Ultraclean Holdings (NASDAQ: UCTT) | Exploring Upstream Opportunities

Updated: Aug 1


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Key Points

  • Ultraclean Holdings is an upstream supplier to major semiconductor equipment manufacturers such as Lam Research and Applied Materials

  • Strong demand for chips is increasing downstream CAPEX spending, which UCTT is primed to take advantage of

  • UCT's service segments may allow it to weather through cyclical downturns better than its peers

  • UCT's vertically integrated growth strategy may allow it to compete more effectively

  • The new expansion plans may yield a greater-than-expected return and growth

  • UCT is trading at valuations multiples similar to industry median levels, but various optionalities could cause an upward rerating of the share price

Company Overview


Launched in 1991 from Mitsubishi Corporation metal’s division, UCT brought along Japanese-developed, ultra-clean manufacturing techniques to the semiconductor equipment industry in Silicon Valley. The management conducted a buyout from Mitsubishi in 2002 and launched UCT as an independent company, and quickly followed up with an IPO in 2004. Since then, through a series of acquisitions and global expansion programs, UCT Holdings has rapidly grown to become a leading developer and supplier of critical subsystems, as well as ultra-high purity cleaning and analytical services for the semiconductor industry.

Business Overview


UCT supplies products and services to Equipment Suppliers (Lam Research and Applied Materials etc.), who then supply wafer fabrication equipment (WFE) to Manufacturers (Micron and Samsung etc.) and Foundries (TSMC and UMC etc.) in the semiconductor industry.

UCT’s product business segment includes Chemical, Gas and Fluid delivery systems, precision robotics and process modules, frame assemblies as well as other high-level assemblies.

Precision Chemical, Gas and Fluid delivery lies at the core of semiconductor manufacturing. Many different gases – corrosives, reactives and inerts – in varying flow rates are delivered to process chambers to produce critical features on silicon wafers that are used in manufacturing logic and memory chips. Not only UCT’s systems deliver these gases in precise quantities and with excellent repeatability, but also with stringent purity levels.

Precision robotics and process modules ensure process repeatability in semiconductor manufacturing. Essentially, these robots accurately move silicon wafers at high speeds without causing damage, throughout the various stages of manufacturing.


Frame assemblies are largely used to connect the large-scale circuitry on circuit boards and electrical devices to the tiny electrical terminals etched on the surface of the semiconductors. This product is usually utilised in the semiconductor device assembly process.

UCT’s service business segment includes ultra-high purity parts cleaning and coating, and high sensitivity micro-contamination analysis. This ensures that the overall useful life of equipment is extended, and that there is no contamination in the various steps of the process.

Below, we can see a breakdown of the distribution of UCT’s revenues in the first quarter of 2021 to get a sense of which segments move the needle for the company’s earnings.

Industry Overview


The semiconductor market can be broken into seven broad categories: memory, logic, micro, analog, optoelectronics, discrete and sensors. The first four – memory, logic, microprocessors, and analog semiconductors – are the so-called integrated circuits (ICs).

Logic and microprocessor chips are the “brain” of a device and are responsible for the processing and operations. These include CPUs (Central Processing Unit) and GPUs (graphics processing units) etc. Memory chips are the computer’s temporary workspace that holds programs and data temporarily. These include (Dynamic Random Access Memory) DRAM and NAND (popularly known as the “short-term” and “long-term” memory for computing devices respectively). Analog chips are used as translators to bridge the gaps into and out of the digital world, converting waveforms into digital data, then reassembling the data back into waveforms for it to be seen or heard. All these chips are integrated into one circuit, hence the term Integrated Circuits (ICs).

Different types of equipment and processes are needed to fabricate the integrated circuits on a silicon wafer; the major processes being deposition, lithography and etching. Simply put, “Deposition is about putting the material on the wafer, lithography is about deciding where you want to leave the material or where you want to take it away, and etching is about removing the material that you don’t want.”

Customer Analysis


The majority of UCT’s revenue for the past 3 years has been derived from its top 3 customers which are equipment suppliers, Lam Research (43% of revenues in 2020), Applied Materials (24% of revenues in 2020) and ASML (greater than 10% of revenues in 2020). These customers are each market leaders in manufacturing equipment for the various processes mentioned above. These highly complex machines are then used by the likes of TSMC, Samsung, Micron etc. for front-end processes.


The chart below shows the movements of the share prices of UCT and its customers. The correlation of the share price movements is above 95%, indicating that UCT’s share price performance is highly correlated to the performance of its major customers.

From the graph above, the correlation between the share price movements between UCT and the downstream players is more than 94%, indicating that UCT's performance is very deeply tied to the performance of its customers. As such, understanding UCT’s customers is imperative to understand the future of UCT.

