Summer Market Meltdown, and 2 Small Semiconductor Stocks With Explosive Return Potential?

Summer Market Meltdown, and 2 Small Semiconductor Stocks With Explosive Return Potential?

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Today we're going to talk about Onto Innovation, one of our small chip fab equipment companies, as well as a much anticipated stock SkyWater technology. But first, we're going to address two questions that we have repeatedly gotten on our channel, and they're two very important questions. We'll kick off the first one about coverage of small cap stocks. Many of the companies that we cover, continuing to go up and what about some small companies that are at a low stock price and have yet to go up. So Nick, what are our thoughts on this? Kasey, is this a mini rant section? Is this, is that what this is here? It sounds like it's gonna be. Okay.

I'm sorry. Hopefully this isn't a mansplain session here, so I'll try to keep this brief. So Kasey, you did a fantastic short. A one minute long explanation on how we approach small cap stocks. I think you can take the opportunity here to woman splain how we approach small cap stock investment and just insert the link to that short video that we did.

And then secondly, we did a longer update on our portfolio process, how we select investments overall. And I think we will answer the question this way. We are managing our money and we actually manage client money as well via a completely separate business from this YouTube channel. Our process here, Is a way to just share our research.

We're not trying to uncover the next Amazon or whatever, the next thousand X stock, get rich quick scheme stock. We have a process. We follow that process and we share information on stocks that we're actually researching because we think there's a viable business that can last many years, ideally decades, and that's what we invest in. If we're not covering a small cap stock that hasn't taken off in price yet, I think the question you should all ask yourselves is, a bull market appears to have started again this year, a new bull market, very different from the previous, one of the 2010s through early 2020s. And if a stock has not taken off in price yet, the question you need to ask yourself is why. What's wrong with the business? Why hasn't the stock price taken off yet? Because we're not traders.

And so we're gonna continue covering businesses with stocks that are continuing to rise because ideally that's what you want. You want to invest in a stock that doesn't just provide quick lift for a few months. You want something that's going to continue to grow for years and years. Please feel free to continue to drop us a comment about companies that you're interested in and want us to take a look at it. If we haven't taken a look at that company, we definitely will and we'll let you know what our thoughts are when we can. So thank you so much for commenting about small cap companies.

We do appreciate your engagement. Second question that has been coming up recently, Nick, is what about the possibility of China invading Taiwan? And this is really coming up because China's economy is quite a mess right now, possibly in deflation territory. So what are the risks involved with this in regards to the semiconductor market? Okay, so Kasey, I think there's really two parts to answering this question, and the first is, let's zoom out and just look at China and that's really what's affecting the market overall right now. That's why we're getting a sell off.

Our opinion is still that we are indeed in a new bull market. Again, it's a very different bull market than the one of the previous decade, which is why we started this channel with this focus on this niche of semiconductors. Pullbacks like this are normal.

They happen almost every year at least once there's going to be a 10% or thereabouts pullback in the overall market. The catalyst for this particular one is China slowing down, and I guess I would just say. What else is new? And let's not limit it to China either. Europe's economy the US economy.

There are so many reasons you could look at it and say, oh, wow, it's a mess. Now's not the time to invest. That is investing. That's why you get return on investment because there is risk involved with it. Now, as companies that participate in these various economies, Solve problems and overcome that risk, you get the reward. Okay.

This is basic investing 1 0 1. There's always risk. China's economy is the current risk, but what else is new? Last decade in the 2010s, this was something that came up. Time and, again, China's economy is slowing and the stock market sold off hard as a result, because it's China, it's such a large part of the global economy.

So this is not a new problem. But I think the question these days that we're getting is, what happens if China's economy, slows down to a point and there's some talking heads and there's some political narrative going on that, what if China's slowing economy and a very high unemployment rate, pushes China to finally invade Taiwan and execute their one China policy and reunify the island of Taiwan with the mainland? Maybe that happens, as far as it looks right now on the news, I'm not seeing any reports that there's mounting of forces along the sea there, separating China from Taiwan. We don't think there's going to be an invasion anytime soon, but again, I think the real answer here is zoom out. If you're worried about semiconductor stocks because of a China invasion of Taiwan, I think you really need to consider the fact that, if China did invade Taiwan, it's not just semiconductor stocks that are gonna get obliterated.

All stocks are going to get absolutely hammered by that kind of event. Of course, if should it happen, the first thing is loss of human life, humanitarian crisis. That would be the primary concern, just as it was with Russia's invasion of Ukraine. But from an economic standpoint, Ukraine is not Taiwan. The global supply chain, regardless of what it is, it's not just chips that would get hit hard by Taiwan.

