Ultra Clean Holdings: Why This Chip Stock Is Not On Our Shopping List (NASDAQ:UCTT)

Thesis Summary

Ultra Clean Holdings, Inc. (UCTT) is a chipmaker with a track record of solid growth. Investors have a positive outlook on the future given the growth of the “Memory” market. However, the company is reliant on a few clients and has subpar profitability. Furthermore, there are risks associated with the foreign side of the business due to regulation. Despite a decent 8% return, we don’t feel the reward outweighs the risk and we remain “Neutral”.

Company Overview

Ultra Clean Holdings produces parts for the semiconductor industry. For those that know the market, the company could be defined as a “foundry” or OEM. These companies operate in contrast to “fabless” chip companies that design semiconductors but don’t produce them in-house. UCTT produces wafers, delivery systems and also provides services to other companies. Below, we can see a breakdown of the distribution of revenues to get a better idea:

(Source: Investor Presentation)

The two main segments, in terms of products, can be broken down into “Memory” and “Logic”. (WFE stands for Wafer Fab Equipment.) UCTT operates in the U.S. and also has a significant presence in South East Asia and China. In fact, revenues have historically been split evenly between domestic and international, although the latter represented 57% in the last quarter. Lastly, let’s look at revenue growth and operating margin:

(Source: Investor Presentation)

The company saw strong revenue during the 2015-2018 period, but that shrank in 2019. Operating margin has been in line with industry standards, around 6-9%. These companies are capital-intensive and operate on thin margins. Lastly, it’s worth mentioning that the balance sheet is remarkably strong, with almost 2x assets over liabilities and a D/E of 0.76

The “issues” with Ultra Clean Holdings

Looking at Ultra Clean Holdings’ operations, there are certainly a few identifiable red flags. Firstly, it is a concerning issue that over ⅔ of revenues come from two customers alone.

(Source: Investor Presentation)

As we can see most of the company’s revenues come from two sources: Lam Research Corporation (LRCX) and Applied Materials (AMAT). This raises concerns over two things, Firstly, revenue growth will be reliant on continued business from these two customers. Secondly, and most importantly, this raises some issues over UCTT’s market power in terms of pricing. UCTT already operates on thin margins, and it is hard to see how the company can raise its profitability in a competitive environment and with such little pricing power.

Another significant cause for concern is the regulatory environment. In recent news, the U.S. government imposed restrictions on China’s largest chip manufacturing company: Semiconductor Manufacturing International Corporation (OTCQX:SMICY). This is bad news for companies like UCTT, which, as seen in the changing distribution of revenue, relies on income from overseas, including China. Certainly, this stock, and the semiconductor industry as a whole, could see significant moves once the result of the election is clear.

Lastly, even if you are looking into investing in this sector of the chip market, Ultra Clean Holdings does not seem like the obvious choice by most metrics:

	UCTT	ACLS	BELFB
Gross Profit Margin	20.18%	41.12%	23.69%
EBITDA Margin	10.71%	12.02%	5.00%
Levered FCF Margin	5.62%	11.95%	6.13%

(Source: Seeking Alpha)

The table above compares UCTT to some of its closest competitors: Axcelis Technologies, Inc. (ACLS) and Bel Fuse Inc. (BELFB). As we can see, the company’s gross profit margin is the lowest of the three. UCTT also fares worse in terms of EBITDA and FCF margin. While these companies aren’t the same, it does seem that UCTT is below the sector average on most profitability metrics (according to data from Seeking Alpha).

Making the “Bull case”

Let’s entertain the idea that UCTT can indeed turn things around. How and why would this happen? The main case for investment in this company is growing. The company has indeed achieved a 20% CAGR over the last 5 years. Bulls believe the growth story could continue, and the latest justification for this is Memory:

(Source: Global Market Insights)

According to the data above, memory, which is the company’s largest revenue source, is set to grow at a CAGR of 13.8% over the next 6 years. The growth is expected to be even bigger for the APAC market, which UCTT has strong exposure to.

By itself, this might not be enough the company would have to also improve its profitability, in our view, to justify an investment. However, this hasn’t been the case in the past. UCTT has made an effort to vertically integrate and add synergies through M&A, but the gains in profitability have always been short-lived. Unless we are missing something, we see no guarantee that this could change shortly.

Valuation

To value UCTT common stock, we are using our regular potential cash flow valuation method. If you’d like more details on the exact specifications and “assumptions” we use, you can read more about it here.

UCTT’s valuation includes the assumption that levels of investment will not be as high, as our model would predict based on previous years after the balance sheet made a great leap in 2018. We are also assuming that the company can maintain its recently improved levels of profitability and working capital relative to revenue. We will also assume that it can pay an average income tax of 21%, rather than the much higher average of the last few years.

With all this considered, which we find optimistic, our estimated long-term cash return rate is 7.7%. This can seem high for a company with such financial solidity, but we have already discussed the risk we see of the business not performing this well.

(Source: Author’s work)

Takeaway

Our valuation yields a reasonable 8% return. Having said this, the valuation may be seen as somewhat optimistic. The current price doesn’t take into account some of the risks and fundamental problems with the company. For now, we remain Neutral on the company and don’t really see a reason to invest. If you want to gain exposure to the semiconductor industry, I believe investor favorites like Advanced Micro Devices (AMD) and Nvidia Corporation (NVDA) will likely outperform the rest of the sector.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.