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Semiconductors Are The New Oil
Nearly every electronic device these days utilizes a semiconductor. From washing machines to cars to computers and phones, virtually every manufactured device or machine contains a chip or an electronic board of some sort.
This makes semiconductors one of the most important supplies in the modern economy. And a strategic concern for great powers. The semiconductor market grew in successive waves, pushed first by computers, then the Internet, then the Cloud, and now AI and IoT (Internet of Things).
It is an industry with strong concentration, with a few firms controlling most of the production. It is also an extremely complex manufacturing process, with each company usually specializing in only a few steps of semiconductor production.
Companies like TSMC or Intel are better known and catch the attention when it comes to investing in semiconductors. But another segment is the suppliers of machines and equipment to these industrial giants. They rely on specialized suppliers, able to provide the best and most reliable equipment to produce at-scale chips and other semiconductors.
An Attractive Industry
Because semiconductor manufacturing is such an exact science, chip producers will want only the best tool available. And because it is such a complex endeavor, this can only be achieved by a handful of very specialized suppliers.
This gives these suppliers great pricing power and a strong economic moat. Companies like TSMC will stick to their existing suppliers or risk disrupting their operations.
It also creates a positive flywheel where existing sales feed into R&D and more internal expertise, which in turn guarantees that any potential new competitor would struggle to achieve the same technical results. And even then, similar results would not be enough to make chip manufacturers take a chance in changing their protocols.
So, with semiconductors becoming a strategic asset, it can make sense to invest in equipment suppliers, as they will benefit from chip foundries build-up, no matter which chip maker (SMIC, TSMC, NVidia, Intel, etc…) ultimately benefits the most from semiconductor demand.
Top 10 Semiconductor Equipment Stocks for Manufacturing Support
The world's largest semiconductor equipment supplier by market cap, ASML is also the leader in the field, with a quasi-monopoly on a key technology called EUV lithography (Extreme UltraViolet). It is the successor to previous technology, also sold by ASML, the DUV lithography (Deep UltraViolet).
Lithography is how the “node” of a processor gets engraved on a silicon wafer, turning into a computer chip. The more advanced the chip, the smaller the node and the more complex the lithography process. The continuous miniaturization of node and lithography improvement is what allowed computers to get more powerful year after year.
EUV allows for ultra-small nodes, up to 7nm, or even 5nm and 3nm. These advanced node levels are often considered necessary for applications like AI, machine learning, 5G, AR/VR, and advanced cloud services.
EUV is currently at the center of the China-USA tensions and trade wars. In the summer of 2022, the USA banned the export of EUV machines to China. This was followed by efforts from Huawei to develop its own EUV solutions, with a patent deposited in December 2022.
By having a de facto monopoly on EUV out of China, ASML is a very prominent chip equipment manufacturer, a status heightened by the US pressure to restrict the export of the technology to its main rival. As a result, ASML is a crucial supplier to all chip manufacturers looking to build the most advanced chips.
More than half of ASML revenues come from EUV technology, and most of its sales are to Taiwan and South Korea, unsurprisingly considering these 2 leaders in chip manufacturing. Sales to China have declined sharply post-sanctions and no longer represent an important market for ASML.
The company has grown its earnings per share by 18% CAGR since 2010, thanks to growing margins, revenues, and the overall growing demand for chips.
This situation makes the company's prospects great but also justifies a very high stock price if measured by the P/E ratio or price to free cash flow.
So, investors in ASML will want to judge if the current price is fair, considering the company's quality, or if other opportunities in the sector can be obtained at a lower price.
Where ASML specializes in lithography, Applied Materials provides a myriad of products supporting the manufacturing of semiconductors. Most will be hard to fully understand for non-engineers, like “Metal and oxide barrier films,” “Color shifting and holographic films,” or “In-chamber patterned metal layers.”
This makes it a central supplier to “virtually anybody that makes a microchip.” It also makes its business model very stable, with more than 60% of revenues coming from subscriptions like equipment automatic renewal, maintenance services, consumable sales, etc. On average, these contracts last 2.6 years and are renewed in more than 90% of cases.
This led the company to register 15 consecutive quarters of year-to-year growth at the end of 2022.
The company has steadily grown its dividend distribution, even if the quicker stock price rise has lowered the dividend yield. The company also repurchased around a quarter of its outstanding shares since 2012.
This makes Applied Material a good stock to stand as a proxy of the semiconductor industry as a whole, with its sales closely following the overall capex spending and manufacturing activities of chip makers, so investors might want to consider buying Applied stock as an alternative to semiconductor ETFs.
