The word inflection has many meanings all of which relate, one way or another, to change, such as in a tone of voice. We’re interested today in change in type of semiconductor (chip) that’s needed for emerging generations of electronic products. We can leave the jargon (e.g. 3D NAND) to the engineers. We’re interested in the role $LRCX, a semiconductor equipment maker, plays in the chip inflection.

Why I’m Interested in $LRCX

I wasn’t attracted by any news, nor do I have a special thing for chips, or any particular business theme. I can take or leave any of them. My interest is stirred by the appearance of a stock in a model I use and have reason to trust.

Lam Research (LRCX) is the longest-tenured position in my Smart Alpha Cherrypicking the Blue Chips model, which can be seen with a free membership on Portfolio123 in the platform’s Ready-to-Go section. I’ve been holding for 135 days, compared to 113 days for the second-longest held position and an average of 26 days for the remaining eight holdings. That says something, considering that the model refreshes weekly. (By saying this I probably unleashed a jinx that will result in me selling next week! But even if that happens, the stock is worth noting as an example of the kind selected by this so-far successful rues-driven strategy.)

Why the Model Cherrypicked LRCX

It’s big: First, and most obvious, it’s an S&P 500 constituent. That’s not necessarily always a great thing. For many, the only positive investment characteristic associated with this stature is liquidity. Large investors own it because, well, because. It’s often just that simple. When you have to commit billions in the equity market, it’s not as if you can park meaningful sums in hot small-caps. But today, there’s more. Rightly or wrongly, many perceive mega-cap stocks as better choices when the market shifts to a risk-off stance.

Its value – sort of: It was a pretty good value play when I got in on 4/13/15. Now, it’s just so-so (I’m OK with that. What value investor wants to buy a value play and then sell when it’s still a value play? Overpriced is what we crave for stocks we’re holding.) LRCX is heading in the right direction, but it’s got a ways to go. Based on metrics that use trailing 12 months data, the stock is above industry medians so we have to talk more about growth to justify valuation (which is do-able, as will be discussed below.) Price/Sales, Price/Free Cash Flow and Price/Book stand at 2.44, 27.25 and 2.52 versus medians of 2.06, 22.26 and 2.22. The good part is PE based on estimated future results: LRCX sells at 11.93 times the estimate of current-year EPS and 10.69 times next year’s estimate (versus medians of 16.91 and 14.08).

Generally good fundamentals: Return on Capital, however you want to define it (Assets, Debt plus Equity, or just Equity) is well above par. Since LRCX is more leveraged than the peer median (it made some significant acquisitions, but the debt is not nearly big enough to cause us to break a sweat nor is it stopping management from retuning capital to shareholders through dividends and share buybacks), I’ll cite Return on Assets (ROA), the ratio that completely eliminates LRCX’s ability to benefit from the way leverage can boost these numbers. The company’s trailing-12-month and five-year average ROAs are 7.55% and 8.45%, versus industry medians of 2.72% and 3.41%. It would be fair, however big the LRCX excesses are, to point fingers at the fact that LRCX’s most recent number is less than the long-term figure while we see the opposite for the industry. But I’m OK with that if there’s an acceptable explanation, and there is, and it relates to the acquisitions. One aspect of this is a non-recurring goodwill write-down that depressed the most recent trailing-12-month net income figure that, in turn, suppressed ROA in the period. More important is the nature of acquisitions. Even the most successful deals can temporarily dampen returns as the capital base jumps all the way up on day one while incremental income tends to materialize over time. Ultimately, it’s the business case for the acquisitions that matters most and that’s an essential element of the big picture, to be discussed below after I touch one more important model-specific base, sentiment.

Sentiment: This is vital. Not only must the stock score well here to be bought, this is actually the only Sell criterion the model uses. In other words, I buy only good fundamental values, but I’ll hold even if it turns into so overpriced dog – so long as the Street doesn’t see it that way and continues to love it. (I do, after all, want to make money, not necessarily preach investment goodness and virtue.) I sell if the Sentiment rank dips below 70 on a 0-100 scale. $LRCX was ranked 91.2 when I bought it, and now, it’s actually higher, at 96.0, based on strong estimate revisions relative to other S&P 500 constituents. And the reason for the revisions brings us, ultimately, the main story here.

The Big Picture

It all starts with semiconductors (chips). This is a once-exotic business that in many ways has by now become somewhat commoditized as devices depending on them have become ubiquitous and as the world has become so good at making them to spec and cheaply. So the industry tends to be breathtakingly cyclical as the chip market rises and falls based on the ebb and flow of demand for products that use them, and periodic introductions of products that require producers to step up and make better chips than have been in use before. LRCX doesn’t make chips, but as a leading producer of equipment used by those who do make them, the industry’s overall fortunes are very relevant.

To play the chip stocks, consider two things: (1) where we are heading in the cycle, and (2) the extent to which an individual company has to potential to outperform the cycle. LRCX is a “go” in both of the above.

Surely you’ve noticed how devices do more and more fancy things in smaller and smaller footprints. This pushes chip-makers harder and harder. As with all segments of this market, there’s a lot more need for precision etch. This is the process of removing surface-material from a chip that starts out smooth (it’s like what you might have learned to do in art school, only there, a lot more aesthetically and a lot less functionally). Etch equipment is LRCX’s traditional stock in trade. It’s a big gorilla in terms of equipment that does this.

Lately, though, LRCX has been expanding its capabilities. This is where the acquisitions come in. These aren’t “deworsification” wastes of capital about which Peter Lynch once warned. The idea is for LRCX to do more aspects of the task its already doing well. For example, the company is now big in deposition, which is the stacking of tiny thin chips – an important reason why smaller and smaller devices can do more and more.

So LRCX is doing more things in the most promising sub-segment of the chip business; i.e. it’s benefitting from and outperforming the ongoing “inflection.” And to top it all off, the company has been becoming more proficient in operational outsourcing, which lets it do more with what capital it has (hence the strong ROAs) and reduces fixed costs and hence risk, an attractive characteristic for when inevitable down cycles occur.

Essentially, these are the issues that have been causing the company to report good numbers, management to raise guidance, and analysts to raise estimates, and the model to stay in the stock.

Conclusion

Aside from meeting the specific criteria of the Cherrypicking-the-Blue-Chips model, the investment case for LRCX stands on the prospect for continuation of the current inflection and the company’s ability to continue of preferably expand its role in the inflection.

The primary risk at this time is, obviously, market risk, relating both to global worries and the potential for eventual rising interest rates. And to some extent, the market risk is likely relevant to the primary source of company risk, the possibility that the inflection may be interrupted by economic factors, particularly in China, that diminish demand for devices that require inflection-related chips. Even so, LRCX still seems to fare well inrelative terms. If this scenario should materialize, there are likely to be many other stocks that suffer as least as much if not worse than LRCX.