Recognizing the Strong Fundamentals Behind the Installed Base Business for Lam Research and Using them to Project out Lam’s Medium-Term Outlook

I have been giving a lot of thought to how Lam is likely to perform over the next few years as well as to its “Installed-Base” business. Lam has gone out of its way to both increasingly highlight the power of its Installed-Base business (its spares and services business) while still preserving the confidentiality of the robustness of the financials. The conundrum for Lam is this. Providing full transparency around the resiliency, profitability and growth of the Installed Base would in-all- likelihood bestow a higher valuation on Lam. The counterpoint to that benefit is transparency on that business’ operating performance would likely make negotiations with customers more difficult and attempts by competitors to poach business more earnest. Therefore, Lam has demurred on providing clear disclosure and chosen to provide more, generally, qualitative characterizations about the business – especially as the broader WFE sector has been contracting of late – to help investors understand the robust, secular growth nature of its Installed Base business.

That all said, Lam has provided just enough disclosure around the Installed-Base business that a high-level model can be constructed that provides an arguably insightful way to think about Lam’s prospects in the medium-term. I believe the Street hasn’t sufficiently connected the dots and realized how powerful a driver of Lam’s overall business the Installed-Base business will be in the years to come.

High level observations and insights:

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Disclaimers: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no indication of future results. A number of points made in this update are a matter of opinion and opinion is subject to change without notice.

Lam is, for all intents and purposes, in the chamber building business. They build machines that are composed of chambers that mostly do deposition (depositing materials on a wafer) and etch (stripping materials from a wafer).
As can be observed in the chart from the prior page (which is p. 8 from Lam’s most recent earnings presentation), it is not a question of whether the installed base of chambers grows or shrinks every year. It’s just a question of how much the installed base grows? During highly robust periods like 2017 & 2018, Lam increased its installed base of chambers ~6,000 per year. During the prior three years (2014-2016), Lam was growing the installed base ~4,000 chambers per year. There are two primary drivers of the growth in the number of chambers in the market: 1) node migrations (the more leading edge the node, the more process steps which typically means more chambers) and 2) capacity additions (capacity additions are often needed just to keep wafer output constant but are certainly needed if additional wafer output is the objective).
Chambers need to be serviced and more frequently than most people appreciate need to be replaced because they consume themselves. The forces that are at work in these chambers (extreme heat and pressure) have a tendency to lead to these chambers wearing out.
The WFE companies provide six month guarantees on new equipment and thereafter whatever needs servicing or to be replaced, the semi manufacturer has to buy, in most circumstances almost exclusively, from the OEM (Lam, Applied, Tokyo Electron, etc.).
Some types of activities are much more “service/spares” intensive than others. Dep and Etch are highly service intensive. Lithography, Inspection, Metrology – not as much.
While in theory the semi manufacturers could go to outside vendors for spare parts, for anything critical, they stick with the OEMs because the OEMs will not take responsibility for poor WFE performance if their spares are not used.
Further, Lam especially has been highly entrepreneurial in its Installed Base business and has been employing things like a) AI to help semi manufacturers determine when a chamber is likely to fail or may not be working optimally due to XYZ and b) service contracts where Lam will guarantee certain levels of performance or optimize performance if a Lam service contract is entered into.
www.fourtreeislandadvisory.com (603) 427-8053 2

Disclaimers: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no indication of future results. A number of points made in this update are a matter of opinion and opinion is subject to change without notice.

All of this has led to Lam’s “Installed Base” business growing revenues 2x that of its growth of its installed base of chambers.
What this generally means is that even in years when chamber growth is going to decline meaningfully from the prior year (as it appears will be happening for Lam, Applied and Tokyo Electron in 2019), the Installed Base business is positioned to still grow and become a meaningfully greater part of the overall business. The Installed Base is strong ballast for Lam.
The strong performance and outlook for the Installed-Base business has largely been attributed to Lam’s recently elevated CEO Tim Archer. Tim is a highly impressive professional and it seems clear that he intends to make success in the Installed-Base business a major area of focus for the Company.
Digesting all of the above, and then knowing a couple other data points:

As of the last investor day in early 2018 Lam indicated that the Installed Base business was ~25% of overall revenues.
Lam has suggested that not only has the installed base business been growing revenues at 2x the rate of chamber growth, but the business is positioned to continue that relationship in the medium term.
All of the above allows for a high-level model to be constructed:
What I have done in the model is the following:

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Disclaimers: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no indication of future results. A number of points made in this update are a matter of opinion and opinion is subject to change without notice.

Taken 2017 as the baseline year and used Lam’s rough guidance that a) in 2017 Installed-Base revenues were ~25% of total revenues and b) that installed based revenues have and are likely to grow at 2x the growth of the installed-base of chambers.
Estimated that installed base sales in CY 2019 will drop to 4,000 chambers (from ~6,000 in both 2017 and 2018) and then march back up to 5,000 in 2020 and 6,000 in 2021.
As Lam has materially ratcheted up its share repurchase activity over the past year and announced a monster new buyback authorization, I’ve forecasted out that the diluted share count drops 7% per year over the forecast period.
For the sake of simplicity, I have assumed that net income margins will remain constant over the forecast period.
Observations reflecting on the model are the following:

Even assuming 33% reduction in new chamber sales in CY 2019 (which is arguably a conservative assumption), should the installed-base business continue to grow revenues at 2x the installed base growth revenues appear likely to decline only 20%.
Lam’s installed base business appears poised to represent 37%+ of Lam’s overall revenues in the coming years up from 25% just a couple years ago.
The market should welcome and reward the consistency and growth of the installed base business by ultimately bestowing a higher earnings multiple on Lam. This is effectively a razor/razor blade business model and the razor blades are poised to play a much larger role in the company’s financials.
Between these business dynamics and Lam’s high level of liquidity, prodigious free cash flow and increasingly aggressive posture towards share repurchase, Lam appears well positioned to deliver on the high end (or even exceed) of its $23-$25 2021 Non-GAAP EPS guidance.
Should Lam deliver on the estimates described in the model, Lam is trading at <9x CY 2020 non-GAAP eps which a) compares to 10-year median P/E of 18.7x (according to YCharts) and b) suggests that Lam is trading at a PEG <0.7x.
www.fourtreeislandadvisory.com (603) 427-8053 4

Disclaimers: All information gathered from sources believed to be accurate, but the accuracy of the information cannot be guaranteed. Past performance is no indication of future results. A number of points made in this update are a matter of opinion and opinion is subject to change without notice.