Onto Innovation Is a Sleeper Stock That Can Rally 85%: Portfolio Manager

Recent price: $47.31

Timeframe: 1-2 years

Thesis

Onto Innovation

is an underfollowed (lightly covered by six sell-side firms) company that is the product of the October 2019 combination of Nanometrics and Rudolph Technologies. The combination of the two companies vaulted Onto from a third- to a second-tier supplier to the semiconductor manufacturing industry. Nanometrics was known principally for its metrology and software tools and sold exclusively to semi manufacturers. Rudolph Technologies had strong businesses in inspection, metrology, lithography, and process control and yield management software. Rudolph’s business was heavily oriented to advanced packaging customers. While Nanometrics effectively bought Rudolph in a merger-of-equals transaction, Rudolph’s CEO and CFO kept their positions in the combined company, and the lead Nanometrics director succeeded to the same position in the combined company.

With primary businesses in inspection, metrology, lithography, and software tools, Onto Innovation has three clear comparables (ASML, KLA, and

Nova Measuring Instruments

). All of them trade at significantly higher valuations than Onto. I submit that Onto’s valuation gap will inevitably close. As long as Onto continues to execute, it is just a matter of time before the company’s shares will significantly outperform those of its peers in a sector that is well positioned to outperform both broader tech and the broader stock market.

Onto is at the center of three major themes in the wafer fabrication equipment (WFE) sector:

Theme One: There is an ever-increasing need for better inspection and metrology tools to improve yields at more challenging leading-edge nodes.

Something remarkable happened on Nov. 9. After 18 years of

Samsung

not only leading, but dominating, the NAND manufacturing market,

Micron Technology

announced a remarkable breakthrough: 176-layer NAND production at high volumes. Samsung has been stuck at 128 layers since the summer of 2019, although there have been reports as far back as April that Samsung was working on 160-layer NAND. There has been speculation that Samsung has been having trouble with its yields at the 128-layer node, and the company reportedly has formed a task force to boost the production yield of its memory chips. Samsung bores a single hole through the 128-layer stack (a very tricky process), while Micron has employed “string stacking” of two 88-layer stacks for its 176-layer NAND.

Elsewhere,

Intel

continues to have execution problems in progressing its semiconductor technology road map. Intel’s current leading-edge semis are being manufactured at 10nm while

Taiwan Semiconductor Manufacturing

is already manufacturing at high volume at 5nm. (There’s a step in between, 7nm, that Intel is still a while from executing on).

Amid this competition, leading-edge inspection and metrology tools are proving to be increasingly critical at leading-edge logic/foundry and memory nodes. These tools ensure that leading-edge semis are meeting their design specifications, and that manufacturing yields are high enough to drive sufficient return on investment (ROI) on semi production. It can take more than two months to manufacture a wafer of leading-edge semiconductors. Any tools that can accelerate the process, better enable the manufacturer to meet design specs, and raise yields is worth a fortune to leading-edge semi manufacturers.

Onto has a suite of products that are highly effective at the leading edge for both metrology and inspection. Onto’s Atlas V metrology system is being used to make as low as two nanometer logic/foundry chips a reality. Atlas V is also being employed by leading-edge memory manufacturers. Onto’s new advanced optical “Aspect” metrology system being employed for high-aspect-ratio semi production is up to 90% faster than existing X-ray metrology competitor products. Onto’s new Impulse V integrated metrology module has demonstrated best-in-class speed (30% faster than existing competitive products) as well as measurement sensitivity, the company said in a recent conference call. Its metrology business is up over 60% over the first three quarters of 2019, the company added. Onto expects its inspection business to increase 25% in 2020 over 2019. The company also said that in macro defect inspection it had grown its market share among the top five integrated device manufacturers, or IDMs, (i.e., Samsung, Taiwan Semiconductor Manufacturing, Intel,

SK hynix,

and Micron) by 20% over the last two years!

The point is simply this: Onto’s metrology and inspection products are becoming de rigueur for successful leading-edge semi manufacturing.

Theme Two: Heavier investment in and reliance upon advanced packaging will continue to drive Moore’s law.

