Lam – Post Update Q1 2019 – October 16, 2018

Congratulations to those that shorted or sold your LRCX into this print, you’ve been finessed by Lam!

Lam reported fiscal Q1 earnings this evening.  Not only did the company announce better results and guidance than most expected (especially those sell-side firms that capitulated into the print (BofA, Nomura, etc)), they announced that they spent $1.7bn on share buyback commitments (presumably ASRs) that are going to decrease the company’s diluted share count to no greater than 161mm (from 175mm shares in June) by the end of 2018. In the September quarter, Lam reduced its diluted share count by almost 6% and indicated by way of its December quarter guidance that the YE share count will be at least 8% below that June end share count.

Before further discussing how Lam has used capital allocation to capitalize on nonsensical trading in LRCX’s shares, a re-cap of the major points that were conveyed on the call that should meaningfully turn the tide in Lam’s (and AMAT’s) shares in the near term.

Highlights from the Lam call:

Materially better guidance provided than the sell-side and buy-side feared going into the call

Going into this call, sentiment in Lamand AMAT’s stocks was close to death (particularly for AMAT).  Sell-side analysts who were tired of their bullishness being unrewarded, flipped to being neutral or materially less bullish with most analysts having taken down their target prices on those stocks in recent weeks.  The narrative that the collective market was buying into was that the September quarter was unlikely to be the trough quarter for Lam and that 1H 2019 was likely to be worse than 2H 2018.

Against that backdrop, Lam delivered FQ1 Non-GAAP EPS of $3.36 vs. $3.20 guidance and IBES consensus of $3.22.  More importantly, Lam guided to a) $3.65 in the December quarter vs. IBES consensus of $3.35 and b) to 1H 2019 being stronger than 2H 2018 (a direct contradiction to the consensus sentiment going into the print).  Lam also indicated that the $100bn WFE number for combined 2018 & 2019 referred to by others (namely Applied) seemed on target. Lam indicated that the stronger outlook for 1H 2019 vs. 2H 2018 was being driven by strength in (in order of magnitude): 1) logic and image sensors 2) foundry and 3) DRAM with the outlook for NAND a little weaker in the 1H of 2019 than they’d previously calibrated. Lam indicated that their improving view for the 1H of 2019 was being driven by a combination of improving industry dynamics combined with continued expected share gain at new nodes (Lam seemed to corroborate that they expect to pick up share at Intel as the company transitions to the 10nm node).

Demand from domestic China was strong during the quarter

25% of sales were to China in the quarter and 2/3 of those sales were to domestic operators in China.  Lam indicated that there are 6-7 major domestic semis in China at this juncture and that Lam sold into domestic Chinese foundry, logic and memory customers.  Lam still indicated that they expect a disciplined (not blowout) ramp from China and also conveyed that while they are sure US/China trade tensions are causing some concerns amongst customers, that there had been no obvious change in behavior, to date, by their customers due to the tensions.

Lam’s installed base business (spares and upgrades) is doing remarkably well

Lam highlighted that there are now over 55k Lam chambers in operation and the growth in installed base revenues last quarter was 2x that of the growth in the number of new chambers. This installed base business should continue to be a strong tailwind, my observation not explicitly corroborated by management, for at least the next four quarters because the torrid pace of new chamber deliveries that ended in the June quarter won’t all anniversary until June of 2019 (warranties typically expire after one year).  So not only will the installed base be a strong growth tailwind for Lam’s business, it should provide significant stability and cash flows for the Company.  This will also, in all likelihood, facilitate another nice dividend raise in 2019 as Lam started harmonizing its dividend policy with its installed base business with the 2018 dividend hike.

More on the buybacks

While $1.7bn went out the door on buybacks, early settles of converts and cash settling employee options, a) not all the shares associated with that spend were settled immediately (as per normal with ASRs) and b) Lam used its full remaining share repurchase authorization and did not announce a new one.  When asked about what Lam was likely to do with regards to an additional authorization, Lam did not commit and indicated that they would come to their own conclusion (between the CFO and CEO) and then go to the board for an additional authorization to the extent that they decided it was the right idea to do so.

Big picture, judging by Lam’s astute behavior, I think it highly likely that sometime in the next quarter or so we will be hearing about a new authorization.  There have been a number of other investors that I’ve talked to that have wondered why Lam has held up slightly better during this onslaught since the end of August on the dep & etch WFE stocks (AMAT down 19.3% vs. LRCX down 15.5% thru the close on October 16).  I have little doubt that Lam’s relatively more aggressive share repurchase activity during the period played a meaningful roll in that relative outperformance.  Lam is also showing its share repurchase hand in a very “friendly to long term Lam investor” way with the way it engaged in its buyback activity last quarter.  When the market was giving up on the stock, Lam went in with both fists to buy-up the shares.