After the production of the actual computer chip, it needs to be “packaged.” It allows the connection of the chip to the other components and protects it from getting damaged.
Another key semiconductor component is memory, which allows the storage of data calculated by the chip.
Both memory and packaging are at the core of Lam Research's business.
The company is making a quarter of its revenues from China and more than half from Korea, Japan, and Taiwan.
Even more than chips, memory tends to be a highly volatile market, with prices potentially fluctuating by more than 34% quarter-to-quarter, as it did in Q4 2022. This can make LAM Research stock equally volatile in the short term.
In the longer term, the company's memory business is steadily growing with the global demand for computing power, and its packaging solutions are used in most chips manufactured, whether they go into a car, a dishwasher, or a top-performing data center for training AIs.
This can make LAM Research another good proxy for the semiconductor industry as a whole, with a stronger exposure to the Chinese market than most. Occasional periods of volatility in prices on semiconductor commodities like memory can be used by investors to buy at cheaper entry points, considering the high cyclicality of the sector.
When producing chips and other semiconductors, it is crucial to have the highest quality possible. One metric is yield, representing how many functional chips are made per silicon wafer.
KLA products are there to measure accurately every step of the manufacturing process, detect any problems, and offer solutions on how to solve them.
This makes KLA an important partner of semiconductor producers for keeping costs low and production efficient.
KLA revenues are highly tied to China (30%) and overall Asia, especially Taiwan (21%) and Korea (18%).
The company has steadily grown its free cash flow, almost tripling it since 2019. The dividend has also grown by 15% CAGR since 2006
Because KLA machines are usually bought when new semiconductor foundry production lines are created, the company is especially sensible to the industry's capex cycle. Demand has softened after the shortage of chips during the pandemic, and there is some price pressure in the short term, reducing the chip maker's plans for new factories in the short term.
In a longer time frame, the plan is to open foundries out of Asia, notably several tens of billions of dollars for chip factories in the US and Europe to “de-risk” production from a possible conflict between China and Taiwan.
So, as long as the USA-China conflict does not escalate out of control, KLA could be one of the prime beneficiaries of the build-up of extra foundry capacity. So, investors in this stock will want to keep a close eye on the industry investment plans.
Similarly to other equipment suppliers in the industry, Tokyo Electron has established a strong presence in a few specific steps of the manufacturing process. Most notably, it controls almost 100% of the market of “coaters” for EUV lithography. This makes this segment directly correlated to the push of TSMC and other top chip makers to use EUV for 7nm nodes and smaller ones.
The company has the largest cumulated installed base of equipment for semiconductor manufacturing globally, with 88,000 machines installed.
The company is also highly dependent on the Chinese market, which is expected to represent 39.3% of its sales in Q1 2024, with most of the rest of its sales done in Asia.
Like most Japanese companies, Tokyo Electron stock has relatively under-performed its peers in the last decade. This was due to a stagnant domestic stock market since the crash in the late 1980s and an economy struggling to escape deflationary pressure.
This is a risk but also an opportunity. It means the company is priced cheaper than its competitors when measured by P/E, dividend yield, or price to free cash flow.
It also seems that the macroeconomic situation of Japan is changing, with the last year marked by the return of inflation and GDP growth, both potentially forcing a change of image for Japanese stocks.
This makes Tokyo Electron a good pick for value investors looking for exposure to the semiconductor industry but unwilling to pay the all-too-common high valuations for stocks in this sector.
When semiconductors are finished, they need to be tested to be sure that the chip or memory bar will actually perform as expected. Teradyne provides the equipment to perform these tests. More than half of the world's semiconductors are tested using Teradyne machines.
Teradyne reaches beyond the chip-making industry and into automotive, robotic, and telecommunication (wireless antenna, WiFi, etc.), even if semiconductors represent the bulk of Teradyne's revenues. The company expects robotics to be a strong growth driver in the coming years and for it to grow from the current 13% of total sales to 19% by 2026.
The company's low dividend yield does not reflect the money returned to shareholders, with the large majority of returns to shareholders in the form of share buybacks.
Teradyne's semiconductor activity is expected to follow the industry's growth thanks to its dominant position in the testing market. But its exposure to other sectors allows it to target stronger growth, counting on the expanding telecom and robotic markets, with drones and EVs another potential profit center.
This makes Teradyne a good pick for investors looking for exposure to both the semiconductor and the automation industry and interested in a strong growth profile.
