Photronics: Underappreciated Tailwinds Creating An Opportunity (NASDAQ:PLAB)

Photo of photomasks for photolithography process an orange boxes

Anatoly Morozov/iStock via Getty Images

Investment Thesis

Demand for Photronics, Inc. (NASDAQ:PLAB) products have several tailwinds which are likely to continue to drive growth and profitability for the next few years. This has translated into improved pricing power and strong free cash flows for the past couple of years and left the company with a strong balance sheet and the ability to invest in new capacity to bolster further growth.

The semiconductor industry will likely see some near-term oversupply. However, due to the factors outlined below, Photronics should continue to be more highly profitable than expected.

Photronics’ Business

Technology can be daunting, but the basics of Photronics’ business can be understood by using some simplified analogies. PLAB manufactures photomasks used in lithography systems to transfer complex circuitry designs onto wafers by Integrated Circuit (IC) chip fabricators and onto substrate panels by Flat Panel Display (FPD) manufacturers. Lithography involves projecting light through a blueprint of the circuitry design onto a wafer or substrate. This blueprint is contained in the patterns etched into the photomasks.

Think of an old-school overhead projector. An empty projector would just throw white light on the wall. Then you put a “transparency” with a picture on the projector bed. White light might still come through portions of the transparency while other areas may completely block the light, so that no light gets through it. Other areas can be of different levels of color, opaqueness or translucency. The result is a picture projected on the screen.

Overhead projector image

CC BY_SA Oliver Toman http://l3t.eu / Author added text

Modern transistors and circuits are, of course, much smaller, more detailed and intricate. Although still commonly called “a photomask”, in fact modern chips have numerous layers, each requiring at least one mask, so it would be more accurate to refer to it as a “photomask set”, which for a 16nm node process might require up to 75 different masks. And as the “light” has gone down the spectrum from visible blue wavelengths to extreme ultraviolet (EUV), mask technologies have had to keep up with the ability to shrink these patterns as well. EUV masks are a whole new technology with multiple layers that reflect the lithography beam rather than transmit light as in optical systems.

The point is that the use of photomasks gives the very expensive lithography machines the ability to manufacture various different chips and displays by utilizing different mask sets. Like the transparencies, mask sets can be reused for as long as they can be cleaned, maintained, and have any defects repaired.

For this reason, it is the creation of new custom designs by Photronics’ customers which drives the demand for new photomasks, not the volume of ICs and FPDs that those customers produce using the masks.

The photomask industry includes captive mask making operations, including Taiwan Semiconductor Manufacturing Company (TSM), or “TSMC”, Samsung, and Intel, which make photomasks for their own fabricating requirements. Photronics, Dai Nippon Printing Co., Ltd (which has joint ventures with Photronics in Taiwan and China), and Toppan, are considered “merchant” suppliers producing mask sets for fabless chip designers and foundries such as United Microelectronics Corporation (UMC) who do not produce their own masks.

The Chip Market

The IC and FPD end markets have historically been very cyclical, even as there is also secular growth driven by more chips used in just about every product made and as display technologies allow for bigger and better screens. As an example, automobiles used to be purely mechanical. The first computer was put in a car by Volkswagen in 1968 to control the electronic fuel injection system. Modern gas vehicles have over 1,000 semiconductor chips for controlling everything from emissions to infotainment. EVs have over 3,000 chips in them – and that’s before self-driving.

Only a small number of firms have the capital to produce the most advanced semiconductors with reduced feature sizes, as the fabrication of each new generation of semiconductors requires more costly equipment and complex processes. For example, TSMC is investing $100 billion over three years to increase capacity, including $12 billion on a fabrication plant in Arizona which will be the first in the US capable of producing 5nm chips.

Surprise Demand On The Trailing Edge

The COVID-19 pandemic massively disrupted the semiconductor market. The auto industry, which likes to operate with lean just-in-time inventory, went from 10% of total IC demand to less than half of that. While the IC supply chain was also rocked by shutdowns, demand for chips used by work from home technologies, medical equipment, virtual learning, gaming systems and other uses skyrocketed. According to the Semiconductor Industry Association, 2021 unit volume reached a record 1.15 trillion with most fabs running at very high utilization rates.

The surprise for the industry, which sees Moore’s Law and “smaller, faster, cheaper” as the overall driving force, was that demand actually was incredibly strong at more mature, older nodes of 28nm and higher. Just because bleeding edge EUV technology is pushing the envelope doesn’t mean that every application needs to go to sub 7nm nodes.

Peter Wennink, the CEO of equipment manufacturer ASML Holding (ASML), made the following comments on the 3Q’22 Earnings Call:

I think you may remember that in our 2016 Capital Markets Day, and even I think in 2018, we anticipated that our deep UV shipments will go down as a result of the cannibalization of EUV. Actually, the opposite happened. It didn’t go down. It grew significantly across our entire customer base…Its consumer, it’s industrial, it’s automotive, it’s energy transition just the sheer application space has grown so much…nobody connected all the dots. There is not one firm on the planet that actually has the full insight into where all these chips are going and where they are being designed into.