The entire global economy is highly reliant on semiconductors. So if Taiwan's production of advanced chips and a lot of other, let's say non advanced chips were to go offline, the whole economy is coming to a screeching halt for a while. So if you're worried about investing in chip stocks because of a China invasion of Taiwan stop worrying about that. You should really be worried about investing in all stocks, in investing, period, should China invade Taiwan, this is not limited to the semiconductor industry.

Yes, Nick, that, that does make a lot of sense. We don't need to talk about this extensively. This is not a political channel. We do not comment on politics, but this is something that our viewers have definitely had questions about.

So hopefully this addresses some of that. Nick, if this theoretically did happen, what stocks would you feel comfortable in investing? It wouldn't change a whole lot from our current viewpoint though, really, Kasey, right? 'cause we're looking for businesses that are highly resilient, In a Myriad of economic situations. And so I think we're looking at, No drum roll needed here, 'cause I don't think it would come as a surprise. The semiconductor fab equipment companies, especially the FAB five A S M L, Applied Materials, Lam Research, Tokyo Electron, and K L A Corp. We're gonna talk about the small cap one here later Onto Innovation, but that's where we would continue to stay invested because should an event like that happen and let's say, Taiwan's chip manufacturing got taken out for some reason. Suddenly the world needs to rebuild that very critical piece of the supply chain.

And so those Fab Five already a relatively unknown part of the fabric of the global economy suddenly become even more important than they already are. We're talking about an unknown here who knows? But that's like my thinking on this anyways. Like you said, though, we're not political experts or commentators.

We don't want to be either. That's our take on this question that we keep getting about Taiwan. Okay, time to move on to Sky Water Technology. This company is a semiconductor foundry and it operates fabs for the manufacturer of wafers, which are the discs that get cut up into chips, and they have packaging facilities as well.

Nick, why does this company bill itself as a US pure play in the manufacturing business? This is it. It's because it is. This is not a term that they use to try to drum up hype or a term that they use that maybe is a bit dubious. It is in fact a pure play, the only US pure play, because other foundries, like including Global Foundries, are not solely based in the US. SkyWater is, as you said, they have two primary facilities, wafer fabrication, that facility is in Minnesota.

And then chip packaging that's a newer facility that is based in Florida and that's it. Those are the only two locations that they have. So maybe you can mention a little bit of the history of this company, Nick, because the ties of this company are closely related to some of the companies we used to own and own right now.

So maybe you can clarify the history of SkyWater technology. Yes. Kasey, we've talked a lot about on semiconductor and one of the reasons we repurchased on semiconductor is because of the current management team, c e o, Hassane El-Khoury, and C F o, Thad Trent. We used to be invested in a company called Cypress Semiconductor. That was the C E O, C F O team that had been brought in to fix Cypress Semiconductor a number of years ago.

And ultimately Cypress was acquired by Infineon. That's Germany's largest chip designer and manufacturer. That deal was completed in 2020 and El-Khoury and Trent moved over to On Semiconductor to execute a sort of similar revamp strategy. So Cypress Semi a company that we used to own, that's actually where SkyWater Technology came from.

So when El-Khoury and Trent were trying to right-size Cypress's operations, One of the things they did was back in 20 16, 20 17, they took their Fab four, that was in Minnesota, and they sold it to a private equity company called Oxbow Industries. It's a private equity firm that's based in Minnesota. So they sold it for $30 million to offload some of the expenses that they didn't need at Cypress, and Oxbow took this fab four in Minnesota and turned it into SkyWater Technology .Oxbow and some of its investors are still the majority shareholders of SkyWater. They're very much in control of the business.

But it's just a little interesting history because SkyWater is technically a startup, but there is a rich history there that goes back to Cypress Semiconductor. Another interesting point ,the c e o of SkyWater technology, Thomas Sonderman , he used to work at a m D in the late two thousands, and then he worked at Global Foundries when that spun off as an independent company, and now he's the c e O at SkyWater Technology. Just interesting kind of backstories on this because yes, SkyWater is a startup, but, it has some fairly deep pocketed backers which could be a positive or a negative depending on how all these things play out in the coming years. But the c e o and the management team well experienced in the Chip Foundry business. That's a good segue into my next question, Nick, about this company.