Until approximately four years ago, the progression of Moore’s law was all about transistor shrink. But as the process of shrinking transistors has become more costly and challenging (and actually detrimental to performance due to data leakage when it comes to NAND), the industry has been relying on three additional means by which to continue to aid the progression: vertical scaling, advanced packaging, and new materials. Companies like

Applied Materials,

KLA, and

Lam Research

increasingly have been talking about the significance and growth of their respective advanced packaging businesses. Onto’s advanced packaging business is about 40% of the company’s revenue. Onto has said that its growth in specialty devices and advanced packaging tools is 50% greater than overall WFE market growth.

The reason why advanced packaging is so important is that it drives significantly greater performance and lower power consumption. All the top five IDMs have been increasingly highlighting the criticality of advanced packaging. Advanced packaging typically entails linking multiple chips in the most effective ways to drive performance. Metrology, inspection and lithography tools used to enable advanced packaging are critical to the IDMs. Per Onto’s last earnings call, “we believe those demanding customers are increasingly and more frequently choosing Onto solutions.”

Theme Three: Smart WFE companies are using software and AI to better service their tools. That improves semi manufacturers’ throughput and yields and drives better customer loyalty and better servicing/spares revenues.

Listen to a Lam or even an Applied Materials earnings call and you’ll hear increasing emphasis given to their software and AI-enabled services used to maximize tool uptime and make sure their WFE operates consistently at optimal levels. The effectiveness of Onto’s software tools is consistently highlighted as a key differentiator for the company. In the most recent earnings call, Onto discussed its AI-Diffract machine-learning software, which “enables advanced modeling of systems spectra data and the integration of multiple data streams to improve times of solution and process robustness.” While leading Tier 1 WFE manufacturers like Lam and Applied Materials derive about 30% of revenue from spares and services, Onto derives almost 30% of its revenue from software and services. While it’s not broken out, it’s fair to conjecture that Onto has the highest percentage of revenue from software sales of any of the Tier 1 or 2 WFE suppliers.

Having provided a sense of the key themes that Onto’s business plays into, here are seven major drivers of the investment thesis for its stock:

• Highly attractive play on metrology, inspection, lithography, and advanced packaging for leading-edge semi manufacturing that is trading at a dramatic discount to peers. Onto has a forward price/earnings ratio of 14, based on 2022 Institutional Brokers’ Estimate System (IBES) earnings estimates. Nova Measuring, by comparison, has a P/E ratio of 23. But Onto’s ratio of its enterprise value to trailing-12-month sales is 7, versus 6.6 for Nova. The valuation differentials make no sense. Onto’s ratio of enterprise value to annualized last-quarter Ebitda (earnings before interest, taxes, depreciation, and amortization) is 18, versus 24 for Nova. Perhaps most importantly, Onto’s price/earnings-to-growth (PEG) ratio is roughly half those of peers and at 0.8 is less than 1.

• Enormous organic growth opportunity. While the two companies that created Onto had combined revenue of roughly $600 million in the year before their combination, Onto believes through serviceable available market (SAM) and total addressable market (TAM) opportunities (driven largely by internal new product development efforts) that the company could be a $3 billion entity sometime in the years to come. The significant growth opportunity for Onto is partly reflected in IBES consensus EPS forecasts suggesting the highest aggregate EPS growth (greater 130% from 2019-2022) compared with any of its closest peers.

• Not only has the company guided to a strong inflection in the fourth quarter, its CEO hinted at a highly robust first quarter of 2021 (and really the first half of 2021) during the most recent earnings call. In response to an analyst’s question about the outlook for the first quarter given a robust outlook for lithography tool deliveries, Onto’s CEO said, “We are very excited for the March Quarter.” Onto’s CEO went on to say that given a) the expansion in memory spending that management believes will persist at least through the first of 2021 b) the expected doubling of 5G handset sales in 2021 and c) the number of firm orders they have for lithography systems, that the first half of 2021 will be very strong for Onto. It’s worth noting that three quarters out is about as far as a company like Onto has good visibility. Of further note, Onto historically (looking at Nanometrics and Rudolph) has been particularly leveraged to memory WFE spending, and 2021 is shaping up to be the best memory WFE spending year since the 2017-2018 period.

• In every quarter since the combination, Onto has beaten consensus estimates. The CEO and CFO have well-earned reputations for consistently underpromising and overdelivering. Recognizing this, it makes the highly constructive tenor of the last earnings call that much more encouraging.

• The company has approximately 15% of its market cap in cash, virtually no debt, and just announced a $100 million buyback (about 4% of its market cap) program. Onto is poised to deliver significantly more in shareholder payouts, as free cash flow (FCF) is growing significantly. Acquisitions or instituting a dividend are also possibilities. Onto has significantly more excess cash and FCF than it needs.

