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I don’t think it’s much of a stretch to say that the tech market has been volatile over the past six months or so, and smaller-cap names have generally fared a little worse than their larger brethren. In that context, Veeco Instruments’ (NASDAQ:VECO) 14% decline since my last update (versus an 18% decline at Applied Materials (AMAT), 12% at ASML (ASML), and 10% at Lam Research (LRCX)) isn’t too awful, though this is a tough stock to benchmark and comparisons to these much larger tool companies are of limited value.
Investor sentiment for the chip space may not be what it was, but the reality is that fabs are still looking to spend large sums to increase capacity, particularly at leading-edge nodes. Moreover, Veeco continues to have attractive leverage to emerging opportunities like extreme ultraviolet (or EUV) lithography, multiple gallium-based substrates, and advanced tool/technology adoption in areas like microLEDs, power semis, and storage.
I’m a little less bullish on the near-term margin outlook for Veeco given supply-chain and mix pressures, and that does take a toll on my cash flow-based and margin-based fair value estimates, but I think the overall outlook for this under-followed equipment supplier is still positive and it’s a name worth considering.
Semiconductor Equipment Driving The Story Now
Veeco has continued to generate better-than-expected quarterly performances despite some emergent challenges in the semiconductor space, pressures from the supply chain, and an expected cyclical decline in the storage business. Here of late, the semiconductor business has been driving the growth, supported not only by meaningful industry investment in capacity but also new customer wins.
Revenue rose 12% year over year and 5% quarter over quarter in the last quarter (the fiscal second quarter), good for a modest 2% beat relative to sell-side expectations. Modest beats have been the trend over several quarters now, with management doing a fairly good job of dialing in slightly conservative but credible guidance.
Revenue was driven by the segments serving semiconductor customers, with revenue in the “Semiconductor” segment up 81% yoy and 26% qoq on strong demand for laser annealing and advanced packaging equipment. Revenue from the Compound Semiconductor segment was more mixed, rising 29% yoy but falling 16% qoq as growth in demand for photonics applications is being offset by some weakening in RF components tied to 5G. The Storage business saw a 58% year-over-year decline and flat sequential performance, as that business continues to go through a “digestion” phase after significant growth. The Scientific & Other business was down 12% yoy and 30% qoq, but makes up less than 10% of the total.
Gross margin declined 130bp year over year to 40.3% (and declined 280bp qoq), with both supply-chain pressures and mix called out as negative drivers. Management didn’t go into much additional detail, other than noting that there was an impact from customers signing off on multiple evaluation systems that were priced lower than typical production units. Operating income rose 8% annually and declined 7% sequentially, with operating margin down 60bp yoy (non-GAAP), and reported non-GAAP EPS were $0.06 (or 21%) ahead of expectations.
The Outlook Seems Secure For Now
Tech stocks have rallied back some over the last couple of months, but there remain concerns in the market about the health of the chip sector as companies work through capacity expansions, shrinking lead-times, and the risk of an economic slowdown (if not recession in 2023). As it pertains to Veeco, it all creates a lot of noise for the near-term outlook.
On the positive side, I haven’t seen much credible evidence that foundries are going to meaningfully postpone or cancel the significant capacity additions that they’ve already announced. Likewise, the recent passage of the CHIPS Act should encourage further production capacity expansions over the next few years. All of that is good for demand for core Veeco offerings like laser annealing, advanced packaging, and MOCVD systems (used in compound semiconductors for power and RF applications, as well as photonics). Likewise, given the impact of back-end capacity shortages (packaging and test) on many semiconductor companies, I believe many of the larger companies will look to invest in at least some redundant capacity on the packaging side.
Also on the positive, I still see opportunities for Veeco to win new business. Management talked about a “milestone” sign-off of an evaluation laser annealing system at a logic customer – I think, but am not sure, that that may be referring to a win with Intel (INTC) – as well as a win with a leading DRAM manufacturer that should lead to follow-on orders in late ’23 or early ’24. Beyond that, there are still opportunities for Veeco to gain slots with its MOCVD equipment for gallium-based compound semiconductors in areas like power, RF, and MEMS, and to gain share in areas like VCSELs.
As far as negatives go, the storage business is still going through its cyclical correction, though it sounds like orders are starting to pick up ahead of the next up-cycle (and storage capacity for data centers is still a growth market). There’s also still an overall risk that the industry is adding too much capacity and that there will be a sharper correction around the corner; I see this as less likely with the most advanced nodes, but it’s a risk that shouldn’t be dismissed out of hand. The long-term growth outlook for semiconductor production (and capacity) remains good, but there has been significant peak-to-trough volatility in the past and I don’t think we’ve entered some new volatility-free phase of the industry’s life cycle.
Another negative to monitor is the risk of further restrictions on trade with China. Sales to China are about 20% of Veeco’s business and while there hasn’t been anything new and concrete of late, there has been talk of further restricting China’s access to equipment targeting leading-edge nodes.
The Outlook
I wish there were more to say about Veeco, but the reality is that this fiscal year has been developing more or less as I expected. I’ve very slightly increased my revenue expectations for FY’22 and slightly reduced them for FY’23, but over the longer term those changes (and other changes made beyond FY’23) net out to basically no change. I’ve chosen to err a little more on the side of caution for near-term margins and cash flow, in part due to the success the company is having in converting lower-margin evaluation units.
This has an impact on near-term valuation, but doesn’t really alter my long-term expectations. If anything, I could argue that it improves the long-term outlook given that those conversions of evaluation units point to more production unit sales down the road and more margin leverage.
As is, I’m still looking for long-term revenue growth of around 7% and adjusted free cash flow growth of more than double that, as I expect FCF margins to climb toward the mid-teens over time. Again it is worth noting that it is unlikely that Veeco’s earnings will grow in a steady upward curve, but will instead see some sharper peaks and valleys along the way.
The Bottom Line
Between discounted cash flow and margin-driven EV/revenue (a methodology that works fairly well for the sector), I believe fair value today is in the mid-to-high $20’s, with an expected long-term annualized total return in the high single digits. That’s not a superb expected return for a small player in a volatile sector, but as I said before, I do see avenues for Veeco to outperform (winning more slots in more applications for its equipment). All told, this is a reasonable buy candidate today, and one worth considering more seriously if there were another sector pullback.
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