How is it different from Taiwan semi manufacturing and Global Foundries? Yeah, so Kasey, this is a US pure play on chip manufacturing, but this is a really good question because this is not an attempt to recreate two of the big players, like you mentioned, Taiwan Semi and global foundries. Taiwan Semi is a mass producer of all sorts of chips. SkyWater is not trying to mass produce, mass market chips. And then Global Foundries is a specialty fab still a large volume third party foundry.

But they have taken a more specialized approach versus tsmc, they don't try to compete with T SMCs, high-end leading edge tech, manufacturing, primarily for industrial markets, for automotive. Sky water's not trying to do that either. They have this very unique model where they want to partner with technology companies to work on novel uses of chips.

So you can almost think of SkyWater technology as not just a startup itself, but a startup that's partnering with other startups, working on brand new technologies and applications for semiconductors. they call this model technology as a service. And one thing that I found really interesting is, It sounds like they co-create or co-develop these chip designs in the lab, and then if it works, they immediately go to production. So there's no lag time between actually creating the chip and producing the chip.

it's a very efficient model. Yeah, it has the potential anyways to be an efficient model from a time perspective especially it is efficient right now, maybe financially efficient down the road. And you make an interesting point here, Kasey, because this is actually been proven out to a certain extent historically by historically, I guess what we mean is like over the last five years, SkyWater has been able to get a couple of government contracts, like with the Department of Defense, the d o d, and what they've been working on with this model out the gate is often what they call their rad hard or radiation hardened silicon. And this type of stuff has specific application and advanced radar products. You can also think of this as an application for space, the emerging space economy space full of lots of radiation, 'cause you're no longer getting shielded from some of the wonderful systems that earth provides.

And so you have to have chips that are not going to fail under those very extreme conditions. And so that's where the company got its start. Most of the revenue right now is from these, primarily government sponsored programs for novel use cases for chips. But I think it would be unfair to call this a government contractor 'cause that's really where they got their start or where maybe they jumpstarted their revenue.

But there's some new areas that they're delving into with actual businesses and companies and startups that, that want to utilize the same model that SkyWater helped get off the ground with some government funding. What are some of those areas for potential growth for SkyWater that are not part of government contracting? So we picked out a couple of items that were mentioned on the earnings call. The first one that the c e o mentioned on the earnings call was BioHealth. This one was really fascinating to me, Kasey, 'cause you did a lot of research into Quantum Si. We did a video on that, Cathie Wood stock that had a really awful second quarter 2023 earnings update.

But based on some comments that were made on the earnings call, it almost sounds like the company that Quantum Si uses for its chips and rapid diagnostics, is possibly SkyWater technology and maybe some of Quantum SI's competitors in that space. Yes, competitors like Thermo Fisher and probably all other huge biotech companies as well as many small ones that are also trying to develop very similar technology. We don't know exactly who SkyWater is partnering with on this front, but it sounds like they have a number of companies working on some sort of rapid diagnostics testing application, using semiconductors, using chips as well as some health wearable companies. It sounds like primarily if these aren't startups, it's maybe bigger companies that are experimenting with some new product or new service. The second new growth outlet, which is also very interesting, and an area that we've really just dabbled with on this channel up to this point is quantum computing.

SkyWater highlighted a couple of expanding relationships. One with the startup, PsiQuantum, p s i quantum, this is a non-publicly traded startup, but they're developing silicon photonic chips. So it sounds like SkyWater is handling the manufacturing of those wafers and chips.

And then a small startup that is publicly traded. D-Wave Quantum ticker symbol Q B T S. Both of these have been called out by SkyWater in the past as customers, tapping Sky Water's wafer fab facility in Minnesota. Perhaps later on maybe there'll be some mention of those companies using the packaging services in Florida, but it's interesting.

This is, I think, illustrates what it is Sky Water does. It's a startup servicing other startups. So it looks like SkyWater getting itself established financially.

Getting itself into a position to be a sustainable business, long-term servicing other startups. So if some of these things like biotech and quantum computing may not be a super investible part of the market right now, all on its own, but you can, as we often point out on this channel, get exposure to these things, to these future growth markets by investing in a semiconductor stock. Because chips are where you have to start in today's day and age if you're looking to build new technology. And so SkyWater might be this very interesting bet on startups. We don't need to spend a lot of time on recent earnings or financials, but here is the chart that I have prepared for all the quarters from Q 1 20 22.

This company IPO'ed in 2021 has been mostly steadily growing since that point. Nick, do you have any thoughts on the financials, on the valuation of this company? Yeah it's highly subjective to try to stick a valuation on it because they lose money and they're not going to start turning a profit anytime soon. At least, on a GAAP basis. On an adjusted basis they're making progress. Maybe they flip to GAAP profitability, maybe free cash flow positive later this year or next year.

