Kulicke & Soffa (NASDAQ: KLIC)

KLIC is a manufacturer of semiconductor interconnecting equipment used for semiconductor bonding / packaging. The company primarily sells wire bonders, the majority of which are ball bonders, as well as a line of wedge bonders and some other tools used in the packaging process. The customers for bonding equipment include outsourced semiconductor assembly and test companies (OSATs; e.g. SPIL, ASX) and integrated device manufacturers (IDMs; e.g. INTC, TXN, FSL). OSATs typically comprise 75-85% of revenue in a given quarter. 

The company went public in 1961 and was headquartered in Pennsylvania until 2010, when the company centralized most operations in Singapore, to be closer to its customers and manufacturing centers. However, the company still maintains certain functions in the US, including a large R&D center and certain IR functions.

Executive Summary

I believe KLIC shares are significantly undervalued and its primary risks largely misunderstood. KLIC maintains a strong leadership position in its field with >65% market share, industry-leading margins, and healthy FCF while sitting on a debt-free cash hoard of $557M, vs. the company market cap of ~$870M. Over the last 12 months, relative to its current EV, KLIC shares trade at a ~17% FCF yield.

In addition to the compelling valuation, management has been under investor / analyst pressure for several quarters to “monetize” its large (and increasing) debt-free cash position. While a dividend is unlikely, there are several capital allocation possibilities likely to unfold over the next 12-18 months that offer additional upside.

As a result, I recommend going long KLIC shares at current levels for a 12-18 month period in anticipation of both greater market recognition of the company’s steeply discounted valuation, as well as the likely monetization of its deep cash position to unlock shareholder value. I believe shares to be worth ~$17+ / share, implying upside potential of 50+%.

Investment Merits

Market Background

Wire bonding is an interconnection method in the semiconductor packaging process. Packaging is the final stage of the semiconductor fabrication process, where semiconductor devices (e.g. integrated circuits, LEDs, MEMS, RAM, etc) are packaged in a supporting case that prevents damage / corrosion and supports the electrical interconnects which connect the device to a circuit board. There are several possible interconnecting methods, all utilizing electricity-conducting material – typically gold, copper, or aluminum.  

Of the packaging processes currently in use, wire bonding is generally considered the most cost-effective and flexible method. Currently, ~85% of semiconductor packages are assembled using wire bonding. While more advanced packaging methods (such as flip chip bonding) comprise the remaining ~15% and growing, the market share mix for advanced packaging is expected to move by only 0.5-1.5% per year (at most) for the next few years, without taking absolute dollars from wire bonding (i.e. due to flip chip growing at a faster rate than wire bonding).

Further, while flip chip is currently the most widely utilized advanced method, far more sophisticated methods will likely take hold of the advanced packaging segment beginning in 2015. There is currently no market consensus that has been accepted as the go-to method of the future, with the only recurring theme among the disparate advanced methods (including flip chip) being prohibitively high costs. As a result, currently (and expected for the next few years), advanced packaging methods are typically only utilized in select use-cases requiring exceptionally high performance (e.g. high-end logic or high-end memory).

Market Leadership

The bonding industry is an oligopoly, with 3-4 players dominating the market. KLIC is the market leader, currently holding ~70% of the bonding market, though likely to be ~65% over the long-term. The other players are ASM Pacific Technology – a large Hong Kong-based semiconductor assembly equipment manufacturer, whose operations span greater than just wire bonding; Shinkawa Ltd – a smaller, more bonding-focused Japanese manufacturer, and BE Semiconductor – a Dutch-based back-end semiconductor equipment manufacturer, also with operations spanning more than just wire bonding. KLIC was one of the original bonding companies in existence and have maintained status as a market leader throughout its history.

Market Sustainability / Growth Drivers

The bonding market is driven by a variety of factors, but is typically tied to the larger, macroeconomic semiconductor cycle, which currently appears to have troughed. After a down year for 2013, industry experts (Gartner, VLSI Research) project the bonding market to follow the semiconductor market in picking back up in 2014 (+11% y/y according to VLSI) and 2015 (+6% y/y according to VLSI).

Within the semiconductor cycle, the “internet of things” trend (whereby previously discrete electronic devices are now connected, like in home automation, but also significantly prevalent in the networking industry), as well as increasing advancements in semiconductor node sizes, have served as long-term secular growth drivers of the bonding market. In general, the elusive holy grail of bonding is the ability to deliver both high throughput / speed and pinpoint precision / accuracy. As a result, semiconductor size changes require more advanced bonders to produce chips at expected levels of throughput and accuracy.

Trend to Copper

In addition to cyclical trends, another recent secular trend that has been driving the bonding industry for the past few years is the move from gold to copper. Historically, gold was the predominant conductive material used for bonding chips to the circuit board cycle (as can be seen in the figure above), due to a variety of preferred electrical properties. However, due to the prohibitively high cost of gold in recent years, coupled with technological advancements, copper has become the preferred material and has spurred a long-term secular trend toward pure copper or copper-capable bonders.

