TOPPY - Photronics: A Hidden Gem Likely To Benefit From AI Growth

2024-01-08 18:08:15 ET

Summary

• The global AI market is projected to grow at 38% annually to reach $1.7 trillion by 2030, driving the growth of photomasks for integrated circuits or semiconductors.
• Photronics, a company that manufactures photomasks for IC production, expects increased demand in the 2nd and 3rd fiscal quarters of 2024.
• The company's low valuation and strong growth has the potential to drive the stock higher for above-average gains.

It is no secret that artificial intelligence [AI] has been the growth story for the 2020s. The global AI market is expected to grow at a robust pace of 37.3% annually to reach about $1.7 trillion by the end of 2030. One of the main components that makes AI possible is integrated circuits [ICs] (also known as semiconductors or microchips). What is not as well known is a growing company that is likely to benefit from AI growth. Photronics ( PLAB ) is one of the behind-the-scenes companies that makes the production of semiconductors possible.

I see Photronics as a solid long-term investment as the stock has an attractive valuation and the company has strong consensus expected earnings growth of about 13% for FY24.

Photronics manufactures photomasks which are used to produce ICs, flat panel displays [FPDs], and to transfer circuit patterns onto microchips. The company is experiencing strong demand for its photomasks as record revenue was achieved for the sixth year in a row.

However, it is worth noting that Photronics stated that there is a current contraction in demand which may last through fiscal Q1 2024. However, the consensus among industry leaders and customers is that demand will be stronger by the mid-point of 2024 or the company's fiscal Q2 & Q3 2024 as the next growth phase begins. The company also stated that photomask demand tends to be less cyclical than the semiconductor industry in general. This gives Photronics some stability in a market that can fluctuate significantly.

Growth Catalysts

The market for IC photomasks is approaching $4 billion annually . The total market for both IC photomasks and FPD photomasks is $7.5 billion. Photronics is a leader in this market with trailing 12 month revenue of $892 million with consensus expectations of $935 million in revenue for FY24 and $1 billion for FY25.

The strong expected growth for AI through the remainder of the decade is likely to create a nice tailwind for Photronics. The company is likely to see growing demand for its photomasks for AI-related semiconductors. Photronics' customers are likely to experience an increasing need for photomasks for producing their AI-related ICs in 2024 and beyond.

Conditions look positive for strong photomask pricing in 2024. There has been a global shortage of photomasks in the market, which could put upward pressure on prices in 2024. The leading photomask manufacturers: Toppan Holdings ( TOPPY ), Dai Nippon Printing ( DNPLY ), and Photronics have been operating at full capacity. Some chip manufacturers have been paying extra fees to photomask producers for expedited deliveries. The expected increase in photomask prices should have a positive impact on Photronics' revenue in 2024. This should also help to widen margins and help the company achieve analyst consensus expectations of 13% EPS growth for FY24.

Photronics also has high operating leverage as a low-cost producer. This helped the company achieve an operating margin of 28.4% for FY23 . This was the highest operating margin in the company's history. This was a significant improvement over the operating margin of 25.7% from FY22 and 14.3% from 2022. The expected increase in photomask prices driving the company's revenue could widen the operating margin further in FY24.

Photronics achieves strong profitability metrics to drive its earnings growth.

We can see from the chart above that Photronics outperforms the sector median on most of its profitability metrics with the exception of gross margin [GM]. Despite lagging the sector in GM, PLAB's other margins such as EBITDA margin and net income margin make up for it as the company significantly outperforms the sector median. These wide margins and PLAB's strong double-digit return on equity and return on total capital helps to drive the company's double-digit earnings growth.

Valuation

Photronics is trading attractively at 12.5x expected EPS of $2.30 for FY24 . This is significantly below the sector median forward PE of 23x.

Photronics also trades below its competitors with a forward EV/EBITDA of 4.5x. Toppan trades with a forward EV/EBITDA of 7x , while Dai Nippon Printing trades with a forward EV/EBITDA of 8 . PLAB also trades significantly below the sector median forward EV/EBITDA of 14.9x.

PLAB's stock has plenty of room to move higher from this attractive low valuation.

I also cross-checked PLAB's valuation with a discounted cash flow analysis. The parameters for the analysis are included in the table below:

The time period for the long-term growth rate is 5 years. With the current price at $28.78 and a fair value price of $39.66 according to the DCF analysis, Photronics is showing upside of 37.8%.

The DCF analysis fair price looks reasonable. The 37.8% potential upside for the stock can be achieved through PLAB's expected EPS growth of 13% plus PE multiple expansion due to the low valuation. The target price of $39.66 would increase the PE to 17.2x expected EPS of $2.30 for FY24. That is still lower than the sector median forward PE of 23x.

The stock price made a significant move higher after the company's fiscal Q4 2023 earnings report. However, the price has been pulling back over the past two weeks. The MACD shows the change in trend from bullish to bearish as the blue MACD line crossed below the red signal line. The RSI confirms the change in trend as it fell from an overbought condition. This looks like profit taking after the fast run-up in price.

Since the company didn't report any negative news, I wouldn't expect the price to drop much further. I would guess that the price might drop to about $26 to $27 and turn the highs from July into support. That would also be about halfway down the flag pole of this recent bull flag formation after the last earnings report. I have observed that these types of bull flag formations tend to stop dropping around the mid-point of the flag pole.

Balance Sheet/Cash Flow

The balance sheet looks strong as Photronics has $499 million in total cash & equivalents with only $18 million in long-term debt. The company also has a category of 'other liabilities' of $47 million on the balance sheet. Even the combination of long-term debt plus other liabilities of $65 million is still significantly lower than PLAB's total cash.

The balance sheet also shows PLAB with 4.2x more current assets than current liabilities and 6x more total assets than total liabilities for total equity of $1.3 billion. It is noteworthy that PLAB has $561 million in retained earnings. Having significantly more assets than liabilities, more cash than debt, and a high amount of retained earnings demonstrates that PLAB has financial stability and is in a great position for continued growth.

The company had $302 million in operating cash flow for FY23. This was a 10% increase over the operating cash flow from FY22 and 2x higher than FY21. PLAB spent $131 million on CapEx and repaid $18.4 million in long-term debt. Only $1.2 million worth of common stock was issued in FY23. The company was left with $122.8 million in unlevered free cash flow. PLAB's strong cash flow further demonstrates the company's strong financial position and its ability to grow going forward.

Risks for the Company

The semiconductor industry historically has been significantly cyclical. The industry has large spikes and dips which can create periods of lower revenue and earnings during the dips.

PLAB relies on a limited number of large customers. The company's five largest customers comprised 51% of PLAB's revenue in FY23. The loss of business from one or more of these customers can have a significant negative impact on the company's revenue.

Bottom Line Outlook for Photronics

Photronics looks great from a valuation and growth standpoint. The stock's low valuation leaves plenty of room for PE multiple expansion while the company grows earnings at a double-digit pace. The DCF analysis above shows about 38% upside for the stock, which is also supported by the low valuation and strong expected earnings growth.

The fact that Photronics is operating at full capacity creates the possibility for expansion in terms of a new production facility. In the meantime, PLAB is poised to benefit from pricing strength in 2024 due to the shortage of photomasks in the market.

Keep in mind that the stock has been pulling back recently. New investors may want to scale in to the stock or wait for a confirmation of a continuation of the uptrend before jumping in.

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