I contend that aggressive buyback activity will a) continue and b) play out in an enormously beneficial way for shareholders over the next 12-36 months.  By buying in stock at these ridiculous levels Lam is teeing up even better results as the earnings accelerate from here and are likely to hit new highs in FY 2020 and beyond.  Lam has not historically been beholden to earnings announcements to announce a re-load of its buyback program.  It will not be surprising if we learn of a new $2bn+ share repurchase program in the coming months.  Even with the recent aggressive FQ1 buyback activity, Lam still has $1.5bn of net cash, $3.9bn of gross cash and over $600mm of FCF growth per quarter to be working with.

Wrapping up – Why all of this is so important

As per Y charts data, Lam has historically traded in a range of 10-20x earnings.  The higher multiples are more associated with trough earnings and the lower end of that range is more associated with peak earnings.  Using Lam’s broad guidance and assuming that Lam will deliver 10% better EPS in the 1sthalf of 2019 than the 2ndhalf of 2018 (Lam broadly was speaking to revenues being higher but there should also be some leverage on margins so 10% EPS growth, especially when share count is dropping meaningfully, seems reasonably conservative), then Lam should deliver around $15 per share in fiscal 2019.  And fiscal 2019 could very well be the near term trough (that’s what many on the sell-side have been conveying).  Put 20x that trough and you hit $300.

But I’d focus the longer-term investor (wish there were more of you out there) on the following. Lam gave long-term guidance at its last investor day that they were likely to hit $24 per share in earnings in FY 2021 assuming that WFE spend stayed flat at FY 2018 levels.  I’d submit that Lam never expected that they would be able to successfully buy in so much stock at these recent lows. Further, given commentary on the call, while Lam didn’t affirm that long-term guidance, they were sufficiently positive on things like how much new NAND wafer capacity is likely to be needed in the next couple years that I suspect the Company sees no need, intellectually, to change their long-term sales, margins and tax rate forecasts. That being the case, I suspect that within three years it’svery reasonable to assume that Lam could/will be delivering $25+ of diluted EPS.

I also believe that if peak to trough earnings declines for Lam are a mere ~15% (i.e. what it looks like FY 2018 to FY 2019 will be), Lam should re-rate meaningfully higher from the low-end of its historic trough EPS multiple range.

Upshot of all of the above in the short and long-term is this.  I will be very unsurprised if Lam doesn’t trade up to $160 tomorrow or by the end of the week.  The shorts will be running to cover and many of the sell-side analysts that recently capitulated due almost entirely due to weak price action will have a hard time not re-warming to the stock given the results and earnings call. Medium-term, the more confidence that the market gains (by other competitors and customers corroborating Lam’s outlook) the more likely Lam is likely to make a strong move back towards $200.  It is important to understand though that this isn’t just a “WFE is likely to be better than expected” story.  This is also a Lam story as it is clear that Lam continues to gain share due to its leading edge tools.  Longer term (within 9+ months), I would be very unsurprised if Lam was hitting new all-time highs.

That all said, Lam is by no means out of the woods.  China is the 1st, 2nd, and 3rdbiggest concern for Lam’s stock.  It is estimated that between 40-50% of semiconductors are sold into China.  Further, China is arguably the growth engine for the world and semis are pro-cyclical.  Finally, if things really took a turn for the worse, there’s always the possibility that there could be further restrictions placed on the sale of equipment to China (I don’t think this likely, but it is possible).  While I am sanguine that there will be material progress made on the trade front in the coming months for a variety of reasons (not least of which is China appears increasingly unable to afford for these trade tensions to build much further and the Trump administration really can’t either), it is clear that the market has been expressing its fears over the possibility of things worseningby selling the semis and WFE stocks.  There’s effectively been a buying strike in the major WFE stocks for a few weeks now (I expect the opposite tomorrow).  If dialogue between the US and China starts becoming more constructive, I expect that the WFE stocks will zoom.  But if things worsen that could prevent these stocks from reverting back to historically reasonable valuations.  I submit that absent these trade tensions Lam should be back above $200 and AMAT should be back above $50 now.

So for the investor with a 12-24 month horizon and who believes that we’re going to make progress with China on the trade front, buy stock, sell leap puts and buy leap calls (I’ve been selling leap puts down at these levels as I already have a full long position).  And for those who think that things are going to become a lot worse with China before things improve, you should’ve stopped reading this update at the outset and be focusing your time on reading about what Jeff Gundlach (or some other good bond fund manager) is up to.