Buy Cabot Microelectronics – a compellingly valued, pure play semi consumables company

Published on SumZero March 13, 2019

“Compound interest is the most powerful force in the universe.”  Albert Einstein

There has been much ink spilled on SZ about the power of compounders. Next to a “risk free arbitrage” play – there are probably few more attractive investment opportunities for an investor.  I believe that Cabot Microelectronics (“CCMP”) is a highly attractive company that is likely to be a multi-year compounder provided that it remains independent long enough.  Something that appears increasingly less likely given the flurry of strategic activity in the niche semi consumables sector.

As any of you who’ve read my prior writings know I’ve, personally, spilled a lot of ink on the semicap equipment sector, specifically, and the semis broadly. I’m a big believer in the secular, multi-year forces (Big Data, AI, cloud computing, mobile, IoT, smart(er) cars, etc.) that should make a number of companies in the semicap equipment sector, specifically, long-term winners.  I also find their capital allocation discipline, their oligopolistic industry structure, and their highly undemanding valuations compelling.

That all said there are two primary components of the typical semicap equipment company’s business and they have different degrees of variability associated with them:

1)   the new systems business (which can go through significant swings in demand).

2)   the spares/services business (which tends to be a secular growth business – for more on this topic see my most recent piece on Lam Research on SZ dated March 10, 2019).

The beauty of a Company like CCMP is manifold but most importantly, it benefits from the same secular trends that a Lam Research or Applied Materials benefit from without having to contend with the demand volatility inherent in the cycles of capital equipment.  CCMP is a pure play consumables company with 82% (Pro Forma for the KMG Chemical acquisition) of its products sold to semiconductor manufacturers.  CCMP sells three primary products to the semis:

1)   Top manufacturer of slurries (33% market share) which are used in the chemical mechanical planarization process (CMP) to remove excess material and smooth the surface on wafers.

2)   2ndby market share (Dow Dupont is #1) in the manufacture and sale of polishing pads used in CMP to remove excess material and smooth the surface on wafers.

3)   Via its acquisition of KMG Chemicals, it is the leading global supplier of high purity chemicals serving semiconductor manufacturers. CCMP formulates, purifies and blends acids, solvents and other wet chemicals used to etch and clean silicon wafers in the production of semiconductors, solar cells and flat panel displays.

In addition, CCMP is the leading producer of drag reducing agents (DRAs) to oil pipeline operators to help facilitate better transport of fuel through pipelines (~12% of revenues).  CCMP also sells wood treatment chemicals used to protect wood against insect damage and decay as well as precision machining and polishing technologies for the optics industry (~6% of revenues).  The bulk of these non-semi related revenues came via the KMG Chemical acquisition and all have something in common.  The business’s focus on the sale of consumables that while critical, do not represent a large part of the bill of materials for their clients.

If you haven’t heard of Cabot Micro (or KMG Chemicals which CCMP purchased for $1.6bn in Q4 2018), you are not alone. By way of background:

–      CCMP was a spun-out from Cabot Corporation (the Boston based specialty and performance materials company) as their microelectronics materials business.

–      The Company conducted an IPO in April of 2000 for which Goldman was the lead underwriter.

–      A good video that provides a high level on CCMP and its products can be found here (https://www.cabotcmp.com/chemical-mechanical-planarization/corporate-video/#group).

–      While KMG Chemicals’ roots go back to 1992, its “Electronic Chemicals” business came by way of acquisition of Air Products & Chemicals’ electronic chems business and then was enhanced with the purchases of similar business from General Chemical Performance Products LLP, OM Group, and, most recently, Nagase Finichem Singapore (Pte) Ltd.

There are ten key attributes that make CCMP a compelling investment opportunity:

1.      Leveraged to secular growth in semis and increasing complexity in semi manufacturing

Last year, for the first time ever, there were over 1 trillion semiconductors sold (according to the Semiconductor Industry Association).  Not only is the use of semiconductors becoming more pervasive by the day with things like AI, big data analytics, IoT, smartwatches displacing traditional wristwear and a variety of appliances becoming “smarter,” more importantly semiconductor intensity (in mobile devices and things like automobiles) and semiconductor node migrations (increased complexity and performance) continues unabated.  CCMP’s products are leveraged not only to the volume of semiconductors produced, but the level of complexity in semiconductors.  The more steps taken to produce and exacting the specifications for a given semi, typically the higher intensity use of CCMPs products.  If broad semiconductor growth is likely to be 2x that of GDP growth, CCMP’s growth should be greater than the semi industry by some factor.