Lam Research’s specialty lies in its plasma etch machines, which are used to create tiny circuitry patterns on silicon wafers. The company also makes cleaning equipment that keeps unwanted particles from contaminating processed wafers. Lam Research also has a high exposure to memory, and in particular NAND, and the overall Asia region was responsible for over 88% of Lam’s revenue for the past 3 years. Lam Research has a 10.8% share in the overall semiconductor WFE market in 2020.


Applied Materials provides manufacturing equipment, services, and software to the semiconductor, display and related industries. The semiconductor systems segment includes semiconductor capital equipment used for many steps of the chip making process. Notably, Applied Materials has the leading market share of 50% in the deposition process, which creates layers of dielectric (insulating) and metal (conducting) materials used to build a semiconductor device. Applied’s top 3 customers are Samsung, TSMC and Intel, contributing to more than 40% of its revenue in 2020. Applied Materials has a 16.4% share in the overall semiconductor WFE market in 2020.

ASML provides chipmakers with hardware, software, and services to mass produce patterns on silicon through lithography. ASML has a dominant market share of 75% in the lithography equipment segment due to its cutting edge extreme ultraviolet (EUV) technology, which is essential to produce chips smaller than 7nm but highly complex to configure and maintain properly. Dutch-listed ASML does not directly compete with Applied Materials and Lam research, as it operates in a different segment. ASML has a 15.4% share in the overall semiconductor WFE market in 2020.

Industry Outlook


The semiconductor industry has evolved rapidly over the years, but the impact of COVID-19 has arguably cemented a paradigm shift that presents a bright outlook for the semiconductor equipment market.


Like many other industries, the semiconductor industry was taken by surprise by the strong demand following the onset of the pandemic. Remote working and schooling, and country-wide lockdowns resulted in the highest growth in sales of laptops in a decade, as well as other electronic devices. At the same time, the uncertainties created by the U.S. and China trade war resulted in stockpiling by large customers. On the supply side, the lockdowns caused a slowdown in production and supply-chain bottlenecks, and natural disasters such as the cold snap in Texas and fires in critical factories in Japan disrupted production. This imbalance between supply and demand created an overall shortage in the semiconductor industry, affecting everything, from PS5s to cars.


More recently, a growing number of industry giants are warning of a longer-than-anticipated deficits due to unprecedented demand, with TSMC stating that the chip crunch may spill into 2022. This stance was further supported by the increasing lead times to procuring chips.

The growing demand is also caused by multiple secular mega-trends that continue to boost the growth of the overall semiconductor industry. The cloud computing industry is expected to grow at a CAGR of 18% till 2026; the AI market at 33.1%; and the 5G infrastructure industry at 29%. These are very high growth rates, which will be fulfilled by large logic and memory foundries, the customers of Lam Research, Applied Materials and ASML.

This is further supported by Moore’s law, a key consideration in the semiconductor industry. Coined in 1965 by Gordon Moore, Intel’s co-founder, the interpretation of the law has changed over the years. Now, Moore’s law is widely accepted to mean that the number of transistors on a chip doubles every 18 to 24 months, resulting in ever faster and cheaper semiconductors. While the exact technicalities are widely debated, the trend remains that innovation is occurring at breakneck speeds. With these increasingly complex processes and the need to fulfil highly technical requirements, surface coatings and texturing becomes more important, leading to a greater intensity of etch and deposition processes.


Hence, demand is expected to cause the semiconductor industry to grow rapidly this year, followed by a slower growth in 2022 and 2023, which could lead to trickle down benefits for UCT. In fact, the World Semiconductor Trade Statistics (WSTS) expects the worldwide semiconductor market growth to rise from 6.8% in 2020 to an outstanding 10.9% in the year 2021.


IC Insights forecasts the DRAM market to expand 41% from last year, while expecting that the price per bit of DRAM will continue to rise in the second half of this year as supply remains tight. The NAND flash market is forecast to record a 22% growth, according to the company. The price per bit of NAND stabilised in the second quarter and is expected to rise over the next two quarters, the company projected. Overall, the total memory market is forecasted to be up by 32%, while the total logic IC market is forecasted to increase by 24% in 2021.


This growth in demand is further illustrated by commonly used leading indicators such as the Book-to-Bill ratio (ratio of orders received to units shipped and billed for a specified period), which responds to end-user demand for semiconductors, and chip prices.

New orders of electronics is also a commonly used leading indicator of the early stage in the production process and is synonymous with demand. Both this, and the Book-to-Bill ratio highlight strong, positive growth, indicating that demand continues to remain strong.