KLIC dominates the copper and copper-capable bonding market. While KLIC already maintains significant market share in the overall bonding market (~70% as discussed above), the company is estimated to hold >85% market share in copper (KLIC management refuses to put a number to it, but has constantly reiterated that it dominates the copper market, is sole-sourced at 2 of the top 5 OSATs, and once essentially laughed off an analyst’s estimate of ~70-75% market share on an earnings call).  

KLIC management estimates the bonding industry to be at ~40% copper (based on machines in use) and expects a long-term mix of 75%, putting the conversion process at ~50-55% penetrated with several more years of runway. In a recent earnings call, management estimated copper equipment sales of 6,000-9,000 machines per year for the next 3 years would put the market at the 75% copper level (which is their expectation).

A rough calculation would show that the copper opportunity for KLIC over that span would come to at least, but likely much greater than, $350M per year (assuming conservative estimates of 85% copper share, $70,000 per machine, and 6,000 sold per year). In FY13, ~78% of KLIC’s equipment revenue was from copper. Assuming a roughly 80/20 split for the next 3 years, that would put KLIC equipment revenue at $438M per year for the next 3 years at the low-end. This would be in-line with LTM equipment revenue in what was still a solidly profitable year, in a conservatively estimated scenario.

Flexible Cost Model

As a result of being beholden to 2-3 levels of cyclical capital expenditure decisions (consumer electronics-to-chip makers / IDMs-to-OSATs), the bonding industry is extremely volatile from quarter-to-quarter. Lead times are typically 8-12 weeks and order contracts are extremely flexible in favor of the customer. As a result, deferred revenue / order levels do not provide any sort of picture of future demand. Nevertheless, over its long history, KLIC has optimized its business model and cost structure for increased flexibility for navigating quarterly extremes.

The company permanently employs a core set of manufacturing personnel, with the remainder being outsourced, temporary workers. This allows KLIC to scale up quickly to meet sudden demand as well as scale down to avoid unnecessary costs. As a result, KLIC has maintained a tight gross margin range on a quarterly and annual basis. From CY10-13, gross margin in a given quarter reached as high as 48.5% and never below 43.4%. Annually, gross margin for CY10-13 was 44.9%, 46.3%, 46.3%, 46.8%. Additionally, as a rule of thumb, management guides its cost structure to ~$36-38M of fixed costs, with the rest variable at ~6-9% of revenue.

The company maintains a breakeven level at ~$350-$375M revenue per year (management has given estimates ranging from ~$85-95M for a given quarter). As a comparison, 2013 was a significant down year due to the low point of the semiconductor cycle coupled with market digestion of the high, copper-induced growth from previous years. Even so, in a significant down year, KLIC generated revenue of $500M, well above the breakeven range, with FCF of $53M – 11% of revenue.

Strong Replacement Market “Floor”

In general, management has been extremely focused on shifting into the next generation of packaging, investing significant resources into R&D to develop its advanced packaging line, currently in beta and with good customer feedback. However, management has noted several times that the wire bonding business is expected to continue as a strong “cash cow” business for the foreseeable future.

Based on back-of-the-envelope math, management has noted that there are roughly 120,000 wire bonders in existence industry-wide, of which 90,000-100,000 are current-generation. These wire bonders carry a life of ~8-12 years. Assuming the midpoint of both estimates, 95,000 machines every 10 years equates to 9,500 per year. Further, as mentioned above, wire bonding is still a growing market, just at a slower CAGR than advanced methods, due to the lower growth of larger-sized nodes.

In conversations with management, they have noted that IC unit count grows at a rate of roughly 7-13% per year, which management discounts down to 3-9% when accounting for improvements in throughput of roughly 4% per year. As a result, in addition to the replacement market of ~9,500 machines per year, the natural market growth should come in at 3-9%, or roughly 4,000-5,000 machines per year at the midpoint. This would put the overall market in the $800-900M range annually (~14,000 machines per year at $60-70K per machine), of which KLIC should maintain ~65% market share ($500-600M in revenue per year).

At this revenue run-rate, plus the likelihood of margin improvement when R&D expense comes down following full roll-out of advanced packaging, KLIC should not only beat breakeven on its replacement market sales alone, but continue to generate strong cash flow from this area of the business. This essentially provides a free call-option on the company’s endeavor into advanced packaging (estimated to be a $4B+ market by 2017-18) and provides a solid floor for the company’s business.

Strong Cash Generation

KLIC’s pricing power as a market leader, flexible cost structure, and favorable foreign tax-rate yields healthy FCF on a regular basis, though volatile from quarter to quarter. Since CY10, KLIC’s FCF has ranged from 9-26% of revenue, depending on cyclical factors. In CY13 – a down year as mentioned above – the company generated FCF of $53M (10.5% of revenue), which included a capex of $21M, a temporarily elevated level vs. the norm of ~$8M per year, due to construction of a new facility. Management expects the normalized ~$8M annual run-rate to resume for CY14. In a normal capex year, FY13 would have yielded FCF of ~$66M, good for ~13% of revenue.