• Highly attractive takeout candidate for ASML, AMAT, Lam, KLA, or Tokyo Electron. It seems a virtual certainty that any attempts at combinations between Tier 1 suppliers are not going to be tolerated. Applied Materials tried it with Tokyo Electron, and Lam tried it with KLA. Regulators scuttled both deals. But Tier 1 companies going after Tier 2 WFE suppliers seems eminently more feasible. In fact, Applied Materials is trying to complete just such a purchase now with its proposed Kokusai Electric acquisition. But while Kokusai has been hung up and its outcome is uncertain, the main issue impeding the Kokusai approval would seem less applicable in the case of an Onto takeout. With Kokusai you have China holding up the purchase of a Japanese Tier 2 WFE company by a U.S. Tier 1 WFE supplier. You could see why China might be dragging its feet in having a U.S. company consolidate a non-U.S. company and more easily influence that company’s ability to sell to Chinese semi manufacturers. Alternatively, if Lam, Applied, or KLA agreed to purchase Onto, it would be a U.S. company buying another U.S. company, with both companies already subject to any limitations the U.S. government may put on them. If Onto were either put into play or put itself up for sale, my strong suspicion is that in the current environment the takeout would come at a high premium. The whole sector, while still very attractive in my opinion, is trading at its all-time high (which should embolden buyers). Further, given the market position of Onto’s product suite, I think it would be “red meat” for any Tier 1 buyer, particularly Lam (which would get a smaller version of the KLA they tried to purchase), ASML, or Applied Materials. The latter already has communicated to the investment community that it has the biggest advanced packaging business in the market and that advanced packaging solutions are an area of intense focus.

• High likelihood of expanding market awareness of Onto. With modest sell-side coverage (six firms versus three times that many for KLA) and many in the market not that familiar with Onto given the new name for the combined business, the likelihood of an accreting valuation as the company a) executes and b) makes its investment narrative better heard (through conferences and expanding sell-side coverage) seems high. On the sell-side research front, Barclays advised Nanometrics on the combination with Rudolph, and Morgan Stanley advised Rudolph. Neither sell-side firm has instituted coverage of Onto yet. With continued strong operational execution and stock performance, it should be simply a matter of time before those firms pick up coverage.

Following are some reasons why Onto’s valuation isn’t more consistent with those of its peers:

• There’s a lack of coverage/exposure, and the market is not yet used to the relatively new combined company.

• The company doesn’t screen well using generally accepted accounting principles (GAAP) because of acquisition accounting. Amortization expense ran at 10% of revenue year to date in 2020 versus a negligible amount before the combination of the two companies during the fourth quarter of 2019. On an adjusted earnings, EV/Ebitda, price/sales or PEG basis, the stock looks very cheap.

• The market might be waiting for more confirmation of the upswing in memory WFE spend (or have forgotten how leveraged Onto is to memory WFE spending). Multiple sources (including Applied Materials, which is the market leader in DRAM WFE) have forecast that 2021 will be a robust year for the growth of DRAM WFE spending. SEMI, the industry trade group, has forecast DRAM WFE spending will increase by 40% to 50% in 2021! Also, with Micron leapfrogging competitors with its 176-layer 3D NAND product, competitors (none of which have more than a 128-layer offering currently) will be scrambling to catch up. That will require heavy NAND WFE spending. This is a catalyst that investors want to be in front of. In semis broadly, but in WFE companies specifically, if the investor waits for confirmation of materially improved demand trends, that investor typically misses a huge move in the underlying stocks.

Key Risks

For the WFE sector, the biggest risk is that at some point the stocks overextend themselves and that something happens that leads to a significant drawdown in WFE demand. I do not believe we are even close on the valuation front. Given the strong secular growth outlook for the sector (combined with increasing recognition of how strategic semi manufacturing is for major Asian countries, the U.S., and Europe), WFE stocks as a rule should be trading at a premium to the market, not a discount. Stocks like Onto (including Lam, AMAT, KLA) trade at meaningful discounts to the market’s forward P/E multiple. And while a deceleration in WFE spending it likely to happen at some point, there appears to be a very firm runway before that occurs. When the Covid pandemic hit, the WFE stocks declined sharply on fears that impaired GDP growth would affect the sector. The exact opposite manifested itself for the WFE companies. Covid catalyzed a great acceleration of existing technology trends that appear to have at least a few years of runway. And with ever-increasing costs of leading-edge node migrations and much larger services and spares businesses that the leading WFE companies can stably rely upon, the WFE sector has a secular tailwind of ever-increasing WFE intensity so long as the industry can deliver technology developments that enable Moore’s law to persist.

