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Lam Research (NASDAQ:LRCX) Posts Better-Than-Expected Sales In Q2 But Quarterly Guidance Underwhelms


Full Report / January 25, 2023
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Semiconductor equipment maker Lam Research (NASDAQ:LCRX) beat analyst expectations in Q2 FY2023 quarter, with revenue up 24.8% year on year to $5.27 billion. However, guidance for the next quarter was less impressive, coming in at $3.8 billion at the midpoint, being 11.7% below analyst estimates. Lam Research made a GAAP profit of $1.46 billion, improving on its profit of $1.19 billion, in the same quarter last year.

Lam Research (LRCX) Q2 FY2023 Highlights:

  • Revenue: $5.27 billion vs analyst estimates of $5.08 billion (3.81% beat)
  • EPS (non-GAAP): $10.71 vs analyst estimates of $10 (7.11% beat)
  • Revenue guidance for Q3 2023 is $3.8 billion at the midpoint, below analyst estimates of $4.3 billion
  • Free cash flow of $976.8 million, roughly flat from previous quarter
  • Inventory Days Outstanding: 151, up from 145 previous quarter
  • Gross Margin (GAAP): 45%, down from 46.7% same quarter last year

Founded in 1980 by David Lam, who pioneered semiconductor etching technology, Lam Research (NASDAQ:LCRX) is one of the leading providers of the wafer fabrication equipment used to make semiconductors.

Lam Research is one of a handful of companies in the world that makes the tools used in deposition, etching, and cleaning wafers. It has a concentrated customer base made up of the biggest chip makers in the world like TSMC, Intel, Samsung and Micron. Its biggest customer base are the producers of memory chips, which have traditionally accounted for about two thirds of Lam’s revenues.

Specifically, Lam’s tools are heavily used in the production of NAND memory, which has evolved into more complex 3D designs over the past few years, requiring more complex tools to etch and deposit more structures on ever shrinking memory chips. In the long run, DRAM will likely shift to 3D designs, providing an opportunity for Lam. Because Lam is so exposed to memory chips, which have the most volatile pricing within semiconductors, Lam’s model tends to be more volatile than its tool maker peers, such as Applied Materials or ASML.

Its primary peers and competitors are Applied Materials, (NASDAQ:AMAT), ASML (NASDAQ:ASML), KLA Corp (NASDAQ:KLAC), and Samsung Electronics (KOSE:005930).

Semiconductor Manufacturing

The semiconductor capital (manufacturing) equipment group has become highly concentrated over the past decade. Suppliers have consolidated, and the increasing cost of innovation have made it unaffordable to almost everybody, except the largest companies, to produce leading edge chips. The result of the increased industry concentration has been higher operating margins and free cash generation through the cycle. Despite this structural improvement, the businesses can still be quite volatile, as demand fluctuations for the semiconductor equipment are magnified by the already cyclical nature of underlying semiconductor demand. Read More Chip manufacturing is done in "batches" on a single round silicon disk, known as a "wafer". Multiple chips can be fabricated on a single wafer, which itself can cost over $10,000 today for the more advanced nodes. The actual chip fabrication process requires hundreds to thousands of steps that are executed at an atomic scale. From start to finish, including fabrication, testing and packaging, it can take 3 months to make a chip. The process to create a silicon wafer starts with sand, which is melted to extract silicon, then purified and formed into a cylinder, which is then sliced down into discs about 1mm thick that are then polished into wafers. Next, the wafers go to a semiconductor foundry and go through a process where successive layers of insulating, conducting, and semiconducting materials are stacked on top of one another to form many small complex interconnected 3D structures (wires, insulators, etc), with each layer consisting of 15-20 processes such as deposition, lithography, etching, stripping, testing, and cleaning.

Sales Growth

Lam Research's revenue growth over the last three years has been strong, averaging 26.7% annually. But as you can see below, last year has not been especially strong, with quarterly revenue growing from $4.22 billion to $5.27 billion. Semiconductors are a cyclical industry and long-term investors should be prepared for periods of high growth, followed by periods of revenue contractions (which can sometimes offer opportune times to buy).