Debt-Free, Cash-Rich Balance Sheet

With low annual capex and a flexible cost model, KLIC has been building its cash position for years, going from $175M in December 2009 to $557M in December 2013, an increase of $382M over 4 years, and inclusive of $142M in debt repayments. While KLIC used to hold a sizeable portion of debt (only ~$30M in net cash in December 2009), the company’s board went on a multi-year crusade to go debt-free in recent years. As a result, KLIC paid down its maturing debt (instead of refinancing) and went debt-free in the third quarter of fiscal 2012 (quarter-ending June). While the company’s interest payments were not high to begin with, KLIC is completely debt-free and is unencumbered by any obligations.

Since paying down debt, KLIC’s cash outflows beyond operating activities have been largely capex-related. With strong and steady cash generation and no real debt or debt-like obligations, the company’s cash position and balance sheet health have skyrocketed and account for vast majority of its assets ($557M in cash and investment vs. total assets of $840M (i.e. cash is 66% of assets), providing a sizeable cushion in a volatile business, as well as a war chest for future opportunities.

Valuation

While there are several possible reasons for KLIC being overlooked, its valuation is at absurdly low levels, especially considering all the factors mentioned above. KLIC’s current market cap is ~$870M. With no debt and a cash position of $552M, KLIC’s EV is ~$316M.

On an LTM basis, KLIC trades at

• EV/Sales – 0.6x
• EV/EBITDA – 3.6x
• FCF Yield (EV) – 17%
• P/E ex Cash – 5.9x
• P/Book – 1.2x

Based on my estimates for calendar 2014, KLIC currently trades at

• EV/Sales – 0.5x
• EV/EBITDA – 2.7x
• FCF Yield (EV) – 22%
• P/E ex Cash – 4.1x

Each of the listed valuation metrics represents a market perspective that views the company as a going-concern risk, which I believe is a ludicrous assessment. Further, the investment merits pointed out above show that KLIC has several attractive properties and should warrant a significantly higher valuation.

My preferred valuation approach here is using FCF yield from EV. KLIC’s core value proposition is its continued growth and potential monetization of its large cash hoard. Additionally, from a pure absolute value standpoint, when eliminating the company’s large cash holdings, the pure operations of the business on an LTM basis has returned cash at a 17% rate of return. This is an absurdly high return. At this rate, the company’s compounded cash return would double in ~4 years. Further, this rate is based on returns in a down year – based on KLIC’s December 30, 2012 EV of $417M, the same metric yielded 50% following the previous fiscal year.

I view this investment as attractive from both an absolute and relative standpoint. Based on my estimates, a 2-year holding period assuming moderately greater market recognition over that period, would yield a compounded return of ~27%, which excludes any direct benefit from the company’s cash holdings, whether via buyback, dividend, acquisitions, or organic growth investments.

On a relative basis, the company’s principal competitors provide poor comparisons for valuation. Shinkawa, in addition to being small, has seldom turned in an operationally positive quarter for the past several years and have, for the most part, been a cash-burning machine. As a result, profitability-based valuations are meaningless and offer no comparison. ASM and BE Semiconductor, on the other hand, are profitable, though ASM does far more than just wire bonding and both are far less profitable than KLIC (e.g. worse on gross margins, EBITDA, FCF).

For the purpose of creating a somewhat comparable a peer benchmark, I have provided a comp sheet with 12 semiconductor equipment manufacturers (not including KLIC) across several areas (packaging, assembly, testing, automation, etc). To optimize the comparison, I eliminated companies with negative operating profit and cash flow over the past year. The peer group yields the following average metrics:

• LTM
  • EV/Sales – 1.9x
  • EV/EBITDA – 12.7x
  • FCF Yield (EV) – 4.2%
  • P/E ex Cash – 27.5x
  • P/Book – 2.1x

• NTM
  • EV/Sales – 1.6x
  • EV/EBITDA – 7.9x
  • FCF Yield (EV) – 6.6%
  • P/E ex Cash – 13.5x

Not only do these average metrics represent valuations several times that of KLIC, but KLIC would be the either lowest or second-lowest in the peer group on each metric, both LTM and NTM. Further, KLIC has the 4^th-highest gross margins in the group (~200 bps behind the third; ~500 bps ahead of the fifth; 800 bps ahead of the average) and the 4^th-highest FCF generation in the group (~70 bps behind third; 300 bps ahead of fifth; 500 bps ahead of the average).