Financial Highlights


Revenue

UCT has managed to outperform WFE growth by an average of 10 points across the past 5 years, as targeted by the management. This was made possible by the various M&As that shall be further elaborated below. In 2018, UCT had a new reportable Service segment due to its acquisition of Quantum Global Technologies.

Margin Analysis

UCT has a strong positive trend of increasing gross margins, pointing to cost reductions due to the vertical integration strategy, which includes complementing product offerings as explained below. The relatively stable operating margin despite the cyclical downturns in 2019 indicates that the company is able to respond better to changing conditions in the market to maintain margins even as demand dries up.

Comparable Companies

UCT has very few direct competitors who operate in the same niche segment of the industry. As such, a peer group was constructed based on the subsegments of the WFE industry. Amongst them, Ichor Holdings was the closest competitor, having the same growth strategy and dealing mainly in the Gas and Fluid Delivery Systems submarket. UCT's customers and downstream players were also included as there are industry wide tailwinds that impact all companies within the sector, thus leading to the high correlation between UCT's share price and those of its customers, as mentioned above.

UCT is currently trading at median levels according to various valuation multiples, where Next-twelve-month (NTM) EV/EBITDA is at 7.98x, compared to the industry average of 7.79x. While the debt ratios, such as the current ratio and Debt/Equity, indicate that the company is taking on more leverage than its peers, the EBITDA/Interest Expense ratio indicates that UCT has a strong capability of paying off its debts. Notably, if the downstream customers were to be removed from the table, it becomes clear that the market recognises UCT's superior EBITDA margins, and is awarding the company a premium P/E and EV/EBITDA multiple. As such, it is difficult to argue that UCT is trading at a discount.


However, I shall discuss my investment theses below which I think could prove to be an opportunity that the market may have underestimated, resulting in a possible upside.

Thesis 1: Robust WFE spending to boost performance


As mentioned above, the demand for semiconductor chips is high. To fulfil this demand, new fabs must be built for supply to catch up. The table below collates the plans of various downstream firms that have announced plans to expand or build new manufacturing plants. These plans have been supported by governments such as the United States Senate, which approved a bill which includes $52 billion to fund semiconductor research, design, and manufacturing within the US to avoid another supply chain paralysis in the future. Japan, South Korea, and the European Union are following suit, while China is also aggressively increasing its manufacturing capabilities in a bid to become self-reliant.

The chart below depicts semiconductor equipment billings, including a few impacting factors such as the 2000 DRAM shortage hoax, which was due to Gartner's incorrect forecasting, leading to hoarding for fear of a shortage. The graph also depicts the effects of the 2008 Great Recession and the strong memory growth in 2018 due to an overestimation of demand for memory chips, which resulted in the memory collapse the following year. Despite these fluctuations, semiconductor billings have been linear and positive, as shown by the dotted blue line. However, the dotted red line illustrates a change in the trend in semiconductor equipment billings in recent years, signalling a more acute demand and hence, CAPEX spending. Thus, strong spending on semiconductor equipment is expected in the coming years. Naturally, this will result in upstream products and services, such as those offered by UCT, to experience an uptick, and hence greater revenues.

The industry estimates the overall WFE spending will grow by 34%, to a new industry record of $81.7 billion in 2021, followed by a 6% increase in 2022 to more than $86 billion. The foundry and logic segments, accounting for more than a half of total wafer fab equipment sales, will grow 39% year-over-year to reach US$45.7 billion in 2021, and another 8% to US$50 billion in 2022.

Until now, Semiconductor manufacturers worldwide will have started construction on 19 new high-volume fabs by the end of this year and break ground on another 10 in 2022 to meet accelerating demand for chips, according to SEMI’s quarterly World Fab Forecast report. The 29 fabs could produce as many as 2.6 million wafers per month (in 200mm equivalents). Equipment spending for the 29 fabs is expected to surpass $140 billion over the next few years.

This increase in equipment spending may extend for a longer period than the market estimates. Of the semiconductor makers beginning construction of new fabs this year, many won’t start installing equipment until 2023 since it takes up to two years after ground is broken to reach that phase, though some could begin equipping as soon as the first half of next year.

Thesis 2: Cushioning the effects of cyclicality


The semiconductor equipment billings graph above also highlights a distinctly notorious characteristic of the semiconductor industry – its cyclicality. Historically, this cyclicality is due to a confluence of demand and supply factors. The upturns occur during periods of high demand which cause supply shortages. Tight supply leads to higher prices and revenue growth. The downturns are caused by inventory build-up which result in falling prices and negative or zero revenue growth. In this cycle, it is estimated that the semiconductor equipment sector may experience positive growth till 2023, where there could be negative growth.


