Just as 4G wireless ushered in a new era of smartphones and mobile apps that we’ve come to depend on, the new 5G wireless standard promises even more exciting innovation in the next decade. 5G enthusiasts envision faster, safer and larger capacity communications, paving the way for new AR / VR applications, more sensor-based automated vehicles, factories and agriculture and other new era applications that we can’t even think about.
The need to power all of these applications is spurring massive increases in demand for next-generation chips. Still, my top three 5G stocks at the moment are not semiconductor producers or designers, but rather the essential tools that semiconductor foundries use to make these chips. See why this sub-segment is my favorite way to play 5G now.
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Lam Research and Applied Materials
You can think of Lam Research (NASDAQ: LRCX) and Applied Materials (NASDAQ: AMAT) such as “Coca-Cola and Pepsi” for semiconductor deposition and recording equipment. Both companies manufacture tools that engrave, or remove, materials on printed wafers, as well as tools that deposit the conductive materials that make up today’s cutting edge chips.
By distinguishing the two, Applied is a little more diverse, as it also has some metrology and inspection tools, in addition to making tools for OLED displays. Lam Research is a little more specialized and creates especially important tools for stacking 3D in NAND memory. Still, both companies serve semiconductor foundries, as well as DRAM and NAND. There are hundreds of steps in the production of high-end chips, so there is really room for the two companies to lead their own steps in the process.
Why do I love these two companies? Three reasons. First, the outlook for your tools is bright. Not only is demand for semiconductors increasing in the foreseeable future, but the more advanced the chip, the greater the capital intensity associated with making that chip. Therefore, many dollars from the 5G super cycle must flow from the chip makers to these companies.
Second, the pickling and depositing industry has consolidated into just a handful of companies, forming an oligopoly that will be difficult to displace. After all, if you’re a chip maker who spends billions in his factory, you don’t want to skimp on these mission-critical tools. An error in a semi-fabrication line can affect performance and be extremely expensive. Both Lam and Applied have also leveraged their huge amounts of data into value-added services they sell to chip makers to improve yields and limit errors. These high-margin services, which tend to grow with the installed base (rather than annual sales of heavier machines), represented 24% of Applied Research’s sales last year and 33% of Lam Research’s sales in the last quarter.
Strong competitive positions and high margin services provide excellent profitability and cash generation. Applied’s operating margins are 26% and its return on equity is 38.5%. Lam Research’s operating margin is 28.7% and its return on equity is an impressive 60%. Surprisingly, neither of these two ROE numbers takes any debt into account, as both companies are practically cash neutral.
Finally, both stocks are quite cheap compared to many other tech stocks and even other popular chip stocks. Both companies negotiate for just under 20 times next year’s profit estimates. This is below the direct P / E multiple 22 of the S&P 500, although these two are better than average deals. In addition, given the large increase in capital expenditures recently announced by customers Semiconductor manufacturing in Taiwan and Samsung, I wouldn’t be surprised if Applied and Lam outperform analysts’ estimates this year.
Both stocks have retreated in recent weeks after huge runs after the November election, but I think the slight downturn is an opportunity for long-term investors. While some may anticipate the end of the current chip boom later this year, I tend to think that the current increase will be more durable and long lasting, especially given the 5G megatrend. And if those shares stay here or fall further, both Applied and Lam generate significant cash flow to repurchase the shares and increase their dividends anyway.
Ichor Holdings
Another way to play both Applied Materials and Lam Research is to buy small cap pairs Ichor Holdings (NASDAQ: ICHR). Ichor is a $ 1.1 billion market capitalization company that manufactures fluid and gas distribution subsystems that go inside the Applied and Lam machines. In fact, last year, Lam and Applied represented 51% and 33% of Ichor’s sales, respectively.
Although Ichor’s business is less differentiated and has lower margins than Applied and Lam, the stock is also cheaper, about 12.5 times this year’s profit estimates. Last week, the company reported strong growth of 29% and earnings per share of $ 0.51, both well above estimates, while expanding margins throughout the year.
It is important to note that Ichor just raised money in December through a small offering of shares, which is a little worrying, since its shares are not so expensive. However, Ichor has grown a lot through acquisitions in the recent past, so another consolidation move may take place.
As a small cap, Ichor may not be on your immediate radar as a 5G game, but it sure seems like a worthy investor way to play the growth in semiconductor equipment manufacturing from the 5G boom.