Based on my preferred valuation method of FCF (to EV) yield, I have assumed a conservative estimate of FCF yield appreciation from its current 17% level on an LTM basis to 15% for the length of the projection period – still much higher than the cheapest companies in the peer group on an NTM basis at 9% (Nikon, LRCX, Tokyo Seimitsu). This yields a 2 year IRR of 27% and total share appreciation of >60%. This excludes potential benefit from a dividend, buyback, or inorganic revenue.

I find it misleading to use market cap rather than EV. KLIC’s large, debt-free cash hoard represents ~66% of KLIC’s assets and therefore skews the actual size of the company’s “operational assets”. As the cash pile has been lying fallow and isn’t being utilized for any ongoing operations, I exclude it from my view of the company’s market value.

Additionally, while the company has periods of solid growth, especially through up-cycles and on innovation-based refreshes, the legacy bonding industry is fully penetrated and does not offer outsized growth and the advanced packaging opportunity is difficult to accurately quantify right now. While the company’s EV/Sales valuation is certainly attractive, it does not form the basis for my valuation thesis. Additionally, as there currently aren’t any temporary or one-time issues below the line, and taxes and capex, though small, are predictably recurring outflows, I find that EBITDA only provides a half-measure of the company’s ultimate profitability. As with sales, EV/EBITDA here is attractive in its own right, but does not form the basis for my valuation thesis. As a result, FCF is my preferred profitability and valuation metric.

Estimates

Revenue

I model the company’s revenue at 65% of the bonding market according to VLSI’s estimates for the next 3 years (which appears to be somewhat conservative and indicative of a replacement market). My projections depart from consensus (I’m about $50M higher on revenue for both calendar 2014 and 2015) due to the lack of guidance more than one quarter out, the general difficulty in projecting the volatile bonding market on a quarterly basis, and the significant historical inaccuracy of the 2 analysts included in consensus estimates. As a result, my revenue estimates for CY14-16 are $608M, $641M, and $589M, respectively.

To back-test my view on the generally inaccurate consensus, I looked at historical consensus estimates on both a quarterly and annual basis, starting with the September 30, 2010 quarter. For quarterly estimates, I looked at the accuracy of the following quarter’s estimate from the day after the previous quarter’s earnings (e.g. if KLIC reported Q2 on July 21, I looked at the Q3 estimate from July 22), versus the actual results. For FY2010, the average quarterly estimate was short by $16M, FY2011 was $8M short quarterly, FY2012 was$7M short quarterly, and FY2013 was $6M high quarterly (it was a down year).

On an annual basis, I did the same analysis, except it measured the forward year estimate after each quarter’s earnings call. In short, from FY10-12 (growth years), full-year estimates after the first 2 fiscal quarters were, on average, ~$190M short of what the full year came out to be (FY13’s estimate was way over).

I feel the more accurate methodology would be to apply the company’s market share, which is solidly stable, to the wire bonding market estimate from the industry experts, which typically carry more accuracy than consensus for individual companies several years out. Therefore, I have no qualms being above consensus in what I feel is still a conservative-sided estimate (I lowered the market share from KLIC’s current % to its long-term expected %, and I believe VLSI’s estimates are conservative in that they assume a mostly replacement-level market). Additionally, I assume anemic growth from the expendable tools segment, no inorganic revenue from an acquisition (which is likely to happen in 2014), and no revenue from the company’s advanced packaging business, which though still in beta, should be at general availability by early 2015.

GM / OpEx / EBITDA / FCF

For GM%, I model 46.5% straight through the projection period, a few bps below CY13 (46.8%). For OpEx, instead of going by line item, I use the company’s long-term quarterly guidance of $37-38M in fixed costs and 6-9% of revenues in variable costs. As a result, I model fixed costs of $152M through the projection period ($38M per quarter) and variable costs at the midpoint of the range (7.5%). I project D&A at 3% of revenue and stock-based compensation at 2% of revenue (both in-line with CY13). I assume interest income of roughly $1M per year (management guidance), taxes at the company’s 10% expected LT rate and capex at $8M per year (management guidance).

This puts adjusted EBITDA for CY14-16 at $115M (19% of rev), $130M (20% of rev), $107M (18% of rev) and FCF for CY14-16 at $75M (12% of rev), $105M (16% of rev), and $106M (18% of rev). Additionally, my estimates include projected change in working capital, which is difficult to predict and volatile on a yearly basis. Excluding change in working capital, FCF for CY14-16 would be $100M (16% of rev), $113M (18% of rev), and $92M (16% of rev). 

Why Does This Opportunity Exist?

In my opinion, KLIC is largely a victim of being generally overlooked by investors due to a variety of factors – very few of which relate to KLIC’s performance, financials, or business prospects. As will be discussed later on, pure awareness, in any form, would serve as its own meaningful catalyst for the stock. I have listed the following factors in order of magnitude, from largest to smallest.