2.    High barriers to entry, market share growth opportunities and benefits of cross-selling KMG Chems to CCMP’s Global Footprint

The semiconductor manufacturing industry is all about precision, repeatability of processes and an inordinately high degree of quality control. Those that sell into the production process at semi manufacturers need to have their products qualified and maintain a consistent degree of high quality as the loss of a batch of wafers due to  defects can not only be expensive ($100k+), it can take more than a month to manufacture certain semis.  CCMP’s products are qualified through a rigorous qualification process at each manufacturer and then it’s, basically, just a question of filling orders.

When it comes to CCMP’s pads, by way of the Nexplanar acquisition announced in 2015, CCMP was able to supplement its organic pads product lines with advanced CMP pads that were easily substitutable with DowDupont’s market leading pads.  While CCMP has far and away the second largest market share in the semi polishing pad market, currently it has only a low-teens market share.  The Company expects its market share to hit the mid-teens in the near term (2019/2020) and be able to continue to grow over time. CCMP has benefited by being able to provide a strong second source for advanced CMP pads.

KMG’s business provides a significant cross sell opportunity for CCMP. KMG high purity electronics chemicals are hazardous and volatile and cannot be transported overseas.  KMG only disclosed having one customer in its last 10-K that represented over 10% of revenues and that was Intel. Given that ~65% of KMG’s business was in electronics chems and Intel was the only large customer – I believe it likely a) that Intel represented significantly more than 10% of revenues and b) that given that KMG’s chems are especially helpful in the production of logic semis and semis with particularly small transistors (10nm and less), those chems would presumably be highly competitive in more Asian markets (like South Korea (Samsung), Taiwan (Taiwan Semi), Singapore (where KMG is building out a facility) and Malaysia).  CCMP’s legacy business has as its top three customers Samsung (18%), Taiwan Semi (12%) and SK Hynix (10%).  CCMP’s customer relationships with key Asian semis should position CCMP well for when it is ready to sell KMG Chems into those markets.

3.    Cabot is highly integrated into its customers manufacturing process and develops proprietary blends of its products to help customers maximize performance

While Cabot manufactures three primary types of slurries, there are literally hundreds of types of mixtures and weightings of those slurries that can/are used to optimize each semi manufacturer’s process.  To a lesser extent, there are numerous options in terms of how various types of pads are prepared and used in the polishing process. CCMP works collaboratively with clients to optimize the slurry mixtures for each client’s needs.  Being as competitive as the semi manufacturing business tends to be, many slurry mixtures are proprietary to an individual customer.  What this means is that CCMP isn’t just selling commodity off the shelf slurry and polishing pad solutions, CCMP has developed deep relationships with key customers (like all the largest semi manufacturers) and this helps the stability of the pricing of their products and the permanency of the customer relationship.

4.    Lower operating volatility than traditional semis

While semis broadly are all benefitting from secular growth of demand, that doesn’t mean that they are immune from cyclical weakness.  The memory semis are all going through a weak pricing environment brought on, largely and arguably, by the slowdown in China that’s been driven by US/China trade tensions.  The WFE companies most leveraged to memory spend have witnessed less spend due to the memory semis slowing their capex spend.  Intel has been challenged by an interminable migration to the 10nm node which has left it unable to meet all the demand for PC chips.

CCMP’s products are not impacted nearly to the same degree as the semi manufacturers or the WFE companies by the pricing trends in the semi market.  CCMP’s sales are most impacted by volume of chip demand and the complexity of the semis being manufactured.  This has not only exhibited itself in CCMP’s operating performance it has shown up in CCMP’s beta (1.2x vs. Lam Research’s 1.5x and Micron’s 1.9x).

