AMAT - Ultra Clean Holdings: Not So Clean

2023-09-06 10:50:23 ET

Summary

• Ultra Clean Holdings has seen a painful share price retreat post the pandemic.
• The company has focused on reducing customer concentration risk and expanding its services through smaller deals.
• Despite increasing revenues, Ultra Clean Holdings is only breaking even at best, making investors cautious about its future earnings prospects.

Late in 2020, I offered a quick recap on Ultra Clean Holdings ( UCTT ) stock after a tumultuous year, which included a sizeable deal. After shares saw a substantial run higher during the year, and the company announced a relative expensive deal, I turned a bit more cautious.

As it turned out, shares quickly doubled but have struggled and have come down ever since, now trading at the same level as late in 2020. While this looks compelling given the continued revenue growth, the issue is that, at these higher revenue levels (even if they are down from a peak), Ultra is breaking even at best, making me extremely cautious here.

A Quick Recap

For some 3 decades, Ultra Clean Holdings has enabled semiconductor technology, and it actually has seen strong momentum ahead of the pandemic. The company was - and still is - active in the preparation phase with strength in front-end processing, including expertise in lithography, CMP, implant, etch, deposition and wafer cleaning, among others.

With a few giants being key clients, customer concentration risk was a thing, with Lam Research ( LRCX ) and Applied Materials ( AMAT ) responsible for two-thirds of sales at the time, although that this reliance had already come down.

To address this reliance issue, the company has focused on other services and capabilities, as well as multiple smaller deals pre-pandemic to reduce reliance further. In the years 2018 and 2019, sales hovered above the billion mark, although that operating profits of $60 million in 2018 were cut in half a year later.

Following the outbreak of the pandemic, the company has only seen accelerating momentum, as the company posted accelerating growth during the pandemic, with revenues trending at a run rate of nearly $1.5 billion and operating profits reported in excess of $100 million, with earnings power trending at $2.50 per share. These operating margins look very low within the semiconductor space, but do note that these are historically high for Ultra.

This meant that at $31 late in 2020, investors were believing that earnings power was not sustainable at 12 times earnings, for the reason mentioned above.

Granted a $1.3 billion enterprise valuation at the time, Ultra Clean announced a rather substantial $348 million deal for Ham-Let, to add $200 million in sales derived from the development, manufacturing and distribution of purity and industrial flow systems. This marked a premium in terms of sales multiples, as net debt would increase to $450 million, which looked okay with a 2.3 times leverage ratio, but this was based on historically higher EBITDA performance. This and lack of near-term earnings per share accretion made me quite cautious to get involved.

Boom - Bust

The cautious stance at $31 late in 2020 was far too cautious with the benefit of hindsight as shares doubled to $60 by April 2021. Ever since, shares have come down a bit, essentially having traded in a $25-$40 range ever since.

With pro forma revenues of $1.5 billion late in 2020, the company has seen further growth as 2021 sales rose to $2.1 billion in 2021 and nearly $2.4 billion in 2022, albeit that fourth quarter revenues were down year-over-year already at $566 million. GAAP operating profits fell from $186 million to $120 million, due to a $77 million loss on a divestment.

This charge, higher interest expenses and higher taxes meant that GAAP earnings were down two thirds to $40 million, equal to $0.88 per share. Adjusted earnings per share fell from $4.20 per share to $3.98 per share, after making no less than 12 adjustments, including a $0.42 per share stock-based compensation charge, for realistic earnings somewhere in the mid $3s.

The earnings generated during the pandemic-related boom meant that net debt had been cut to $155 million by year-end 2022, a modest amount. The issue was that the business was seeing real challenges with first quarter sales seen at just $395-$445 million due to a softer market, as well as an estimated $30 million negative impact due to a cybersecurity incident at one of its suppliers. This was set to result in a mere $0.12-$0.32 adjusted earnings per share number for the first quarter of 2023.

First quarter sales did eventually come in at $433 million, down 23% on the year, although the $0.17 adjusted earnings per share number was relatively modest. The company guided for second quarter sales at a midpoint of $435 million, with earnings seen around $0.25 per share, but results came in soft.

By July, the company posted second quarter sales of $422 million, as adjusted earnings came in at $0.17 per share. Moreover, similar results were seen in the third quarter, with sales seen around $430 million and adjusted earnings at around $0.18 per share. The disappointing factor is that even with revenues trending at $1.7 billion per annum, the company is not able to post substantial adjusted earnings, and actually posts GAAP losses, while the business was solidly profitable on just a billion revenue number not too long ago!

While this performance is not too worrying with a $164 million net debt load, the reality is that earnings power is very modest and not able to support the shares here from a valuation perspective. Quite frankly, I am disappointed with the earnings power given the level of sales here.

A Final Word

With shares flat over the past nearly three-year period, I am not naturally appealed to the shares, even as they are cut in half from the 2021 highs. The company is seeing a lost 2023, and is breaking even at best based on realistic earnings, providing little fundamental valuation support to the shares.

While a recovery could easily happen amidst a recovery in the cycle, the reality is that the business remains quite cyclical despite the diversification efforts, as quite frankly, I fail to see a compelling risk-reward here.

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