Misunderstood Technology Threat

Most likely the key reason why KLIC is overlooked is what appears to be a gross misunderstanding of the supposed threats to wire bonding. As mentioned earlier, wire bonding is the most cost-effective and efficient method in the market and is currently used for ~80-85% of semiconductors. However, as lead counts increase and semiconductor node sizes shrink, in accordance with Moore’s law and increased performance needs for select use cases, more advanced packaging methods become required / economical.

Advanced packaging currently comprises the other 15-20%, with the most widely known and currently used advanced packaging method known as flip chip packaging. However, flip chip is unlikely to be the advanced packaging method used long-term. Currently, there are a wide array of advanced methods being developed, utilizing different approaches to attain the ultimate goal of high-end speed and high-end precision on increasingly higher pin counts for increasingly smaller chip sizes. KLIC management expects advanced packaging to start heating up materially in 2015 (likely in-concert with the release of 14nm nodes).

There are several misconceptions as to the threat that advanced packaging represents to traditional wire bonding.

• “Flip chip is the packaging method of the future” – industry sources far and wide (Gartner, VLSI, packaging companies, OSATs, etc) have largely suppressed this notion and have noted that flip chip is largely not economical vs. wire bonding, due to a variety of factors, including cost and throughput. While flip chip has advantages when it comes to greater power and processing performance and smaller physical footprint, the cost relegates its need to select applications that require those traits. E.g. smartphones and tablets, where form factor, power efficiency, and processing power are all key attributes. However, for nearly all other chip use cases, these attributes are not paramount and the cost becomes a significant headwind for widespread usage. As management related to me, “why would you put a $17 processing chip in an otherwise $5 alarm clock?”
• “Smaller nodes sizes inhibit wire bonding” – this is not exactly true. While wire bonding becomes more difficult at smaller node sizes, it is only a problem when combined with high lead count. In speaking with management, the wire bonding threshold is roughly 800 leads. Meaning, when approaching 800 leads on semiconductor nodes smaller than 28nm (e.g. 22nm and 14nm), the economics of packaging tilt towards flip chip / advanced packaging vs. wire bonding. However, this only means that those specific cases (i.e. small chips with high lead counts) would be using advanced packaging, not the vast majority of other use cases. Further, this changeover is already in effect – the 15-20% of the market utilizing flip chip are exactly these use cases already, meaning wire bonding isn’t going to lose share of what it already has lost.
• “The shift in share toward advanced packaging will shrink the wire bonding market” – this is possibly the largest misconception. The overall semiconductor chip market is growing, with different verticals growing at different rates. One of the highest growing segments of the technology market today is the smartphone and tablet market, which use high-end processing and memory chips that typically utilize flip chip or other advanced methods. Due to the varying growth rates, management estimates a mix shift toward flip chip of 0.5-1.5% per year, with the high point of that estimate considered unlikely. Regardless, were the high-end of the estimate to stay true, the market would move ~4.5% toward flip chip over the next 3 years, putting the split at 80%/20% (VLSI estimates 82%/18%).

However, more importantly, the current and expected shift in share toward advanced packaging is due to advanced packaging growing at a higher rate than wire bonding, not due to any absolute dollar shift. As a result, even if the market split was to dramatically shift toward advanced packaging, this would only be due to advanced packaging becoming as big as wire bonding, not due to wire bonding shrinking. In fact, management expects the wire bonding market to continue growing at a net CAGR (i.e. after subtracting expected packaging throughput improvements) of 3-9% long-term.

Ultimately, the misconception about technology risk is based on the false assumption that larger nodes will be discontinued and wire bonding will become obsolete. This is eminently false, with the reality being that smaller chip sizes are more expensive to produce, with no reason to be implemented where it’s not needed – to reiterate management’s parable, “why would you put a $17 processing chip in an otherwise $5 alarm clock?”. Additionally, with natural IC unit growth over time, combined with trends, such as “internet of everything”, the amount of “simple” semiconductor chips in demand should continue to increase at a small but steady rate over the long term.

Cyclical and Volatile Industry

As has been mentioned above, the semiconductor capital equipment industry is cyclical, seasonal, and highly volatile. Quarterly and annual comparisons are often difficult due to multi-quarter cycles for the semiconductor industry, combined with the inherent volatility and seasonality of a market largely driven by consumer electronics. Investors with a weak stomach for short-term / quarter-to-quarter volatility have no interest in such markets due to wild swings and unpredictability. This leaves significant opportunity for long-term focused investors, with holding periods measured in years, not quarters.

Formerly Poor Balance Sheet

While KLIC’s balance sheet is currently pristine, this was not the case until the June 2012 quarter. Prior to that point, KLIC had a poorly constructed balance sheet for a company playing in a volatile industry. As recently as FY10, KLIC maintained a net cash position of only $83M, which presented real going-concern risk. It doesn’t appear investors have noticed the total turnaround of the company’s financial position.

