LRCX - Lam Research: Navigating A Shifting Semiconductor Landscape

2023-07-12 15:34:10 ET

Summary

• Lam Research Corporation reported Q1 2023 financials showing resilience despite a challenging market environment, offsetting weaknesses with deferred revenue dynamics.
• The company's focus on cutting-edge technologies like AI and cloud computing could prove lucrative, with a growing demand for advanced semiconductor fabrication equipment.
• Despite short-term challenges, the long-term outlook for Lam Research and the semiconductor industry remains promising, with a new technology cycle on the horizon.

When I wrote this article about Lam Research Corporation ( LRCX ), the company was in an uncertain place due to the risk of recession and the cyclical nature of the semiconductor industry. Thanks to AI-related tailwinds, the stock has surged roughly 31% since my bull call, which has changed the picture significantly. The semiconductor industry is ironically in a cooldown period even though rumors of strong forward demand due to AI-related chip needs dominate headlines. Today we will take a look at Lam Research Corporation and discuss what investors can expect from the stock going forward.

Lam has been a great beneficiary of the pandemic trade. Supply chain disruptions have greatly improved margins in the semiconductor space. This, combined with an overall revenue improvement almost industrywide, had lifted many stocks in the space to historic highs. The industry experienced a stint of volatility due to fears that margins would begin to compress sharply as the economy reached a new normal. Interestingly margins have remained stubbornly high with only a minor fall-off. This situation is evolving, and we are seeing revenue forecasts come down due to slowing demand. Defiantly the stocks remain near historic highs and have rebounded strongly from the post-pandemic selloff rewarding shareholders handsomely.

In Lam's case, the underlying business demonstrates resilience despite a challenging market environment. With macroeconomic risks skewed to the downside, many companies have begun cutting back on investment and R&D efforts as they look to beef up their balance sheets for what might be an economic slowdown. This has been negative for semiconductor companies like Lam Research, but it is typical. Semiconductor companies typically outperform most other companies in expansionary cycles due to their relative scarcity and ability to command premium prices in the face of strong market demand. This demand has been supported by secular trends in the technology space for decades now and the emergence of AI, the meta-verse and overall increases in device complexity will likely continue to support these trends for the long-term. Under that logic, Lam Research stands to benefit very greatly from what might be the next big paradigm shift in the global economy. For this reason, investors should view the potential decline in revenue over the next few quarters as a pause or rebalancing rather than some chaotic disruption to the company's core business. Nevertheless, the company is not resting on its laurels. Leadership is already busily building out its next strategy as the chip market is expected to normalize over the next few quarters.

The Future Is in the Cutting-Edge

LRCX's strategic focus on cutting-edge technologies could prove lucrative in the long run. As AI, cloud computing, IoT, and similar technologies continue their upward trajectory, there will undoubtedly be a growing demand for advanced semiconductor fabrication equipment. This new technology cycle presents significant growth opportunities for companies like Lam Research that have already invested in innovative technologies and have an established market presence.

Lam Research has positioned itself as a forerunner in technological innovation, placing a significant bet on extreme ultraviolet (EUV) lithography with its dry-resist technology. Not only has the company demonstrated its commitment to advancing the chip manufacturing process, but it has also shown a dedication to environmental, social, and governance ((ESG)) measures. Their new technology enables a reduced use of raw materials by a factor of five to ten, translating to cost savings for customers and a more sustainable solution overall. Collaborations with ASML and imec have played a pivotal role in this advancement, reflecting Lam's commitment to synergistic innovation that promises to bring notable benefits to customers and the industry at large.

Lam's new dry-resist technology also seems to offer a promising trajectory for the future of EUV lithography. It potentially lowers the dose, increasing resolution, enhancing productivity, and widening the exposure process window. By facilitating continuous scaling for advanced logic and memory devices, Lam is addressing key challenges of EUV lithography head-on. With the backing of multiple chipmakers, Lam, ASML, and imec aim to optimize dry resist technology to extract the best possible performance. This bold step forward is a testament to Lam's comprehensive patterning strategy and its drive to enhance the productivity and performance of EUV, proving once again why it's a compelling contender in the semiconductor industry.

The company's robust customer support business line also provides an additional revenue stream, tapping into the growing installed base for chip fabrication equipment. This arm of the business could act as a stable source of income, providing some balance against the volatility of the semiconductor industry though the company will always earn the bulk of its revenue selling chips.

Industry Prospects Amid Turbulence

It's no secret that the semiconductor industry is characterized by cyclicality and faces significant macro headwinds.

However, the situation isn't entirely grim. Despite a YoY drop of 8.7% in IC sales, there are encouraging signs of gradual recovery. In fact, sales from March 2023 alone slightly exceeded those from the previous month, an optimistic sign for the sector. Additionally, Q1 2023 sales were only 2.9% lower than the same period in 2021 when the semi boom was in full swing. This suggests a return to normalcy on the horizon, bolstering hopes for a semi-market rebound.

It is, however, important to put that timeframe on these expectations. This is unlikely to be a one or two month turnaround. We should expect some cooling over the coming quarters. The expectations will likely be centered around the Federal Reserve's attempt to address runaway inflation. In some investment circles, individuals have been declaring victory on inflation, but in my opinion, this is pre-emptive. The Federal Reserve has been pretty clear about its stance on inflation. They are looking to return to that 2% target and are comfortable risking a recession to achieve that goal. Ironically a recession would almost certainly eliminate inflation, but the social cost and damage to the Federal Reserve's image would have a lasting impact, especially following the events of the 2008 recession.