Lam Research Total Revenue

This was a decent quarter for Lam Research as revenues grew 24.8%, topping analyst estimates by 3.81%. This marks 13 straight quarters of revenue growth, which means the current upcycle has had a good run, as a typical upcycle tends to be 8-10 quarters.

Lam Research's revenue growth was positive this quarter, but the company is guiding to decline of 6.41% YoY next quarter, while analysts expect to see declines of 17.3% over the next twelve months.

Product Demand & Outstanding Inventory

Days Inventory Outstanding (DIO) are an important metric for chipmakers, as it reflects the capital intensity of the business and the cyclical nature of semiconductor supply and demand. In a tight supply environment, inventories tend to be stable, allowing chipmakers to exert pricing power. Steadily increasing DIO can be a warning sign that demand is weak, and if inventories continue to rise the company may have to downsize production.

Lam Research Inventory Days Outstanding

This quarter, Lam Research’s inventory days came in at 151, 32 days above the five year average, suggesting that that inventory has grown to higher levels than what we used to see in the past.

Pricing Power

Lam Research's gross profit margin, how much the company gets to keep after paying the costs of manufacturing its products, came in at 45% in Q2, down 1.8 percentage points year on year.

Lam Research Gross Margin (GAAP)

Despite declining over the past year, Lam Research still retains industry average gross margins, averaging 45.2%, pointing to a good competitive offering, decent cost controls, and only modest pricing pressure.

Profitability

Lam Research reported an operating margin of 32.1% in Q2, up 0.1 percentage points year on year. Operating margins are one of the best measures of profitability, telling us how much the company gets to keep after paying the costs of manufacturing the product, selling and marketing it and most importantly, keeping products relevant through research and development spending.

Lam Research Adjusted Operating Margin

Operating margins have been trending down over the last year, averaging 31.5%. However, Lam Research's margins remain one of the highest in the industry, driven by its strong gross margins and economies of scale generated from its highly efficient operating model.

Earnings, Cash & Competitive Moat

Wall St analysts are expecting earnings per share to decline 27.5% over the next twelve months, although estimates are likely to change post earnings.

Earnings are important, but we believe cash is king as you cannot pay bills with accounting profits. Lam Research's free cash flow came in at $976.8 million in Q2, down 24.9% year on year.

Lam Research Free Cash Flow

Lam Research has generated $2.95 billion in free cash flow over the last twelve months, translating to 15.5% of revenues. This is a strong result; Lam Research's free cash flow conversion was higher than most semiconductor companies, in the last year. If it maintains this level of cash generation, it will be able to invest plenty in new products, and ride out any cyclical downturn more easily.

Lam Research’s average return on invested capital (ROIC) over the last 5 years of 68% implies it has a strong competitive position and is able to invest in profitable growth over the long term.

Key Takeaways from Lam Research's Q2 Results

Sporting a market capitalization of $66.4 billion, more than $4.58 billion in cash and with positive free cash flow over the last twelve months, we're confident that Lam Research has the resources it needs to pursue a high growth business strategy.

We were impressed by how strongly Lam Research outperformed analysts’ earnings expectations this quarter. And we were also excited to see that it outperformed Wall St’s revenue expectations. On the other hand, it was unfortunate to see that the revenue guidance for the next quarter missed analysts' expectations and the inventory levels increased a little. Overall, this quarter's results were not the best we've seen from Lam Research. The company is down 3.56% on the results and currently trades at $471 per share.

Is Now The Time?

When considering Lam Research, investors should take into account its valuation and business qualities, as well as what happened in the latest quarter. Although we have other favorites, we understand the arguments that Lam Research is not a bad business. We would expect growth rates to moderate from here, but its revenue growth has been solid, over the last three years. And on top of that, its impressive operating margins are indicative of an highly efficient business model.

Lam Research's price to earnings ratio based on the next twelve months of 18.7x indicates that the market is definitely optimistic about its growth prospects. There are things to like about Lam Research and there's no doubt it is a bit of a market darling, at least for some. But it seems that there is a lot of optimism already priced in and we are wondering whether there might be better opportunities elsewhere right now.

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