5.  Scarcity value and high level of strategic activity in the semi consumable sector

There are only three, public, pure play semi consumable companies (Entegris, Versum Materials and CCMP) and two of them were spinouts: CCMP (from Cabot Corp) and Versum Materials (from Air Products & Chemicals). All three are similarly sized: Versum $5.9bn enterprise value, Entegris $5.2bn enterprise value and CCMP $4.1bn enterprise value.  All three companies were built-up through acquisition with the most recently completed deal being CCMP’s 4thquarter 2018, $1.6bn acquisition of KMG Chemicals.

One way or another, this group of public entities is going to be shrinking from three to two in the coming months.  In January, Entegris and Versum entered into a definitive merger agreement where Entegris shareholders would end up owning 52.5% of the combined entity and Versum would gain four of the nine board seats in Newco.  On February 27th, $42bn market cap healthcare, life sciences and performance materials German conglomerate Merck KGaA made an unsolicited, all-cash offer for Versum that values the company at a >20% premium to where the Entegris offer currently stands. That offer has been rebuffed by Versum’s board.

In Merck KGaA’s offer letter from February 27, they make the case that any strategic looking at this space would make:

“Our Performance Materials business is an innovation driven market leader in electronic chemicals with exposure to high growth market segments.  Given ongoing technological change including AI, internet-of-things, data analytics and the like, long term secular trends will create lasting demand for semiconductors.  The leaders in the industry will be those willing to invest and able to innovate and adapt to change.” {bolding done for emphasis}

At Merck KGaA’s offer price for Versum, it is valuing the company at 13.3 EBITDA.  CCMP’s value per share would be $160 if the same multiple were applied to 2020 forecast EBITDA.  Further, Merck’s offer has been rebuffed and has been done without any negotiation with Versum. To the extent that Merck and Versum engaged in negotiations, it has been speculated that Versum could ultimately sell for $52-$55 per share (closer to 14-14.5x EV/EBITDA).

The point is this, one way or another Versum is going to be acquired. These semi consumable company assets are selling out at highly attractive multiples.  KMG Chemicals sold for 13.1x adjusted forward EBITDA pre-synergies.  CCMP and Entegris are going to be the last two standing.   And either Entegris or Merck KGaA is going to be left unsatisfied and presumably still on the hunt for a combination.  With CCMP being both the smallest and most inexpensive of the bunch, it appears like the most attractive and actionable target.

Beyond the losing bidder in the Versum situation, logical potential acquirers of CCMP include the WFE companies that should logically want to further enhance their Installed-Base spares/services business with consumables (KLA-Tencor, Lam Research and Applied Materials all make sensible acquirers). For a Company like Lam Research, acquiring CCMP could be a means by which it could provide segment reporting while still obfuscating its high performing, highly profitable Installed-Base business.  Further, CCMP’s business is exactly the type of business that Danaher should be interested in as should Honeywell or 3M.

6.    High level of transparency over the medium-term into CCMP’s business

One of the great things about an S-4 being filed and the KMG Chemicals deal being done partially for stock is that both Cabot and KMG provide forecasts going out the next five years.  Putting those forecasts together and then layering in the expected synergies from the deal, one can gain a pretty clear picture of how the Companies expect the business to perform over the medium term.

Synthesizing the S-4 disclosure with 2019 guidance provided with recent quarterly results and then making some assumptions on allocations of free cash flow, a broader picture can be constructed.

Should CCMP be able to deliver that kind of performance, it should result in a multi-year compounding stock.

7.  Significant De-leveraging opportunity

As highlighted in the above model, CCMP should have ample free cash flow after dividends to both paydown debt and buyback stock.  If CCMP were to just dedicate FCF after dividends to paying down debt, the Company should be able to reduce its debt by 80% in the next four years and thereby bring itself to a net debt position of $0.

8.  Limited Sell-Side coverage, but with plenty of reason for that coverage base to grow, provides an attractive opportunity for the diligent investor

According to CCMP, there are currently only four firms covering the Company:  Citi (Amanda Scarnati), Buckingham Research (Dmitry Silversteyn), Loop Capital Markets (Chris Kapsch) and Seaport Global (Michael Harrison).  Given that Goldman advised CCMP on the KMG Chemical deal (and led their IPO albeit 19 years ago), it would seem a natural for them to pick-up coverage.  Further, as Cabot keeps on delivering superlative performance and its market cap expands it should garner more coverage.