Though semiconductor manufacturers like Lam Research often focus on B2B sales, they are not immune to large-scale disruptions in consumer confidence declines like what would happen in an instance of high unemployment, for example. This is because their clients often sell hardware to individual users, and inventory gluts can appear quite quickly if companies cannot offload inventory. For the moment, unemployment figures are hovering near historic lows.

It's hard to envision a deep recession without a surge in unemployment rates. It is important to recognize, however, that the Federal Reserve's interest rate hikes have not bitten yet, and we should clearly understand the effect the aggressive rate hikes have had on the economy throughout the back half of the calendar year 2023. It is also important to remember that in the 2008 recession, unemployment rates didn't peak until 2010, so it's entirely possible that we begin to see surges in 2024 if any holes in the economy aren't quickly addressed by the government or Federal Reserve. It is also noteworthy that the Federal Reserve has so far responded quickly to address any potential crises, like its implementation of the BTFP program that ended the run on regional banks. We will likely see some banks go under in the event of an economic slowdown, but if it is contained, then it will be unlikely that we will experience any widespread consumer fear, which will, of course, trickle down to the technology and automotive industries, which are two key spaces for Lam research. In any case, no one really knows how the Fed will react to another financial crisis or even in what situations the Fed would begin to act. It is perhaps best for investors to go into any semiconductor investment with an allocation that justifies a wide risk tolerance.

The Government's Role: Incentives and Trade Relations

Recent geopolitical moves have reshaped the playing field in the semiconductor industry, with potential implications for Lam Research. For instance, the Chinese government's recent announcement concerning the need for export permits for gallium and germanium, two critical metals used in computer chips, signals a shift in the dynamics of the semiconductor supply chain. China dominates the production of these metals, contributing 60% and 80% of the global supply of germanium and gallium, respectively, according to the Critical Raw Minerals Alliance. The new controls could see China potentially limit the supply of these metals, a move that could reverberate across the chip-making industry.

Furthermore, ongoing trade tensions between the U.S. and China remain a pivotal point of consideration. The U.S. has been imposing export restrictions to limit China's access to semiconductor technology, further escalating trade tension around semiconductors and raw materials. The ripple effects of this tension on Lam Research could be multifaceted, especially considering the recent clarification they received from the U.S. government on export regulations to China. These geopolitical currents might offer both opportunities and challenges, making the company's performance and strategic positioning in this environment a point of keen interest for analysts and investors.

However, with every challenge, there comes opportunity. On the domestic front, governments globally are bolstering support for in-house chip manufacturing, which could prove beneficial for Lam Research. The U.S. Chips and Science Act, providing incentives for domestic chip production, is a testament to this trend. The potential of exporting certain products, along with increased demand from memory chip manufacturers, could bolster Lam's financial performance despite international turbulence.

Financials and Valuation

LRCX's Q1 2023 financial report showed the firm had a sequential revenue decline of 27% to $3.87 billion.

This downturn can largely be attributed to weak demand, specifically in the memory market, and regulatory restrictions on exports to the Chinese market.

Despite these challenges, Lam Research demonstrated strength. The operating margin reached 30.97%. This was in large part due to a strong showing in the company's premium business lines. The expectation for some time was that we would see aggressive margin compression across the industry. We can see in the chart below that this trend is just beginning, and there's no guarantee that it will continue its downward trajectory, but it is a downward trajectory.

The company also beat bottom-line expectations, reporting an adjusted EPS of $6.99 compared to the consensus EPS of $6.53. We can see that the coming EPS forecasts signal a slowdown for Lam Research's business over the next four quarters. This should figure heavily in any investment thesis.

When it comes to valuation, LRCX currently trades at a P/E ratio of 17.25x, which suggests that the stock is fairly priced based on the five-year average of $17.63 for each dollar of the company's earnings.

The Takeaway

Lam Research Corporation navigates a shifting landscape that could significantly influence its future, including geopolitical tensions, government policy changes, and a somewhat volatile semiconductor industry. Despite a sequential revenue decline of 27% in Q1 2023 due to regulatory restrictions and weaker demand.

Investors should consider the firm's strategic focus on cutting-edge technologies like extreme ultraviolet (EUV) lithography and its environmental, social, and governance ((ESG)) measures, both of which could prove lucrative in the long run. With its dedication to innovative technologies, customer support, and a diversified business line, Lam Research looks set to ride out any short-term industry turbulence.

Geopolitical factors, particularly the China-U.S. trade tensions and the recent Chinese export permit requirement for critical metals used in chip manufacturing, may introduce significant challenges. Additionally, the macroeconomic conditions and Federal Reserve's measures to curb inflation may further impact the semiconductor industry and, by extension, LRCX's performance.

The stock is fairly priced with respect to historic averages, and we may begin to see some multiple compression if the economy begins to deteriorate. I have parted with my shares as I believe the easy money has been made, and the short-term risk is to the downside. I will monitor the stock for a more attractive valuation in the future, but there is no great reason to rush to sell. I rate the stock a hold.

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