% as reported and 5% in constant currency. The vision care businesses were solid, with eyeglass lenses up 6% cc, contact lenses up 7% cc, and intraocular lenses up 7% cc, while endoscope revenue declined 9% cc. Ceramic bone sales improved 12% cc.

Operating earnings declined 8%, including some uplift from currency, and margin declined about three points to 28.4%. IT profits fell 20% (with margin down 90bp to 47.5%) on the decline in highly profitable HDD glass substrates, while Life Care profits rose 10%, with margin down 80bp to 21.2%.

… And The EUV Shoe Is Next To Drop

Management sounds relatively confident that the end is in sight for the HDD inventory correction. Many players in the PC space (including chip companies and PC companies) have expressed their view that the March quarter will be the bottom for the cycle. HOYA management expects another 25% year-over-year decline in March, but a recovery thereafter. I don't expect a V-shaped recovery in the PC business and I do have some concerns about demand from data center customers, as I do believe that data center spending will be soft in 2023 outside of the hyperscalers.

The bigger issue for HOYA in the near term is the cyclical adjustment underway in the semiconductor industry. While demand in some high-end applications (like data center networking) has remained healthy, demand from smartphones, PCs, gaming, data center processing, communications, and so on has softened. With inventory corrections on the way, management is expecting a 15% year-over-year decline in mask blank sales and a two-quarter correction cycle.

I fully expect this to be a modest correction, and I expect demand to rebound sharply thereafter. TSMC ( TSM ) has noted that N3/N3E tape-outs have been trending at 2x the rate of the prior N5 cycle, and I expect that will drive strong EUV demand in relatively short order. With roughly 80% share in the EUV mask blank market, HOYA is a prime beneficiary of the ongoing growth in the use of EUV at leading nodes. I'd also note, though, that Veeco ( VECO ) is a derivative play here, as they provide ion beam etch equipment needed to produce the blanks (and they sell to Hoya and AGC (5201.T)).

Multiple Growth Drivers Ahead, But There's Work To Do In Life Care

I'm bullish on the growth prospects in IT. While I do see some risk that EUV mask blank customers may look to diversify their supply base (giving a boost to AGC and Shin-Etsu ( SHECY )), I think the strong growth in EUV and the upcoming launch of high numerical aperture EUV (high-NA) will drive good momentum in a business that's already very profitable for HOYA (60% adjusted margins).

I'm likewise bullish on the HDD substrate business on the other side of this correction. There are still opportunities for HOYA to leverage customers switching from aluminum to glass substrates, and likewise still a lot of growth ahead in data center investments in nearline storage. HOYA is also about to ramp substrates for drives using heat-assisted magnetic recording (or HAMR).

I do expect some changes in the Life Care business.

The vision care business is fine. HOYA has executed well on its strategy of targeting growth in emerging markets like Brazil and China, as well as in product innovation (like its MiYOSMART lenses for near-sightedness in young children). The intraocular lens business likewise remains attractive, with the company leveraging opportunities in trifocal IOLs and largely ignoring the competitive U.S. market.

The endoscope business, though, needs work and the CEO has said as much. The company has lost share to Olympus ( OLYMY ) over time and margins are actually rather poor (low double-digits). I believe a lot of the issues here have to do with going up against the 800lb gorilla in the imaging space and not really working on the therapeutic side. It's tough to stand out purely on the basis of imaging capabilities, and the more attractive growth in endoscopy is in therapeutic areas.

HOYA has the resources to invest/acquire a broader platform in therapeutic endoscopy, but failing that, it may well make sense to retreat from less profitable, more commoditized areas of the market. The question really is about how much risk management is willing to take on in pursuit of better growth and long-term profitability. HOYA hasn't traditionally been a risk-taking company (management usually looks to press their advantages in existing business and look for adjacent opportunities), and so a path that includes more R&D and clinical trials may not be for them, but it would be the best opportunity for improving long-term growth here.

The Outlook

To the extent that high-single-digit revenue growth can be called a "lull", I do expect a brief lull in HOYA's growth ahead of reacceleration in FY'24 and FY'25 driven by recoveries in the HDD, mask blank, and photomask businesses. Long term, I expect revenue growth to annualize at around 7%, with the Life Care business growing less vigorously, but still generating reliable profits and free cash flow.

Weakness in HDD substrates and semiconductor products is impacting near-term profitability, but I expect margins to reaccelerate next year and into FY'25, with EBITDA margins heading over 40% and adjusted operating margins accelerating to the low-to-mid-30%'s. At the free cash flow line, I expect ongoing leverage as HOYA transitions from FCF margins in the low-20%'s to the mid-20%'s, driving high single-digit FCF growth.

Discounted cash flow doesn't suggest that HOYA is particularly cheap now, and likewise it takes a little work to find a multiples-based approach that drives an attractive fair value. A forward P/E multiple of 25x is reasonable given how the market has valued this company in the past, and with the addition of the net cash on the balance sheet, that supports a fair value around 10% to 15% above today's price.

The Bottom Line

The appeal of HOYA isn't that it's a cheap stock trading at an unfair multiple. Rather, it's that it's a more reasonably-priced growth company leveraged to above-average growth potential in EUV-driven semiconductor production and ongoing data center growth (and potential further conversion from aluminum to glass HDD substrates), with some possibility of upside from the Life Care business. I do believe that's a worthwhile opportunity, and this is a name worth considering at this time.

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