Another risk for the WFE sector is that President-elect Biden picks up where Trump left off in terms of making the semiconductor industry a key chess piece in the U.S./China trade conflict. The market clearly thinks the likelihood is that tensions will ratchet down with a Biden presidency. That seems a reasonable bet. But things can change, and there’s no question that Trump’s mercurial brinksmanship with China, where semis were a key weapon in his arsenal, caused a negative overhang on WFE manufacturer valuations.

Onto competes against companies like KLA, ASML and Applied Materials that dwarf it in size and financial resources. Further, with so many points of interface between the Tier 1 WFE companies and the top-tier IDMs, one has to assume that the likes of KLA and Applied have a scale advantage with the top IDMs when marketing and defending the competitive positions of their metrology and inspection products. That said, the semi manufacturing industry is ruthless (Former Intel CEO Andy Grove famously named a book Only the Paranoid Survive), and whichever WFE company provides the best tool/solution in a particular area typically wins—no matter the size of the company manufacturing that tool. Onto has carved out a great and rapidly growing business in some of the areas most important to the future success of both major and second- or third-tier semi manufacturers. While Onto’s sales, like those of most WFE companies, may be concentrated in the top IDMs, Onto boasts more than 150 customers to which it has sold multiple products; that’s further validation of the value of its product portfolio.

Macro Perspective and Summary

On a macro level, the market has witnessed a sea change in the way the investment community is viewing the WFE stocks over the past two months. Three things have driven the significant move higher in WFE stocks:

• The market has come to the realization that the technology trends that Covid has accelerated are having a major positive impact on the medium-term demand outlook for operations of the WFE companies.

• Investors feel that the election results materially derisk the brinksmanship between the U.S. and China. The election results also probably increase the likelihood of the CHIPS for America act (or something like it) passing. That could lead to similar moves by other countries/regions.

• Last but not least, I believe the market has been coming to the realization of what Samsung’s intent to catch up in its foundry capabilities and regain leadership in NAND means for the WFE companies. The company is spending $116 billion in its next-generation chip business in an attempt to catch up to Taiwan Semiconductor, Bloomberg reported last month. On Dec. 4, Samsung Securities published a report on the WFE sector forecasting that Samsung Electronics would spend $17 billion on WFE in 2020 (up from $10 billion in 2019) and a staggering $23 billion in 2021. Samsung’s previous WFE spending high was $14 billion back in 2017!

Those key realizations, combined with how the sector appears very inexpensive relative to other sectors in technology (which are both overextended in valuation and rely on WFE either directly or indirectly to power their businesses), suggest the sector still has significant room to run from current levels.

In late November SEMI published an article on website saying that WFE revenues are soaring (up about 24% globally so far in 2020) amid the pandemic. That was followed by an early December article indicating that third-quarter WFE billings growth was 30% over the year-earlier quarter. Global semiconductor revenues are broadly viewed as having a growth rate that’s about twice global GDP growth. In September of 2020 global semiconductor revenue growth was 12% year over year. That was the second consecutive month of double-digit global semiconductor revenue growth. Third-quarter U.S. GDP, by comparison, declined about 2% year over year. Providing a more concrete visual on the medium-term outlook for WFE spending, SEMI published an article on Nov. 3 forecasting very robust spending for the next few years, with at least 38 new 300mm fabrication plants, or fabs, constructed from now to 2024. Such fabs require multibillion-dollar investments. Building and equipping that many new fabs could require $250 billion-plus, but companies also will have to spend an enormous amount of money simply upgrading existing fabs that are trying to deliver on increasingly intensive leading-edge node requirements. The upshot is that we appear to be in the midst of a multiyear acceleration of semiconductor demand that will require the semi manufacturers to spend dramatically in order to meet that demand. The WFE companies will be huge beneficiaries in this narrative.

Against that backdrop, Onto provides leading-edge solutions related to some of the highest-value themes in WFE.

For the full report, including a valuation discussion, please go to SumZero.com.