Under-covered by the Street

KLIC is a US listed stock in a largely Far-East market. Without being listed with its principal competitors on any of the Far-East exchanges, KLIC gets no investor love on either side of the Pacific. As far as I can tell, only 3 sell-side analysts (BofA-ML, Jefferies, DA Davidson) currently cover KLIC (at least semi-regularly), in addition to some independent research boutiques. Though the company was previously covered by a few more broker-dealers (Credit Suisse and Oppenheimer), they have either dropped coverage or just stopped reporting on the name.

Small Size + Mature

KLIC maintains an unsexy combination of being a small cap company in a fully penetrated market. Investors looking for SMID cap growth or large cap value are certainly looking elsewhere and, in general, large institutional investors may have a difficult time finding an appropriately sized position in KLIC.

Largely Operated out of the Far East

Though KLIC was founded in the US and still maintains some significant functions in Fort Washington, PA, KLIC’s recent move of most functions to Singapore has somewhat taken it off the US investor map.

Key Risks

Slowdown of Copper Transition

The copper transition could slow down significantly, hampering the overall bonding market, but KLIC even more so due to its disproportionate copper share. KLIC’s top 2 customers (2 large OSATs) are at 50% copper penetrated and have slowed their purchases of copper machines, while IDMs have been slower on the copper uptake.

Response: While IDMs have been slower on the copper uptake, management has noted that IDMs are increasingly outsourcing more of their packaging functions, which will drive copper volume regardless of who the direct KLIC customer is (i.e. OSATs will need to increase capacity to take on more copper projects formerly handled by IDMs in-house, even if they already have a strong penetration of copper-capable machines). To this end, while tier-1 OSATs have publicly announced reduced capex spending (which directly impacts KLIC), the company has worked to further diversify its customer base and has received significant demand from tier-2 OSATs, who have picked up much of the slack from the diminished tier-1 demand. Additionally, KLIC management’s long-term 75% penetration estimate is actually a recent upward adjustment from their original estimate of 70%, indicating increased optimism in the market demand (regardless of customer) for copper bonders over the next 3 years. Management’s recent estimate of 6,000-9,000 copper machines sold per year for the next 3 years is also a recent estimate, indicating strong management confidence. It should be noted, management has traditionally been extremely conservative on guidance, especially when it comes to providing any indication of things to come farther than 1 quarter out.

Smaller Semiconductor Node Sizes Reduce Wire Bonding Viability

As semiconductor node sizes get increasingly smaller, wire bonding faces the risk of not being viable in high lead-count applications, such as high-performance memory and processing, due to size constraints. This becomes an issue at sub-28nm node sizes, including 20nm coming into the market in 2014 and 14nm expected in 2015.

Response: Smaller node sizes are one of the drivers of the need for more advanced packaging methods. However, as it stands now, traditional wire bonding is not materially threatened, as sub-28nm nodes make up a small amount of the total chips in production / use, and the cost savings associated with smaller node sizes has had diminishing returns for some time. According to IBS, the cost savings by moving to 32/28nm was less than 3%, and the move to 22/20nm nodes will actually increase costs. The most compelling driver of smaller node usage is the small form factor required for certain consumer electronics applications.

Management doesn’t expect 20nm nodes to become a material piece of the market until 2015 at the earliest and even then, it won’t necessarily be serious threat to most historically wire-bonded applications. Additionally, many advanced packaging technologies incorporate some aspect of wire bonding, which offers 2 positives for KLIC – 1) continued relevance within advanced packaging solutions, regardless of the specific method 2) a leg-up on competition in the advanced packaging market due to the company’s existing expertise in wire bonding.

Most importantly, due to the costs (or lack of savings) associated with both moving toward smaller nodes, as well as the higher cost of advanced packaging solutions, most applications that don’t gain significant benefit from moving to smaller semiconductor nodes, as well as those applications that don’t require advanced packaging, should continue utilizing the cost effective wire bonding solution and should more than adequately sustain a long-term replacement market.

KLIC Stumbles in Advanced Packaging Offerings

As the copper-induced growth spurt matures and wire bonding becomes more of a replacement business, the focus has turned toward advanced packaging methods that can provide high performance at high manufacturing throughput levels, with greater size and power efficiency at an affordable cost. This is where the market is moving and the relevant players are all gearing up. However, there is no current consensus as to what will be the preferred method going forward, especially as the advanced methods currently being developed typically offer no more than 1-2 of high performance, high throughput, size efficiency, power efficiency, and affordable cost.

Like its competitors, KLIC has moved considerable resources toward developing its advanced packaging offerings, but without a clear market direction, KLIC faces the risk of developing a product that meets lower-than-desired / expected market acceptance. Such a stumble would set the company back considerably and change the dynamic of the company’s future.

