As the world increasingly embraces a digital-first future, anything that can help the semiconductor industry to drive down costs, boost efficiency and bulk up the power of microchips should have a bright future. This is exactly where Nasdaq-listed Lam Research (LRCX:NASDAQ) oozes pedigree yet its stock currently trades on a discounted price to earnings multiple that you might associate with a low growth, low quality company.

Based on recently published forecasts from investment bank Berenberg, the June 2023 PE is 12.3. So why does the market seem to hate the stock? Before we get to that, let’s understand what Lam Research does.

This is a Silicon Valley-based business that designs and makes a range of unique semiconductor manufacturing equipment focused on meeting the industry’s escalating demands, especially given the increasing complexity of semiconductor designs and manufacturing processes. Lam Research designs specialist equipment that helps semiconductor manufacturers improve yields, lower costs, shrink processing time and reduce defects on microchips.

TRENDS DRIVING THE BUSINESS

Traditionally big in memory chips, this is an area booming thanks to the rapid rise of cloud computing, big data analytics, mobile devices and other connected world applications. Since data storage is the starting point of the digital economy, there is a huge demand for memory chips, particularly the more efficient variety. But technological advancements in areas like in-car electronics, 3D device architecture and advanced packaging technologies are also playing to Lam’s strengths.

Since 2015, revenues have gone from $4.6 billion to more than $17.2 billion (to 30 June 2022), while net income has jumped over 600% to $4.66 billion or $33.11 per share. Gross margins last year were 45.6%, impressive for a capital equipment manufacturer, while net profit margins were 26.7%.

Return on equity and investment has averaged over 50% and 30% during the past five years. Net debt of $1.35 billion last year was just 67% of equity, and Berenberg believes Lam Research will report net cash of nearly $4 billion this year thanks to a $6.5 billion free cash flow projection.

Berenberg is one of 27 analysts that follow the stock, 16 of which have buy recommendations on the shares; the remaining 11 are neutral, there’s not one sell recommendation, according to Investing.com data. The consensus share price target is $574, implying 53% upside, but even if we use Berenberg’s more conservative $470, it still implies 25%-plus upside to a PE of about 16 on financial year 2024 estimates.

WHAT ARE THE RISKS?

This paints a compelling investment picture for Lam Research, so what are the caveats? The big elephant in the room is the souring relationship between Washington and Beijing that has led to tightening restrictions on Chinese companies’ access to US technology.

The technology space has emerged as a major battlefield as nations fight for political and social hegemony around the world. Microchips are the building blocks of the tech industry, so it is no surprise that China and the US are increasingly at loggerheads over the industry, putting Lam Research sales to China under scrutiny.

While the company reported first-quarter results (to 30 September 2022) a week or so ago, and guided for Q2 above consensus estimates, there are concerns about what’s coming down the line, with Lam Research warning that 2023 will likely
see a $2 billion to $2.5 billion impact from the China restrictions.

According to one analyst at KeyBanc Capital Markets, investors are likely to ‘take little comfort’ from Lam Research’s upbeat results and
guidance, as it ‘indicated that 2023 wafer fabrication equipment revenues could fall in the low-$70 billion range, and that the company
would likely underperform the WFE decline given its memory exposure’.

Yet the market has been witnessing stiffening restrictions on China by the US authorities for most of the year and have been massaging down estimates accordingly. The share price has also fallen to reflect the gradually changing reality, having weakened throughout 2022. Year-to-date the shares are 48% lower.

This was illustrated by Berenberg comments following the Q1 results. ‘During Lam’s earnings conference call on Wednesday, management said it expects WFE to be in the low $90 billion range for 2022, followed by a more than 20% decline in 2023, with memory capex accounting for a large portion of the decline; this is in line with the street’s view at this point.’

In other words, this is already in the price, and we believe, then some, given the market’s propensity to exaggerate both good prospects and poor. ‘In our view, the only risk that is not in the numbers today will be foundry and logic spending cuts in 2023 if there is any delay to TSMC’s (2330:TPE) 3nm (three nanometre) ramp-up plan,’ said Berenberg.

Lam Research remains a brilliant business at an attractive price because the market is focusing too much on short-term issues and not enough on its massive opportunities from a multi-year industrial growth phase.

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