Ultra Clean Holdings Is Sitting On The Fence (NASDAQ:UCTT)

Ultra Clean Holdings, Inc. (NASDAQ:UCTT) has been on somewhat of a roll lately. The stock trended lower for pretty much the entire first half of 2022, but it did much better in the month of July. The stock even came close to completing what would have been a breakout at the end of the month, but the effort failed after the release of the most recent quarterly report caused the stock to drop. Why will be covered next.

Why the Q2 report got a poor reception from the market

The Q2 report was not all bad. It actually came with a number of positives. For instance, revenue and non-GAAP EPS exceeded consensus estimates. Q2 revenue increased by 18% YoY to $608.7M, coming close to matching the record high. UCTT finished Q2 with a net loss of $25M or $0.56 per share in terms of GAAP and a net income of $47.4M or $1.04 per share in terms of non-GAAP, which represents an increase of 5% YoY. The table below shows the numbers for Q2 FY2022.

Note that there was a charge of $56M or $1.24 per share in Q2 due to the divestiture of several businesses. This pushed the GAAP numbers into the red, but it is excluded in the non-GAAP numbers. Non-GAAP earnings growth benefited from a lower tax rate of 15.2% in Q2 FY2022, down from 17.6% in Q1 FY2022 and 16.4% in Q2 FY2021. The non-GAAP weighted-average share count increased to 45.64M in Q2 FY2022, up from 44.25M in Q1 FY2022 and 45.59M in Q2 FY2021. Cash and equivalent was $421M at the end of Q2, down from $466M at the start of FY2022.

(GAAP)	Q2 FY2022	Q1 FY2022	Q2 FY2021	QoQ	YoY
Revenue	$608.697M	$564.144M	$515.200M	7.90%	18.15%
Gross margin	19.4%	20.2%	19.4%	(80bps)	–
Operating margin	(0.9%)	8.1%	6.2%	(900bps)	(710bps)
Income (loss) from operations	($5.511M)	$45.711M	$31.947M	–	–
Net income (loss) attributable to UCTT	($25.093M)	$27.930M	$17.098M	–	–
EPS	($0.56)	$0.61	$0.39	–	–
(Non-GAAP)
Revenue	$608.697M	$564.144M	$515.200M	7.90%	18.15%
Gross margin	20.3%	20.5%	21.2%	(20bps)	(90bps)
Operating margin	11.1%	10.9%	11.7%	20bps	(60bps)
Income from operations	$67.390M	$61.633M	$60.430M	9.34%	11.52%
Net income	$47.415M	$43.325M	$43.678M	9.44%	8.56%
EPS	$1.04	$0.95	$0.99	9.47%	5.05%

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Source: UCTT Form 8-K

However, Q3 guidance was a different story as it was worse than expected. Consensus estimates expected non-GAAP EPS of $1.23, but the actual number was significantly less. Guidance calls for Q3 FY2022 revenue of $585-645M, an increase of 11.1% YoY at the midpoint. The forecast expects GAAP EPS of $0.32-0.55, a decline of 37.9% YoY at the midpoint, and non-GAAP EPS of $0.94-1.18, a decline of 0.9% YoY at the midpoint. The wide range in guidance is a reflection of the high degree of uncertainty UCTT is faced with, especially with supply chain disruptions fairly common these days.

	Q3 FY2022 (guidance)	Q3 FY2021	YoY
Revenue	$585-645M	$553.7M	5.65-16.49%
GAAP EPS	$0.32-0.55	$0.70	(21.43-54.29%)
Non-GAAP EPS	$0.94-1.18	$1.07	(12.15)-10.28%

Click to enlarge

Guidance did not extend into Q4, but management added some color as to the rest of FY2022. UCTT expects growth to continue as demand remains strong. From the Q2 earnings call:

“For the second half of this year, we reiterate our belief that 2022 will be another year of growth for the WFE market and UCT. Broad-based rational spending supporting leading and trailing edge devices continues to keep demand elevated. While some customer order flows and delivery schedules have been adjusted into the following quarters to align with ongoing supply chain constraints and capacity limitations, we have not seen any significant cancellations.”

A transcript of the Q2 FY2022 earnings call can be found here.

Management is upbeat about the outlook further ahead. While UCTT acknowledges there is weakness in certain segments of the semiconductor market, other segments are holding strong.

“Our outlook for 2023 remains favorable. While there are signs of potential weakness in PC, low-end smartphones and some consumer electronics, those are being offset by strong demand in the high-performance computing, IoT, robotics and automotive sectors. Today, the chip industry powers most aspects of our economy, so it’s far less vulnerable to a single retail end market, and so is UCT.”

These comments from UCTT are reassuring in light of recent worries about the health of the semiconductor market. There are increasing reports suggesting demand for semiconductor chips is starting to crack, which would undoubtedly have negative ramifications for suppliers of equipment needed to manufacture those chips.

