Note from Daily Trade Alert: The following article first appeared in The Growth Stock Advisor, a premium newsletter offered by Investors Alley.
One of my main secrets to successful investing is to not buy the stocks in the headlines. Better to buy the pick-and-shovel plays that allow the headline makers to do what they do.
Find the behind-the-scenes companies that make the high-profile industries work, and you will likely find a profitable, long-term investment. Let me show you what I mean by focusing on an industry that has been in the economic headlines a lot in 2021: semiconductors.
The Global Semiconductor Shortage and More
The global semiconductor shortage is causing disruptions in all sorts of industries, from automaking to electronics to video games to healthcare equipment.
The supply squeeze will not disappear overnight. Companies ranging from IBM to Taiwan Semiconductor (TSM)—the world’s largest contract semiconductor manufacturer—say the shortage will take some time to resolve. TSM CEO C.C. Wei estimates that it could persist until 2023!
Even after the shortage is resolved, the semiconductor industry will still have a strong, long-term tailwind behind it. Several megatrends are likely to play out of the next few decades, including the rise of cloud computing, continued adoption of artificial intelligence (AI) and the Internet of Things (IoT), the transition to 5G, and the shift to electric and autonomous vehicles.
Taken together, these trends indicate the semiconductor industry will be sitting in this sweet spot for many years…but it will be even sweeter for the companies that supply the picks and shovels to the semiconductor industry. Here is one such company:
Entegris: The Unknown Semiconductor Play
Manufacturing semiconductors involves literally hundreds of steps. During the process, numerous materials are applied to a silicon wafer to build integrated circuits onto its surface.
Entegris (ENTG) supplies the specialist chemicals, micro-contamination controls, and advanced materials handling solutions that underpin these processes. Its products enable semiconductor manufacturers to reduce defects, increase yields and improve the reliability of their chips.
The company is, essentially, a play on semiconductor demand. Roughly 90% of its revenues come from the semiconductor industry. The other 10% of its revenues comes from the life sciences and solar power sectors.
Entegris’s client list includes two chipmaking powerhouses: Taiwan Semiconductor and Samsung. These two tip global semiconductor companies’ spending is closing in on 45% of the total spending in the industry! According to market research firm IC Insights, Samsung alone spent $93.2 billion on its semiconductor business over the past three years,
And keep this in mind: the more sophisticated chips get, the more steps there will be in their manufacture. That, in turn, will create more demand for Entegris’s products and solutions. Longer-term, that should raise company’s revenue per wafer.
Now, let’s take a closer look at the company itself.
Entegris’s Three Divisions Put the Company “In the Chips”
Entegris is split into three business lines. The largest of these is the microcontamination control division, which provides systems to purify the liquid chemicals and gases used in making semiconductors. This income stream accounted for about 40% of the company’s total 2020 revenue. Microcontamination control was also was Entegris’s highest-margin segment: the adjusted operating profit margin coming in at 33.5% in 2020.
Next is Entegris’s specialty chemicals and engineered materials division, which made up close to a third of revenues in 2020. Its 2020 operating profit margin was 21%. This division supplies the high purity chemicals, gases, and coatings needed for layering material on a wafer and cleaning its surface.
Finally, there is Entegris’s advanced materials handling segment. This division accounted for nearly 30% of the company’s total revenue in 2020, but remains Entegris’s lowest-margin business (adjusted operating profit margin was 20.6% in 2020). This division provides solutions for the clean and safe delivery of critical chemicals from manufacturers to semiconductor makers’ facilities. It also offers systems that protect wafers from damage during the chip-making process.
Entegris’s future—so integrally tied to that of the semiconductor industry—looks very bright. About 70% of its sales come from products consumed during the chip-making process.
There are no competitors that can match Entegris’s global footprint or come close to its broad portfolio of more than 15,000 products. Plus, many of its most critical products are tailored to suit clients’ specific manufacturing needs. That means it would be both costly and time consuming for a semiconductor company to switch to a competitor. This translates to a high degree of customer retention and recurring revenue.
And with a high degree of fixed costs, Entegris benefits from operational gearing as volumes rise. In other words, as volume rises, profits follow.
Entegris has benefitted, and will continue to benefit for the foreseeable future, from the global chip shortage.
Boosted by demand for liquid filtration as well as advanced materials and coatings for leading edge applications that involve the smallest and most advanced chips, the company ended the first quarter of 2021 with a record order book, and saw its revenue jump by 24% year on year to $513 million. Entegris’s adjusted operating income surged by 29% in the first quarter to $128 million; its adjusted operating margin rose 80 basis points to 25% and its diluted GAAP earnings per share soared by 38% to $0.62 per share.
Looking toward the immediate future, Entegris has raised its full-year guidance—it now expects that 2021 revenue will rise by 17% to 19%. That means it will outperform the broader semiconductor market, which the company forecast to grow by 13% to 14%. Prior guidance was for Entegris to experience 11% to 13% growth in 2021.
One big reason for the increased guidance is the fact that top customer Taiwan Semiconductor recently bumped up its 2021 capital expenditure budget from the $25 billion to $28 billion range to $30 billion.
But what about the more distant future?
One way for Entegris to stay ahead of its competitors is to continue to invest in research and development. The company has invested more than 7% of its sales in R&D in each of the past three years. It has more than 2,500 active patents.
Entegris estimates, for the chips that process information, the industry spend per wafer for 5nm chips is almost three times that of 28nm chips! So, to capitalize on this trend, the company focused more than half of its R&D spending towards solutions for more advanced chip architecture, such as filtration products for making sub-7nm chips.
I love the Entegris management’s global smarts. The company is investing $200 million in a new factory in Taiwan, which due for completion in 2023. By that time, half of the company’s production operations will be located in Asia, where most semiconductors are manufactured.
In January, Entegris shares peaked at 39 times consensus 2022 earnings. And now, and following the tech stocks selloff, the forward PE ratio has dropped closer to 30.
That’s still not cheap, trading above the average stock in the sector that has a forward PE ratio in the 20 to 21 range. But with the semiconductor industry in a huge, multi-year upswing, Entegris’s unique growth story is worth the high price tag, making a long-term 5-star stock. It can be bought at any price up to $135 a share.
— Tony Daltorio
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Source: Growth Stock Advisor