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Stock Strategist Industry Reports

Chip Equipment's Bright Prospects Are Etched in Stone and Silicon

We see strong growth and reduced cyclicality for the industry.

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The wafer fabrication equipment space has been historically cyclical but has enjoyed stellar growth over the past five years thanks to sustained investment by leading-edge logic, foundry, and memory customers. The $50 billion-plus market is dominated by five major suppliers--Applied Materials (AMAT), ASML (ASML), Lam Research (LRCX), KLA (KLAC), and Tokyo Electron (8035)--which account for over 70% of the market and represent an integral part of the semiconductor ecosystem.

We foresee reduced cyclicality for the industry, thanks to consolidation of key customers and an increase in end-market diversity beyond PCs and smartphones toward the public cloud, 5G network rollout, a rise in automotive chip content, and artificial intelligence chip proliferation. Past downturns created challenging conditions for equipment suppliers and chipmakers alike to maintain investment levels and development of new chips or tools. We believe chipmakers (especially memory customers) are better equipped to navigate downturns with greater cash cushions and profitability levels, thanks to consolidation and more rational behavior from a supply/demand standpoint. With both the supplier and customer bases down to a smaller cohort (including the five aforementioned equipment vendors and chipmakers such as TSMC (TSM), Samsung (SMSN), Intel (INTC), and Micron (MU)), we think the wafer fabrication equipment market is now more supportive of consistent and resilient excess returns.

Over the next five years, we think this market will see a 6% compound annual growth rate, with the proliferation of extreme ultraviolet lithography, higher-layer-count 3D NAND, and new transistor structures supporting demand for more advanced tools. China also represents a strong growth opportunity for wafer fabrication equipment, though not without risks, as ongoing U.S.-China trade tensions may lead to additional export restrictions for U.S. companies. Additionally, we expect the top five suppliers to outperform the industry growth rate, thanks to share gains and services growth. Four of the top five players warrant wide economic moats thanks to cost advantages and intangible assets. The fifth, Tokyo Electron, has a narrow moat rating. Our top picks are Lam Research and KLA in terms of opportunity in upcoming technology transitions. We would be avid buyers on a pullback.

Key Takeaways

  • We assign the leading semiconductor capital equipment companies wide economic moat ratings (with the exception of Tokyo Electron with a narrow moat rating) for their cost advantages and intangible assets that allow them to earn excess returns on invested capital.
  • We foresee reduced cyclicality for the industry, thanks to consolidation toward a smaller number of key customers and because leading-edge vendors are generally agnostic to which chipmaker wins, as they sell advanced equipment to all parties.
  • With the consolidation of both suppliers and chipmakers, we think the wafer fabrication equipment market is now more supportive of sustained and resilient excess returns.
  • We expect wafer fabrication equipment spending to reach a CAGR of 6% over the next five years due to the increasing complexity of chip manufacturing related to 7- and 5-nanometer process technologies and advanced DRAM and 3D NAND supporting greater memory and storage requirements from cloud data centers to high-end smartphones. We believe this 6% CAGR is reasonable when compared with future capital expenditure plans and operating profitability at key customers.
  • Despite a weaker economic climate related to COVID-19, the acceleration of the digital transformation in support of work-, learn-, and play-from-home trends has indirectly benefited wafer fabrication equipment spending in 2020. We think 2021 growth will be higher than 2020 as DRAM investments begin to recover while logic and foundry spending remains robust thanks to ramp-ups of the latest process nodes from the likes of TSMC.
  • The services segment for major wafer fabrication equipment suppliers has turned into a solid recurring revenue stream that should help mitigate future volatility in equipment sales.
  • China is an attractive growth opportunity as it seeks to reduce its reliance on foreign semiconductors and build up its domestic chipmaking ecosystem with the likes of SMIC (00981) and YMTC. U.S.-China tensions could hurt U.S.-based equipment suppliers while giving non-U.S. entities such as Tokyo Electron a boost in sales and market share.
  • Chipmakers will require extreme ultraviolet lithography tools to continue advancing their process technologies to make the latest chips found in PCs, iPhones, and servers. ASML’s EUV sales are expected to grow 20% in 2021 as a result of continued adoption at the leading edge. We expect lithography to outpace wafer fabrication equipment over the next five years as a result of greater EUV penetration.

Our Top Picks
We expect the top five suppliers to outpace the broader wafer fabrication equipment market over the next five years through a combination of market share gains and services strength. On average, we foresee a 9% revenue CAGR over the next five years for the top five, ahead of the 6% CAGR for overall wafer fabrication equipment spending. Of the top five, we view the four wide-moat companies (Applied Materials, ASML, Lam Research, and KLA) favorably, though all are trading either at or above our fair value estimates. Each of these suppliers boasts enviable qualities: ASML as the EUV leader; Applied Materials as the large and well-diversified vendor; Lam Research as a strong innovator poised for solid share gains; and KLA as the dominant PDC supplier primarily responsible for enabling many of the key process technology transitions.

We believe Lam Research is well positioned to gain additional market share in critical etch and deposition segments, in addition to served addressable market expansion via new products in the atomic layer deposition and photoresist processing equipment segments.

KLA is the leader in process diagnostic and control tools, which help chipmakers inspect wafers for defects and proper critical dimensions to identify and correct problem sources. As chips increase in complexity and ramping up new process technologies face new challenges, KLA’s tools help the industry improve yields, accelerate product ramp-ups, and maximize profitability. We think KLA is a pure-play bet on increasingly sophisticated semiconductors as a result of the slowing of Moore’s Law. Additionally, KLA has shown it can maintain decent levels of growth even during years of wafer fabrication equipment contraction, such as 2019.

This information was published as part of a larger report, which is available to Morningstar’s institutional clients.

Abhinav Davuluri does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.