According to the most recent Form 10-K, UCTT derived 64% of FY2021 sales from Applied Materials (AMAT) and Lam Research (LRCX), two of the largest suppliers of semiconductor manufacturing equipment. UCTT is thus very much dependent on a healthy semiconductor market to grow sales and profits. UCTT will need strength in some market segments to keep offsetting weakness elsewhere.

Nevertheless, it’s worth mentioning that a number of big-name semiconductor companies have reported falling demand for certain types of semiconductors, specifically those used in smartphones and PCs. For instance, Intel (INTC) and Qualcomm (QCOM) have both issued pessimistic guidance recently, citing weakness in demand for PCs and smartphones, respectively.

Suppliers of semiconductor manufacturing equipment have benefited greatly from plans to expand the production of semiconductor chips. In fact, the bull case for UCTT rests on the assumption that this expansion will continue unabated. However, the weakness in demand for products like PCs and smartphones have convinced some manufacturers to make changes to these plans.

For instance, SK Hynix has postponed its planned $3.3B expansion of a memory chip fab. If more fab projects are delayed or even canceled, less semiconductor equipment will be needed from the likes of AMAT and LRCX. If both see demand go down, UCTT will be affected as well since most of its sales is derived from these two companies.

The stock gets rejected

The stock fell 7% in response to the latest guidance and was even down as much as 12% at one point. The drop came in the aftermath of a powerful rally that saw the stock gain 34% in the weeks following the low on July 1 and prior to the release of the Q2 report. The rally was in part helped along with the impending passing of the CHIPS Act in the U.S. Congress. However, the latest report seems to have put an end to the rally, at least temporarily. The chart below shows how the stock has rallied in recent weeks after falling for most of 2022.

Note how the recent rally was preceded by a long downtrend that lasted months. In fact, the lows can be connected to form a descending trendline, which in turn forms the lower bound of a channel. The stock was in the process of breaking through the upper bound of this channel, but the recent drop puts the stock back within the channel.

The channel remains intact and it is pointing down, which suggest the stock is likely heading lower if there is no breakout and the stock stays within the channel. However, it’s worth noting that the stock bounced when it came to close to dropping below the 50-day moving average, which could be interpreted as a positive sign for the bulls.

UCTT is on the fence at the moment. On the one hand, the stock remains stuck in a descending channel, having failed to break through the resistance imposed by the upper bound of the channel. On the other hand, the stock is within striking distance of a breakout as it remains close to the upper bound of the channel. It’s true the stock failed to break through resistance the last time, but it could have more success if it goes for another attempt. At the moment, UCTT is down 41% YTD.

UCTT has a few cards up its sleeve

Guidance was soft and the charts are leaning bearish, but UCTT is not without its strengths. Valuations have dropped along with the price of the stock. UCTT is now trading at a discount to its 5-year average. For instance, UCTT trades at 12 times forward earnings with a trailing P/E of 19. In comparison, the 5-year average is 22 times forward earnings. The table below shows the multiples for UCTT.

	UCTT
Market cap	$1.54B
Enterprise value	$1.79B
Revenue (“ttm”)	$2,341.6M
EBITDA	$304.6M
Trailing P/E	19.45
Forward P/E	12.47
PEG ratio	–
P/S	0.66
P/B	1.82
EV/sales	0.76
Trailing EV/EBITDA	5.87
Forward EV/EBITDA	5.55

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Source: SeekingAlpha

Investor takeaways

The latest report from UCTT was a mix of good and bad, although the latter managed to overshadow the former judging by the market’s reaction. On the one hand, the Q2 results were better than expected and UCTT remains upbeat about the state of the market. On the other hand, Q3 guidance was light, which inflamed concerns people had about where the market is heading.

Demand for semiconductor equipment may still be holding up, but for how long remains anyone’s guess. The fact is that demand for certain types of semiconductor chips continues to fall and it is possible other types could see demand go down in the near future. UCTT is banking on current strength in some market segments continuing to offset weakness in other segments, but there are no guarantees that is assured. Some companies are already scaling back some of their expansion plans, which does not bode well for the market. The market for semiconductor equipment may already be past its peak in the current cycle.

I am neutral on UCTT. Multiples are lower than they have been in recent past and UCTT is still growing, but earnings growth appears to be heading in the wrong direction. Market demand is still there, but there are definite signs the market is getting weaker and not stronger. While the charts leave open the possibility of a rally in the short term, it is unlikely the rally will be sustained if earnings falter due to the wafer fab equipment market going down.

Bottom line, the case for long UCTT has its strengths, but there are more weaknesses. The market for semiconductor chips has to get better to take away concerns people have about equipment suppliers and relates names, UCTT included. As long as this has yet to happen, staying on the sidelines with regard to UCTT is the way to go.