Versum Materials and Entegris each have 2x (8 firms) the research coverage of CCMP.  One would also think that with all of the deal activity in the space, that that would draw more research coverage.  That all said, the lack of coverage provides the diligent investor that much more opportunity in the name.  In my discussions with other investors on the buy-side that have significant interests in the semi space, it’s been surprising how few of them were aware of CCMP.

9.    A highly consistent “UPOD” (under-promise over deliver) Company

As highlighted in the above chart courtesy of Fidelity, CCMP has a tendency to materially beat IBES quarterly estimates.  Over the last eight quarters, CCMP only put up one miss.  Further, the Company delivered a median beat of IBES consensus estimates of 14.3%.

10.  CCMP’s stock is cheap on both an absolute and relative to peers basis

As alluded to at various points throughout this piece, CCMP trades at a very attractive valuation.  Whether comparing to peers (10.3x 2021 EPS vs. 21x for Versum and 14x for Entegris), on a standalone basis (13x 2020 and 10x 2021 EPS), based on a PEG of 0.6x or based on EV/EBITDA (<10x 2020 and <9x 2021), Cabot Microelectronics appears compellingly undervalued.  This low valuation exists despite it being a true “razor blade/consumables” business with strong secular growth characteristics.  Further, it is clear from unsolicited acquisition activity in the space that 20x forward earnings is not an unreasonable valuation to achieve on a takeout in this sector.

Risks

Semiconductor sector risk– At the end of the day, CCMP is a semi related stock and its stock is influenced heavily by macro themes surrounding the sector.  As Semis are pro-cyclical stocks, CCMP is negatively impacted when there are global growth scares and conversely benefits when the market becomes more constructive on the global growth outlook.  That all said, as highlighted multiple times through-out this write-up, I believe that CCMP’s operating performance is likely to be considerably less volatile than many other sub-sectors within semis. Because of this, I also believe that CCMP deserves a meaningful valuation re-rating and that should be achieved over time should it continue to deliver strong operating performance.

Competition

While there aren’t many pure plays of any size in the semi consumable space, there are parts of much larger companies that are better resourced that compete in certain sectors.  DowDupont is the strong leader in polishing pads.  Honeywell, BASF and Avantor (formerly Mallinckrodt Baker) compete in electronic chemicals.

Limited sell-side Coverage

While I think this presents an opportunity for the diligent investor, it also presents a challenge.  With limited sell-side coverage there is limited visibility for the sector broadly but particularly for CCMP.  Just as easily as one can argue that the sector and CCMP specifically is due for more coverage.  With the sector winnowing from three to two in coming months, it is just as possible that more ardent sector and CCMP coverage never materializes under the assumption that all the industry players are likely to ultimately be subsumed by bigger conglomerates (or that the sector is too niche to warrant more coverage).

Acquisition Integration risk

KMG Chemical was a large deal for CCMP.  While there is plenty of opportunity in terms of integrating the two companies, there’s always the risk of poor execution. That said, the Company indicated in the last quarter that it is already on track for $13mm of run-rate synergies (half of the total expected) with just half-a-quarter of operations under the combined company’s belt.

CCMP is leveraged ~3x on a Pro Forma Gross Debt basis

The Company has indicated that reducing leverage is their top priority with free cash flow, but this is the semiconductor industry and adding financial risk to operating risk can lead to heightened volatility in terms of operating and stock performance.  That said, this type of consumables business should have more room than normal for leverage on the business.

Technology risk

To the extent that the competition comes up with next generation products that leapfrog any of CCMP’s core offerings, given a limited product set that could materially impact the performance of CCMP’s business.

Prolonged, continued trade tensions with China

While this isn’t expected, to the extent that this were to occur and continue to cast a pall over the whole tech sector and particularly the semis – that would also impact CCMP.  On the flip side, as indicated by Microchip on their most recent earnings call, if the US and China come to some kind of agreement that ratchets down trade tensions, it should be a “bonanza” for semi stocks.

Summary

CCMP’s purifying chemicals aren’t necessary to reveal the compelling opportunity in CCMP’s shares.  This is a straightforward, highly attractive business trading at an inexpensive valuation that at some point is likely to be put into play.  And if CCMP isn’t put into play, all the better, as I believe it to have all the characteristics of a multi-year compounder with less volatility than many other sub-sectors within semis.

Buy CCMP.