But what I do know is that, the number of mask sets that are being run in Logic from let’s say 20-nanometer upward to 28, 45, 65, 90, 0.13 micron the number of mask sets over the last 12 years has been relatively stable running through our tools, except for the last two years. We see a significant increase in the number of mask sets up to 30% to 40% being used in that technology category…

And if you ask me exactly where it goes, I have to also say, I’m not – we don’t have that full clarity. But what we do know is that, the number of designs in the deep UV space above 20-nanometer is significantly increasing…So I think that this is where, blame on us, blame us the industry that we don’t have that visibility but we don’t. But what we do know, there is a shortage and a significant increase in the number of designs.

So with the benefit of hindsight, we know that there was industrywide underestimation of the demand for more mature technology nodes along the supply chain, including mask makers and equipment suppliers. Meanwhile, capital spending was largely concentrated on gearing up for EUV. The result was that by the time demand recovered in 2021, there were years of underinvestment in mainstream mask capacity and related tools.

As Photronics CEO Frank Lee stated in the 3Q22 earnings call:

At this moment, the mainstream product, we don’t see any slowdown in customer tape-out activities. However, we do see a little bit of push-out in the high-end mass tape-out, not necessarily in all customers, but we do see some slowdown in customer tape-out.

This is reflected in PLAB’s recent results which show that they actually had the highest revenue growth in the mainstream market:

Photronics 3Q22 IC Revenue Breakdown

Photronics 3Q22 Earnings Presentation

The shortage of mature node photomasks is likely to persist for at least a few years. This is because many of the manufacturers of the equipment to produce those mask tools have stopped supporting them, despite the fact that mature mask nodes account for about 88% of all mask demand. Exacerbating this shortage is that historically these masks have lower average selling prices than high-end masks, making it difficult to reinvest in new tooling. However, PLAB management stated that better pricing is what is now helping them record record sales and margins:

Photronics 3Q22 Earnings Presentation Income Summary

Photronics 3Q22 Earnings Presentation

Note that this recent trend is in stark contrast to the more cautious tone found in the company’s SEC filing:

The photomask industry is highly competitive, and most of our customers utilize multiple photomask suppliers…We expect to face continued competition which, in the past, has led to pressure to reduce prices. We believe the pressure to reduce prices, together with the significant investment required in capital equipment to manufacture high-end photomasks, has contributed to the decrease in the number of independent manufacturers, and we expect such pressure to continue in the future.

Foundries are increasingly signing long-term agreements (“LTAs”) with customers and it’s starting to influence the mask market as well. Chip designers don’t want to invest in increasingly expensive manufacturing equipment, especially if they can’t keep them fully utilized with their own requirements, yet they also want to ensure that the capacity is available when they do need it. With the shortage of masks, this is also benefitting PLAB as CFO John Jordan noted in the 3Q22 earnings call:

We used to approach customers to try to put long-term purchase agreements in place and that helped us support our revenue predictions for our investments in China. Over time since then, it’s now more symbiotic and the customers are coming to us for long-term agreements as much as we’re going to them because they want to ensure their capacity going forward to get the masks that they need. So as a result, the number of long-term purchase agreements we have in place continues to increase.

Bespoke Silicon

Another factor driving the demand for new photomask sets is that the demand for custom chips is increasing. There are differences in opinion over whether or not this is just a resurgence of the past interest in Application Specific Integrated Circuits (ASICs) over commercial off the shelf (COTS) commodity chips or something more holistic in marrying hardware and software architectures. However, the decrease in the cost of custom ICs and growing uses in many specialty fields has undoubtedly led to increasing use of custom chips. As noted above, this increase in design activity is what drives the demand for new mask sets, not just the overall volume of IC production.

Global Supply Chain Rebalancing

Supply chain shortages and rising geopolitical concerns are forcing governments around the world to strengthen or initiate programs to support domestic and regional semiconductor manufacturing. These incentives are considered necessary since the high cost of investing in manufacturing and R&D is difficult for many players to recoup. In the US, this led to passage of the CHIPS and Science Act which provides $52 billion to support new manufacturing capacity and research and training initiatives. While the US remains a leader in design and technology, the actual manufacturing, materials and packaging in the US has fallen dramatically:

SEMICONDUCTOR INDUSTRY VALUE ADDED BY ACTIVITY AND REGION 2021

Semiconductor Industry Association

Meanwhile, China is investing $150 billion in semiconductors from 2014 to 2030 in an attempt to close the technology gap with the West even while the US is imposing new export bans on advanced technology and equipment. Europe, South Korea, Japan, Taiwan, Thailand, Vietnam, India, Mexico, and Canada all have incentive programs to support the industry as well.