However, we can observe a long-term upward bias in the overall billings, despite the fluctuations year on year. Until recently, semiconductors were mainly used in consumer and auto electronics — and were therefore cyclical. Looking ahead, we can see further exponential growth in data management with the rollout of 5G mobile networks, the internet of things, machine learning and artificial intelligence. Semiconductors are now ubiquitous as they now play a much larger role in a wider range of business, administrative and personal applications, hinting at an excellent sustainable growth potential.


UCT’s Service segment may also prove to be a buffer against cyclicality. In this segment, Fab utilisation rates are the biggest driver, which is a function of end user demand. However, as yield becomes increasingly important at the most advanced nodes, advanced coatings are becoming a really important factor. Before this, UCT would simply clean a part and apply a specific coating, and then return it. Now, as the industry transitions into 3-nanometer logic chips, specialty coatings and surface texturing has become an increasingly important player. Management believes that despite this function being a very small portion of revenues currently, the company has a solid positioning to take advantage of the unprecedented growth in that space.


This means that the additional cleaning requirements may dethrone fab utilisation rates, and by extension, end demand, as the most important driver of the segment. Increasing complexity of chips may cause more content and services being used by UCT’s customers, and a demand for more complex approaches and leading edge kind of cleaning applications, which UCT specialises in.


This optionality of the cleaning and the analytics business parting ways with wafer starts and actually growing a little faster, as well as gaining market share, could help to cushion the impact of cyclicality on the overall business, indicating the possibility of a stronger and more stable growth.

Thesis 3: UCT's growth strategy to gain competitive advantage


UCT has aspirational goals of achieving revenues of $2 billion over the next few years. The management has been steadily building up towards this goal, through a series of expansion and M&As. The table illustrates the company’s track record of accretive acquisitions, which have grown their addressable market and revenues.

These acquisitions have allowed UCT to diversify its product offerings, and play an increasingly vital role in meeting their customers' needs, from the design processes all the way to the support and service maintenance requirements found in any high-volume manufacturing fab. This vertical integration, which covers many steps of the various processes, may allow UCT to charge a lower price over their competitors, while maintaining its margins.


This has enabled UCT to carve out a competitive advantage against even its closest competitors. For instance, ICHR is attempting to mimic UCT’s vertically-integrated growth strategy through acquisitions, but have only managed to establish a position in the gas delivery systems segment. UCT has a complementary cleaning service segment to further bolster revenues, which ICHR does not.


The vertical integration will play an even more vital role as more complex processes are used to support the next node transition in the industry. Foundries will exercise their negotiating powers over equipment providers, who will ask for lower prices from upstream suppliers like UCT. The ability to maintain margins may cause a divergence in the performance of UCT against its peers, causing it to stand out.


However, it is yet to be seen if the M&As are accretive. looking at the past 5 years, these acquisitions have contributed to an increase in their top line, while margins have remained relatively stable in the same time period. If the synergies of the acquisitions are not realised and hence, translate to better margins, then it can be argued that these acquisitions have actually been value dilutive. Should the above narrative play out, UCT could pull far ahead of its competitors and present a good opportunity for investors.


In the same vein, UCT’s most recent addition to its portfolio is Ham-Let, which boasts an overall gross margin of 25.2%, above UCT’s overall gross margin of 21.4%. 60% of Ham-Let’s revenue is derived from the semiconductor segment, which is set to grow with WFE. The remaining 40% of revenue comes from the Fab construction segment, which expands UCT’s total addressable market (TAM) by $2.0 billion.


At the same time, UCT had announced plans to expand their global footprint to Malaysia in Q2 of last year, which is due to begin production in the third quarter and support revenue run rates of $600 million to $800 million annually when fully ramped. This facility will be responsible for high cost manufacturing, and is projected to improve the company’s overall margins due to the low cost of labour. The company has also announced that they have projects ready, in order to utilise the additional capacity.


Lastly, another goal that the company has involves adding a third reportable customer, from the lithography space, to our products division. UCT announced that they have been “designated as an approved design and production partner for a major lithography company and continue to win manufacturing awards on our next-generation tools”. Currently, the company is in the midst of helping their customer get their product to the market and then becoming the high-volume production house for those products as they roll out. This is in line with UCT’s goal of expanding their suite of capabilities to play a larger, more valuable role for their customers, and is likely to cause a significant elevation in revenue.