But I think that the short story is here. This is a startup. It's still losing money. They're gross margin on product sold is very thin, mid 20% range. They have a long ways to go until they reach that 40, 50% gross margin range, which is healthy for an established foundry business. And I mentioned earlier having a backer like Oxbow Industries can be a positive.

This is where it could be a positive right now. SkyWater only has $16 million in cash and investments on balance and 91 million in debt. So they have the ability, they have this program where they can sell new shares to the market to raise cash as needed. That dilutes, especially the big shareholder oxbow, probably a semi acceptable situation for them if SkyWater continues to grow. But just bear in mind, like if this narrative suddenly changes, you have a very large majority shareholder over 40% ownership of Sky Water's total shares outstanding. As of right now, as of this recording in mid August, 2023.

If they decide that they want out, you suddenly have a lot of selling pressure on this small cap stock. It's a positive having a big backer like that, but it also is a potential negative if the growth story suddenly deteriorates and Oxbow decides we're done. So with all that being said, is this stock a buy? Kasey, when we have mentioned it in the past, including a couple of months ago it was on our watch list after this Q two update, we think the stock has been largely de-risked. We think the market is fully pricing in the myriad of risks facing this very small company.

And I think the only valuation metric that makes any sort of sense right now, and it is highly subjective, but price to sales usually a chip manufacturing company will trade for three, four, maybe five times sales if it's well established, growing a little bit but highly profitable. SkyWater currently trades for about 1.1, 1.2 times trailing 12 month sales. If the company continues to grow and makes more progress on profitability, this is probably a very cheap stock price, but it is contingent on that. And remember, this is a startup, so if we are going to buy right now, it's going to be a very small nibble.

Again, Kasey, like at the outset of this video reference our video on small cap stocks, and we think it's important that investors if you're going to dabble with small cap stocks, you need to own a couple dozen, a few dozen of these things because most of them are not going to pan out at all. You're going to lose money on them. Small cap stock does not equal big gains. It might, but more often than not, what it actually means is you're probably going to underperform the market at best over the long term. So if you wanna buy SkyWater technology, it should be part of a well-rounded basket of small cap bets.

Onto Innovation is a small to mid-cap chip manufacturing equipment company that is, highly profitable. In fact, it is number three in semiconductor process control, right under K L a corp and applied materials. What type of equipment differentiates Onto Innovation from those two companies? And why is this company of interest to us? You mean besides the fact that we own a little bit of it? That's why it's a primary interest to us.

But really, Kasey you explained I think very succinctly why it is a small business playing in a large market and doing so successfully and profitably. What differentiates Onto is it's product, again, a product of merger, two smaller companies merged together in 2019 to create this new business called Onto Innovation. And the way they attacked the metrology and process diagnostic control. Basically measuring the fine features on wafers and chips and then also helping control and measure the manufacturing process itself. Making sure it's working the way it's supposed to is they went after the high end processes. So those involving.

Extreme ultraviolet lithography. The machines A S M L provides deep ultraviolet lithography, so maybe what we would call the previous generation of most advanced chip making machines. That's where they have made their name for themselves, is going after that very specific high-end market and their machines do a very good job.

As evidenced by the fact that customers keep buying metrology equipment from them, they do a good job at that. What customers are buying Onto Innovations equipment? So the biggest customer is none other than Taiwan Semiconductor Manufacturing onto reveals this in their annual reports. It looks like Samsung. SK Hynix, South Korea's two giants in memory chip making are frequently big customers, so onto not exempt from the downturn in the semiconductor industry this year because of those big customers. It sounds like based on the last earnings call, T S M C, Taiwan semi still buying equipment.

And then the memory makers, not so much, a lot of pain going on there, but there is a bit of a pivot going on that's interesting. I'll show you a table with revenue growth, 20 23 so far and 2022. This company has been steadily growing until this year where it had some decline, and in fact in the last quarter, they missed their guidance. revenue for the quarter ended up at 191 million, which was below the $203 million guidance given by management last quarter. So what happened and why do we still have hope for this company? It was a pretty simple answer and a very acceptable one.

So there were just a couple pieces of equipment that the customer, it sounds like probably T S M C, Told Onto to , hold onto those pieces of equipment, and upgrade them. And so the delivery and sale got shifted from Q two into Q three. Pretty simple, right? It would've been revenue that was recognized, and they would've met or exceeded guidance in Q two, but instead, those sales are getting pushed into Q three. Okay, that seems like a perfectly reasonable issue and will be solved next quarter. So let's go back to that growth potential that you see for Onto Innovation.

