Lam Research: Attractive Valuation With Promising Dividend Growth
Ignatiev
Investment thesis
Chipmakers look like the apparent choice when discussing investing in the semiconductor industry. However, chipmakers cannot operate without the wafer fabrication equipment. Lam Research Corporation (NASDAQ:LRCX) is one of the industry's leading companies, demonstrating stellar revenue growth and profitability. The company faces temporary headwinds due to the end market weakness, but secular trends are favorable. The company's diversified portfolio of products and best-in-class profitability gives it a solid competitive advantage to benefit from the expected industry growth. The stock is currently attractively valued, and its stellar dividend growth history makes it an attractive investment for both growth and value investors. All in all, I assign the stock a "Buy" rating.
Company information
Lam Research is a global supplier of innovative wafer fabrication equipment and services to the semiconductor industry. LRCX's customers are the largest semiconductor manufacturers, including Intel (INTC), Taiwan Semiconductor (TSM), Micron Technology (MU), Samsung Electronics, and others.
The company's fiscal year ends on the last Sunday of June each year. LRCX operates in one reportable business segment: manufacturing and servicing wafer-processing semiconductor manufacturing equipment. According to the latest 10-K report, the company generates about 90% of its revenue outside the U.S.
LRCX's latest 10-K report
Financials
The company's financial performance over the last decade has been strong. Revenue compounded at 15.8% annually, and the operating margin has expanded substantially as the business scaled up. LRCX's free cash flow [FCF] margin ex-stock-based compensation [ex-SBC] has been consistently positive and mostly at double digits, which is solid.
Author's calculations
The business is capital-intensive, and the company has to allocate a substantial portion of its revenue to capex and R&D. As LRCX delivered strong revenue growth over the long term, I believe the management's decision-making related to investment projects has been exceptional. I like how LRCX balances allocating capital between sustaining growth and keeping shareholders happy with consistent share buybacks and dividend payouts. A dividend yield of 1.2% is modest and may not be worth mentioning, but the last five years 22% CAGR is massive and looks very promising from the long-term perspective. Last but not least about the capital allocation approach: the balance sheet. LRCX is in a net cash position with a very prudent leverage level. Liquidity metrics and the covered ratio are more than enough to be confident regarding the company's ability to weather even long-term storms.
Seeking Alpha
The latest quarterly earnings were released on July 26, when the company topped consensus estimates. The current harsh environment, which includes pressures on the global economy and weak demand from end markets, adversely affects the company's earnings. Revenue declined 31% YoY, and the adjusted EPS shrank from $8.83 to $5.98.
Seeking Alpha
The company's weak financial performance is temporary and relates purely to the weakness in the global economy. As the phase of the global economic cycle passes this turmoil, the demand for wafer fabrication equipment [WFE] will apparently bounce back. Underinvestment in WFE over multiple quarters is unsustainable, given the powerful secular tailwinds for the semiconductor industry, like AI or IoT, are gaining strong momentum. Earnings consensus estimates expect revenue to start recovering in the second half of FY 2024, and FY 2025 will demonstrate about 19% YoY growth. The company's strong financial position gives me a high level of conviction that LRCX has more than enough resources to weather this temporary storm.
As a long-term investor, secular trends are more important than temporary weakness. The global WEF market is expected to compound 8.4% yearly up to 2028, which is a solid bullish sign. In its latest 10-K, the company names Applied Materials (AMAT) as the primary competitor. The two companies are close competitors and demonstrate almost identical profitability metrics.
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What I like in this comparison is that LRCX is much more efficient from the per-employee perspective. LRCX generates 35% more net income per employee, which is a massive gap. LRCX is slightly stronger than other profitability metrics despite AMAT's larger scale. I think that this efficiency indicates that LRCX is well-positioned to compete with AMAT, which is a larger company. Another point that makes me optimistic about LRCX's ability to capture positive secular trends is its diverse set of products. Lam's products are in various processes and applications across three major fabrication phases: Deposition, Etch, and Clean.
LRCX's latest 10-K report
Having a diverse portfolio of products decreases product concentration risks and provides cost efficiencies for the business. It also means the company has a vast base of intangible assets and patents, making it legally protected which improves its moat.
Valuation
The stock rallied 65% year-to-date, significantly outpacing the broader market. Seeking Alpha Quant assigns the stock the lowest possible "F" rating, meaning the stock is substantially overvalued. Indeed, current multiples are substantially higher than the sector median and historical averages.
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But LRCX is a growth company, so the discounted cash flow [DCF] approach would give solid evidence regarding the fairness of the current market cap. I use a 10% WACC for discounting. I have revenue consensus estimates for the next five fiscal years, projecting a solid double-digit CAGR. For the years beyond I incorporate a 10% revenue CAGR. I use the last five years' average for the current FCF margin and expect it to expand by 50 basis points yearly.
Author's calculations
According to my DCF calculations, the company's fair value is nearly $100 billion. That said, the current stock price has about 13% upside potential. Since LRCX pays dividends, we can also use the dividend discount model [DDM] to get a more robust level of conviction.
Consensus dividend estimates forecast a $7.73 payout per share in FY 2025. I use a long-term 10-year dividend CAGR for the sector median and round it down to 9%. I use the same 10% WACC for discounting.
Author's calculations
According to the DDM formula, LRCX's stock's fair price is $773, indicating a 13% upside potential. To conclude, my valuation analysis suggests the stock is about 13% undervalued, which I consider attractive.
Risks to consider
The company generates about 90% of its total sales outside the U.S. LRCX's heavy presence in international markets exposes it to significant currency exchange fluctuations and varying economic conditions across different countries. Unfavorable foreign exchange rate fluctuations might adversely affect the company's earnings. A vast international presence also means LRCX's operations are vulnerable to risks associated with global trade trends and regulatory challenges. This risk is more elevated nowadays, amid geopolitical tension between the U.S. and China. It is crucial to underline because a quarter of the company's sales are generated in China.
The semiconductor industry is cyclical and depends on the health of the overall economy. As a result, Lam is vulnerable to traditional risks such as an abrupt decline in semiconductor demand, excessive chip inventories in the distribution network, and a decline in semiconductor machine orders. LRCX is dependent on a limited group of major customers, and changes in their demand and supply schedules could adversely affect Lam's performance.
Bottom line
To conclude, Lam Research is a "Buy". It is a high-quality business operating in a promising WEF industry. While recent quarterly performance reveals heavy dependence on the broader economic health, headwinds are temporary. Secular trends are positive, and the company's stellar profitability metrics and diverse products portfolio suggest the company is well-positioned to utilize tailwinds. The valuation is attractive, and the dividend growth rate looks promising, which outweighs the potential risks and uncertainties.
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