Response: This is probably the most open-ended risk that the company (and the investment thesis) faces. Were advanced packaging methods to meet sooner-than-expected acceptance, and were KLIC to stumble in producing a market leading product, this scenario would set the company back materially. However, this is a difficult risk to handicap as well, as there are several unknowns about where the industry will move when looking out 5+ years. At this point in time, it doesn’t appear that a clear bonding method of the future will emerge over the next 2-3 years that would materially impact KLIC. Further, I am confident that KLIC will continue to be a major player in the bonding market due to its extensive experience, strong R&D and engineering track record, and considerable cash resources / strong balance sheet. However, this remains a considerable long-term risk. For its part, KLIC’s advanced packaging solution – a thermo-compression bonder – is in beta and has received strong customer feedback. Management expects general availability to hit in early 2015. Based on the market dynamics management imparted to me, as well as management’s more conservative target market share, advanced packaging is much more likely to be a positive than a negative.

Prolonged Trough Period for the Semiconductor Market

The semiconductor market, currently in the trough portion of its cycle, could see a prolonged period of weakness that would bring 12-24 month estimates down considerably and have KLIC operating closer to breakeven for several quarters.

Response: This is also a difficult risk to handicap, as the macroeconomics could go in several directions. However, industry experts (Gartner, VLSI) expect the industry to begin to pick back up and management of semiconductor companies have mostly intimated similar feelings in recent history. This represents more of a market risk that is difficult to predict, but seen as unlikely by those closest to the market.

Management Makes Dilutive Acquisition

Management has been somewhat vocal about proactively vetting potential acquisition targets and is likely to do something in the next 12-18 months, before advanced packaging multiples begin to materially expand. While this would represent a potentially strong use of its cash pile, an expensive, dilutive acquisition especially if late, might both hamstring profitability and ruin the pristine balance sheet.

Response: management has noted on earnings calls that there are several conservative criteria that they hold dear in their acquisition-vetting process. While they have not been specific about the criteria, they have implied that they are focused on an accretive acquisition. Further, based on the board’s focus on building a strong balance sheet in recent years, it would be perplexing to find KLIC throwing away several years of capital structure management by biting off more than it can chew in an expensive acquisition. Management has noted to me in discussions that they are wary of increasing valuations in 2015 for advanced packaging, making it clear that the company is focused on getting in early at a good price.

KLIC Sits on its Cash Pile

KLIC management may continue to sit on its cash pile, withstanding investor / analyst pressure, using the reasoning of keeping a strong cash cushion in a volatile industry, as well as keeping dry powder for a potential acquisition that may never happen. This would negate several possible catalysts that would bring greater awareness to KLIC, which is a key to realizing a greater valuation.

Response: This is certainly possible but highly unlikely in my opinion. Investor / analyst pressure has been strong and steady and cash relative to assets is approaching ridiculous levels. While management has a history of being conservative, they do not have a history of being stupid. Management is well aware of the pressure and the need to monetize its cash pile. I find this to be a possible but improbably risk.

Catalysts

Cash Monetization

KLIC is sitting on a significant cash pile and has been under pressure from investors / analysts to do something with it. There are 5 possible scenarios:

1. Acquisition – this is almost definitely going to happen and likely within the next 12 months or so. Management has noted for several quarters that they look at acquisition targets monthly and have been significantly focused on making an acquisition to help build out its advanced packaging business. Additionally, in speaking with management, it is clear that they view 2015 as the beginning of significant advanced packaging relevancy, which would materially increase advanced packaging valuations. As a result, I view it is highly likely that KLIC makes an acquisition before such time. Additionally, management has also noted that it has deeply conservative acquisition standards around price, accretion/dilution, etc, making it unlikely that KLIC makes an expensive and dilutive acquisition that depletes reserves and weighs down profitability. A solid acquisition should accomplish several things, including monetization of a stationary stock pile, greater investor recognition, and higher valuation due to the high-growth aspect of the advanced packaging market.
2. Stock Buyback – This is the more likely of a cash return to shareholders (i.e. vs. a dividend). Based on management commentary over several quarters / years, buybacks are an ongoing debate amongst the board and is always a possibility. However, management has stressed several times that it is focused on enhancing its advanced packaging portfolio through capex / R&D and very possibly an acquisition. Additionally, 80% of cash is offshore, which would result in a repatriation tax hit. Nevertheless, there is a solid possibility that if no acquisition is made in the near future, the board may give in to pressure and institute a buyback program. More likely, were the company to make an acquisition that wouldn’t drain its cash resources (e.g. in the $100-250M range), a buyback may be a serious possibility at that point
3. Dividend – unlikely to be instituted as a regular quarterly dividend, though a special dividend is certainly possible, in lieu of a buyback, if the cash isn’t used for an acquisition in the near future. Management is apprehensive to the idea of effectively creating a regular quarterly “liability” in such a volatile industry.
4. Organic Investment (capex / R&D) – this is already being done, but with management guiding capex back to its ~$8M annual run-rate and without a significant hike expected in R&D, organic investments are unlikely to make any kind of dent in the company’s cash pile. As a result, it is highly unlikely that KLIC will stick to only this scenario.
5. Nothing – less likely than a dividend. Pressure has been mounting for a while, to the point that management will often address capital allocation plans / concerns in its prepared earnings remarks to head-off questioning later. Something will be done and management seems committed to doing something positive with the cash, though they are more focused on building the business first before returning cash to shareholders.