As with any industry, growing government spending and support means that there will inevitably be more investment and production than what market forces alone would achieve. Whether this aggravates the boom-and-bust cycles of this already choppy industry remains to be seen. Having said that, more fabs will mean the need for photomasks, regardless of whether the fab utilization rates are 75% or 100%.

Undervalued Opportunity

Photronics is currently trading in the middle of its 52-week range. Its P/E ratio, however, is near a three year low:

Chart
Data by YCharts

Although Seeking Alpha’s Factor Grades give it an “A” for valuation, the overall Quant Rating is a “Hold” due to negative earnings and sales revisions for 2023. I believe that these revisions are based on the historical cyclicality of the semiconductor industry, which in the past has had an effect on PLAB’s results as well. However, as discussed above, I believe that the photomask industry will ride out the currently developing weakness.

Seeking Alpha Factor Grades for PLAB 11_18_2022

Seeking Alpha

PLAB Valuation as of 11_18_2022

Seeking Alpha

Photronics 3Q22 Updated Target Model

Photronics 3Q22 Earnings Presentation

The current valuation of $1.04 billion (net of book value of joint venture minority interests) is barely four times projected free cash flow in a couple of years. While a lot can happen in two years, even if there are bumps along the way, the long-term outlook for semiconductors and the photomasks needed to make them is still very likely to be realized.

Risks

Photronics is not a diversified company. They operate in one industry, making photomasks for two types of lithography markets – integrated circuits and flat panel displays. Furthermore, as disclosed in the company’s October 31, 2021, 10-K:

Revenue from United Microelectronics Corp. Co., Ltd. accounted for approximately 17%, 16% and 15% of our total revenues in 2021, 2020 and 2019, respectively, and revenue from Samsung Electronics Co., Ltd. accounted for approximately 12%, 14% and 16% of our total revenues in those respective years. Our five largest customers, in the aggregate, accounted for approximately 43%, 45% and 46% of our revenue in 2021, 2020 and 2019, respectively.

This is significant customer concentration. Also, Samsung Foundry also makes masks and appears to be a declining customer for PLAB. If the photomask market does become more balanced, this decline could accelerate.

PLAB is not a large company. Even with the growth and profitability that the company has recently enjoyed, it remains smaller and with fewer resources than some competitors, customers, and suppliers. This means that the pricing power that they are currently enjoying could come under pressure again in the future.

It also means that they might not be able to invest as much in new technologies as other companies, especially captive mask shops owned by the likes of Intel, TSMC and Samsung. Another disclosure from the company’s 10-K states:

Previously, there was a trend towards the divesture or closing of captive photomask operations by semiconductor manufacturers, and an increase in the share of the market served by independent merchant manufacturers. This trend was driven by the increased complexity and cost of capital equipment used in manufacturing photomasks and the lack of economy of scale for many semiconductor and FPD manufacturers to effectively utilize the equipment. However, more recently, to reach certain roadmap milestones, some captive mask facilities have been investing at faster rates than independent manufacturers, particularly in the foundry logic and memory spaces.

TSMC produced 26 percent of the world semiconductor output value in 2021, excluding memory. TSMC also claims to be the world’s largest mask making company, and also has partnerships with PLAB’s competitor / JV partner DNP as well as with Toppan. To put things in perspective, TSMC’s 2022 CapEx budget is $36 billion, of which “about 10% will be spent on advanced packaging and mask making“. By comparison, PLAB’s 2022 CapEx budget is $100 million.

China has accounted for most recent growth. As of 3Q22, China revenues accounted for 27.5% of the company’s total. Through the first nine months of 2022, China revenues more than doubled to $160.2 million. Although DNP owns half of this business through two joint ventures, it still represents a significant part of PLAB’s growth strategy. The risks to increasing geopolitical tensions between China and the US could lead to restrictions on the company’s businesses there.

The company has short visibility over near-term revenues. Customers order mask sets with turnaround times of 24 hours to 2-3 weeks. As a result, the company has no significant backlog at any point in time. On the other hand, lead times for the manufacturing equipment PLAB buys can be 12 months. This creates significant risk in accurately planning for capacity utilization. As a capital-intensive business with high fixed costs, this can lead to large swings in profitability.

Technological changes are largely beyond the company’s control. The company spends close to $20 million annually on R&D expenses in addition to the substantial capital expenditures required. However, the company does not rely on any material patents of its own and believes that its sales are dependent on customer service, proximity to markets, product quality, etc. and that many customers use multiple mask suppliers.

Conclusion

This article lays out the reasons that Photronics business may be largely shielded from the temporary downturn that the broader semiconductor industry is gearing up for over the next 2-3 quarters. However, the valuation of the company seems to discount the possibility that this time might indeed be different. Even if there are minor short-term headwinds for the company, they should be shorter and shallower than the overall industry is facing.

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