The plan is to double their revenue in the next five years. So what do you see as one of the main growth drivers for that? Obviously the continuous expansion of the most advanced chip makers those using ASML's equipment, extreme ultraviolet and deep ultraviolet lithography. Though that's in a slump right now, right at the moment. Lots of growth there.

Advanced packaging though is emerging as a, high priority, not just for these most advanced node manufacturers of the actual wafers with the smallest transistors, the smallest features on the wafers and chips themselves. But advanced packaging getting to be highly important for advanced manufacturing nodes as well. So when we say advanced packaging, we're talking about things like 2.5 dimensional architecture, three dimensional architecture where you have chiplets getting co packaged together in new novel ways. Or maybe chips getting stacked on top of each other.

And then through silicon vias, TSVs, where you like, have these holes that go through those layers filled with copper. Onto, has a suite of equipment that can help measure that advanced packaging. So it's not just the transistor size that's advanced, but also now the packaging. And so you have a whole wave of new applications coming online and will continue to come online over the next five to 10 years that needs this stuff.

I think the poster child for this is electric vehicles. And along with electric vehicles, advanced driver assist systems eventually fully autonomous vehicles, they need advanced chip packaging. And so lots of new novel uses for Onto Innovations metrology and process diagnostic and control equipment. Their plan of doubling their revenue to $2 billion in the next five years is a lofty goal. What is the valuation right now, and is the stock a fair price at around $110 per share? This is the big question Kasey, 'cause goals in of themselves do not make a stock a buy. It's about the management team's ability to execute on the plan to reach those goals.

So 2 billion in sales is more than double where we're at right now. It's double the high point that on reached in 2022, they hit 1 billion even in sales in 2022. Currently the stock trades for 31 times, trailing 12 month earnings. Like you mentioned highly profitable even in a downturn, but it's not a cheap stock, and they're not back in growth mode yet. Their outlook for Q three and Q four seems to imply that they're going to begin growing again on a sequential basis, quarter to quarter basis. Maybe they hit the quarterly revenue highs that they had last year in 2022.

Maybe they're hitting those again by the first half of 2024. That's a probable outcome that we have worked into our assumptions here with our portfolio, but it's not a cheap stock, so we have it in our portfolio. We're not necessarily buying it right now. We're comfortable with the position it harbors in our portfolio. It's not a big position at all.

It's less than 1% of our portfolio, but we do think it is fairly valued if they can execute on that plan. It's going to be a tall order though, kasey, as you mentioned the big competitors, KLA Corp the biggest, they're almost synonymous in metrology and process diagnostic control. Applied materials plays in the space. Actually A S M L does too.

They provide some metrology services along with their equipment. We've done some other coverage of small companies in the space, even smaller than Onto you have Nova, you have CamTek. There's a small company called Cohu that we see occasionally making headlines out there as having big growth opportunity. But it's interesting that Onto is the one that has really given pretty specific guidance for the next five years. We think a lot of that has to do with the company's foresight into its customer orders coming down the pike, we have dozens of new fabs under construction, right now, even more fabs getting retrofitted with new equipment to accommodate this upcoming tidal wave of new chip demand in the next five years. Again, from things like electric vehicles and advanced driver assist systems.

So we think this is a lofty goal. It's going to be a challenge for the company to get there, but if they can pull it off, what it probably means is not just potential doubling in revenue growth, but also higher profit margins and above average earnings per share growth, not just for the market, but really for the whole chip industry overall. We think this could be emphasis on, could be a big semiconductor market out performer in the next five years. Speaking of small cap stocks, we have an upcoming video about indie and some other companies that have some potentially large risks that are getting glossed over. So we'll have that video to you next week.

In addition to that we're going to talk about an AI stock that no one talks about being an AI stock that could be a super hot deal right now. We will talk about that and we'll reveal what it is. And also, we know that the market correction right now driven by China's economy is on everyone's mind.

But we're also going to talk about some cloud infrastructure developments and why we think the cloud market is about to lead the market on its next run higher at some point, and what our stock picks are in that market. Our goal is to reach 10,000 subscribers by the end of this year. Please help us out by hitting the subscribe button and sharing our channel with fellow investors. And if you feel like it, please leave us a tip on our Ko-Fi account. Link is into the description.

We're still drinking plenty of coffee and sometimes craft beer, so please hit us up in the comments with any questions you may have and we appreciate you very much for watching our channel. Thanks again from Chip Stock Investor.

2023-08-25 07:04

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