Catalysts


Outperformance by Ham-Let or Malaysia Facility

Currently, the market is unsure of the exact effect of the Malaysia factory and the Ham-Let acquisition on UCT’s revenue and margins. The management mentioned that the Malaysia facility is on track to begin production in the third quarter, and has already won projects which will use that facility as the initial production site. The current climate of unprecedented demand may very well cause performance to be above expectations. This is further highlighted by the chart below, which highlights the company's history of beating earnings expectations, and could do so this year too.

New acquisition or customer

The company has a strong track record of organic expansions and M&As that happen every year, or alternate year. This behaviour might continue given the low interest rate environment and bright industry outlook that makes it easier to obtain loans for such plans. There could also be significant developments in onboarding the customer in the lithography space, thereby increasing revenues unexpectedly too.


Possible M&A target due to industry consolidation

In 2009, the top 10 wafer capacity leaders held 54% of total global capacity and the top five leaders accounted for 36% of capacity. In 2021, top 5 wafer capacity leaders in the market account for 54% of all global capacity. This trend of consolidation has occurred in most parts of the semiconductor value chain. For UCT, as the vertical integration ability expands, it becomes more of a target for acquisitions, especially given the synergies with downstream functions.

Risks


Possible Margin Squeeze

The particular segment of the industry that UCT operates in is highly competitive, where there are a limited number of potential customers. At the same time, UCT’s products and services yield similar results across the industry, making it difficult to provide a unique value proposition. Some of UCT’s competitors may even have substantially greater financial, technical, manufacturing and marketing resources. Meanwhile, due to their size and level of contribution to UCT’s revenue, UCT’s largest customers are able to use their superior negotiating leverage to obtain discounts. Hence, competitive pressures may cause intensified price-based competition and a margin squeeze.


However, a key differentiating factor for UCT over its competitors lies in its reputation and customer relationships which have been developed and strengthened over the years. Qualification processes to approve new suppliers are lengthy, typically involving the inspection and audit of facilities and evaluation of various processes and procedures. These qualification processes also incur costs, preventing customers from switching suppliers easily.


As mentioned above, high degrees of specialisation in the industry has seen UCT’s customers elect to outsource their gas delivery systems and other critical subsystems including cleaning and analytics.


Customer Concentration

The majority of UCT’s revenue for the past 3 years has been derived from its top 3 customers; namely Lam Research (53% of revenues in 2020), Applied Materials (30% of revenues in 2020) and ASML (greater than 10% of revenues in 2020). Currently, customers outsource their gas delivery systems and other critical subsystems including cleaning and analytics to UCT. These customers could elect in the future to develop and manufacture these subsystems internally, causing a big hit to UCT’s revenues.


However, the increasingly complex and customised requirements of products and processes has resulted in companies specialising in niche markets. UCT’s vertical integration encourages WFE firms to outsource subsystems to avoid significant costs arising from creating their own in-house systems, thereby making it unlikely for UCT to lose a significant customer.


Another consideration is the possibility of customers defaulting on payments or cancelling orders. This risk is mitigated as UCT’s customers are leading suppliers of semis equipment in the industry and have strong balance sheets, making it unlikely for such a situation to occur.


Trade War Intensifies

As seen by the chart above which highlights the Projected High-Volume Fabs Beginning Construction, Asia-Pacific is set to be the Fastest Growing Market. However, the Trump administration barred China - the world's top chips producer - from obtaining advanced semiconductor manufacturing gear and technology, while making it more difficult to sell Chinese-made products to companies with US ties. Despite the signing of the phase one deal in January last year, these rules still exist today, and US officials have said the tariffs will remain in place for now. To make matters worse, Lam Research, UCT’s largest customer, obtains almost 32% of its revenue from China. Should the Trade war intensify, UCT’s customers could experience a significant drop in revenues, which could spill over to UCT as well.

Conclusion


All in all, it is likely that UCT’s product segment will experience a surge in demand as equipment sales remain elevated till 2023. As Fab construction takes about 1 to 1.5 years to be completed, there is a possibility that WFE spending could remain strong in 2023 too, exceeding analysts expectations. Once equipment sales eventually slow down, UCT's service segment should help its growth continue to outperform the WFE market. Increases in the absolute number of wafer starts due to the additional fabs, as well as increasing technical requirements which leads to more intensive cleaning processes - these factors may cushion the impact of cyclicality on the business. At the same time, the vertical integrated growth strategy may allow UCT to gain an edge over its competitors. Lastly, optionalities of new M&As or onboarding a customer from the lithography space could lead to a whole new value segment, thereby presenting an opportunity for investors.


At UCT's current valuation, it is difficult to acknowledge which of the above mentioned theses have already been priced in, and to what extent. However, the various optionalities mentioned above, if executed well, could result in an upwards rerating of the share price, and hence upside for investors.