A stock buyback, dividend (special or regular), or an acquisition each provide more than one catalyst. With KLIC being sorely overlooked and an unsexy play, any of these actions would bring greater awareness / recognition to the stock, which should boost value, in addition to the value added by the action itself. For purposes of my valuation, I have not factored in the value to be obtained by the actions themselves, but rather only from the recognition that one of these actions would bring to the stock and boost its market valuation. Both a buyback and a dividend return obvious value to shareholders, while an acquisition, which is likely to be accretive, should provide a significantly greater return than the ~$1M per year in interest income.

Semiconductor Cycle / Market Upswing

Industry experts and management from many semiconductor players indicate that 2014 should see the beginning of a recovery in the semiconductor cycle. A strong semiconductor market upswing would bring growth to both KLIC and the sector at large, attracting greater investor attention as well as possibly increased sell-side coverage.

Successful Advanced Packaging Product Rollout

A successful rollout of its next-generation advanced packaging product line could spur the next growth cycle in the bonding market, probably much greater than the early days of the copper transition. Management has estimated the advanced packaging market to be greater than $4B by 2017-18, far larger than the current wire bonding TAM of ~$0.8-1.0B. Management has a product – a thermo-compression bonder – in beta and expects to have a full-scale rollout by early 2015.

KLIC management sees 3D packaging as a strong advanced packaging approach and has invested in developing equipment for this method. In short, 3D packaging is an advanced packaging method that stacks ICs, wafers, or dies, interconnecting them vertically so that they behave as a single device. This is accomplished using technology known as through-silicon vertical interconnect access (VIA), commonly referred to as TSV. Through the use of TSV, 3D packages bundle significant functionality into a small footprint, with the ability to combine different devices in the stack, e.g. CMOS logic, DRAM, etc into the same stacked package. TSV / 3D packaging also shortens electrical paths through the device, improving performance.

Based on discussions with management, the company’s advanced packaging opportunity over the next 2-3 years is sizeable. As opposed to wire bonders, which sell at roughly $60,000-80,000, thermo-compression bonders (the equipment KLIC is developing for 3D packaging) would sell for roughly $1M. Management estimates that there are roughly 100 such machines in the market currently, accounting for roughly 0.5% of bonded IC units, which would put the market in use today at ~$100M. Management expects the TSV market to account for ~2-5% of the market, or $400M - $1B, by 2016-2018, of which KLIC expects to be able to capture roughly 30% market share. This would represent an (unmodeled) upside scenario of an additional $120-300M in revenue. Plus, according to management, the margins on thermo-compression bonders are higher than for wire bonders, thus accretive to cash flow.

While this opportunity is still a ways off, we should see some chatter on this topic over the next 12 months and it represents a strong upside / growth scenario to what is already a compelling business. While a strong rollout would obviously be a positive driver, merely the expectation of success would drive greater interest in the space from investors, and would hopefully pull in increased sell-side coverage.

Increased Analyst Coverage

As noted above, increased analyst coverage would serve to bring much-needed attention to the stock and its cheap valuation and strong position. There are several factors that would bring sell-side analysts back to the table, but whatever the specific reason is largely irrelevant. As an undercovered small cap name in a cyclical and volatile industry, greater institutional publicity would go a long way to unlock shareholder value. With several catalysts on the horizon (advanced packaging, semi cycle upswing, possible acquisition, etc), sell-side coverage would serve as an additional bump to the stock and a catalyst in its own right. As a result, even just the possibility of the above catalysts – prior to, or without, its actual occurrence – may be enough to draw sell-side attention and boost the stock.

Accelerators

The following events would serve to accelerate the thesis and would unlock significant shareholder value, but do not factor into the value proposition of the core thesis.

Activist Investor

If an activist investor were to get involved, it is likely the stock would disproportionately benefit. At the very least, a “loud” activist would bring much-needed attention to the stock. At its best, an activist scenario could bring a buyout or significant cash distribution to shareholders.

Private Equity Buyout / Go-Private Transaction

While I am not aware of any chatter to this end, with the company’s strong cash generation profile, pristine balance sheet, and cheap valuation, KLIC makes for an excellent private equity target. Additionally, were management to get tired of dealing with shareholder pressure to distribute its cash hoard, in addition to its attractiveness as a PE takeout candidate, it wouldn’t be crazy for management to take the company private.

Listing on the Far-East Exchanges

Were KLIC to get listing on a Far-East exchange, the enhanced visibility – even if not to US-based investors, could potentially drive demand for the stock and unlock solid value.