Entegris produces high-purity specialty chemicals for various sectors, including semiconductors, life sciences, and diverse industries (aerospace, glass, chemicals, water treatment).
More advanced chips need more material and chemicals than previous generations and are less tolerant of impurities. This means that Entegris benefits not only from the growing chip and semiconductor production but also from a growing demand for the production of each individual item.
The same can be said for life science products. For example, oligonucleotides, cell cultures, and small molecules are increasingly useful in new therapies for rare diseases or cancer. And life-saving therapies are required by the FDA to respond to the highest quality standards.
The company revenues are roughly split in half between semiconductor production and the other sectors.
The company has a history of growth through acquisition, making it a serial acquirer and gathering a wide array of specialty technology into one company. This benefits both parties, as the acquired company can access Entegris's sales network and discover new opportunities by merging its technology or manufacturing capacities with other branches of Entegris.
Entegris has a larger growth potential than most suppliers to semiconductor producers thanks to its exposure to multiple industries, including high-growth sectors like life science and aerospace. It also has the potential to expand into new sectors, thanks to an excellent track record of acquisitions and integration of other companies into Entegris.
This makes Entegris a good stock pick for investors looking for long-term growth, good capital allocation, and open-ended expansion beyond semiconductors and into other highly innovative sectors.
Photronics produces photomasks, an important component of the semiconductor industry. They are used during the lithography to direct the engraving and the pattern that will turn the silicon wafer into a chip. Photomasks are also used to produce flat panel displays, used in screens for TV, smartphones, etc…
In Q2 2023, semiconductor applications represented $167M of revenues for Photronics and flat panel displays $62M.
The photomask market is expected to grow slowly, at a rate of 2.5% CAGR until 2026. This is partially due to the fact that more advanced chips do not necessarily require more photomask while delivering more computing power.
To some extent, Photronic's current valuation reflects the low growth expectation, with a P/E around 11-12.
Still, the company is a key supplier of the semiconductor industry and a dominant player in its market niche. So, it can be argued that such a high-quality company would deserve a larger valuation premium. The potential for growing demand for high-quality screens (e.g., in EVs) and TV from the emerging middle class in the developing world might not be fully priced in either.
So Photronics might be more of a fit for investors looking for a “safe” play in semiconductors, with a stable niche market dominated by one company and with some potential for growth or a repricing that might not be fully appreciated by the market.
Spel is India’s leading semiconductor assembling and testing provider. 60% of the company is held by Natronix, a privately held company headquartered in Singapore.
India has been looking to develop its semiconductor industry as a matter of national economic development and has given it a lot of political attention. This comes after a lot of attention has been given to Micron and Foxconn's intention to build chip manufacturing facilities in India and a push for national champions to produce chips domestically.
In the background, the growing tensions between China and the US and the threat of a Taiwan invasion make India a tempting alternative for “de-risking” a strategic supply chain.
With India's growing economy looking to climb up the supply chain and grow its industry, SPEL could be a good opportunity to capitalize on the evolution of globalization.
However, investors will need to be cautious, as the stock has already increased more than 10-fold since its lows in early 2020. So, some optimism about semiconductor manufacturing in India might already be priced in.
Aehr is a semiconductor company with a specialization in silicon carbide. More precisely, the company is producing equipment for testing the silicon carbide wafers. This gives it a presence in the EV automotive sector and smartphones, computer chips, and photonics/telecommunication.
Silicon carbide is a type of silicon compound used for high-energy electric systems. They notably allow for very high power loads required for the fast charging of EVs.
This makes Aehr a very niche and technical company and a crucial component of the supply chain and “on the way to becoming the industry standard for a critical manufacturing step for silicon carbide power semiconductors.”
Aehr is also actively developing new markets, notably the Gallium Nitride burn-in market, used in high-power applications like photovoltaic inverters.
This gives Aehr a very diversified customer base, looking like the who’s-who of the semiconductor industry, including TSMC, Texas Instruments, Seagate, and Bosch.
By occupying a small and important niche (silicon carbide testing) inside another niche in the EV supply chain (silicon carbide power electronics), Aehr is well positioned to benefit from the growth in EV production volume, irrespective of the latest battery technology, car model or change in charging plugs standards.
The downside to this unique position is that markets seem already well aware of it, with the stock price having skyrocketed 20x since March 2021.
So, investors must carefully assess what growth is already priced in. And the potential of new markets, like Gallium Nitride testing, to utilize Aehr’s unique technology for new applications.