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Nearly four months into this project, we’ve remained relatively consistent in our concern about the direction of the equity market. Of late, with that concern growing, we’ve focused more on defensive and countercyclical longs — and of course short ideas.

For the latter group, we’ve been comfortable with targeting stocks that already are down big. That strategy worked out well for our first short idea, Carvana (CVNA), which had declined 78% from its 52-week high and 64% year-to-date at the time of publication in April. CVNA has dropped another 75% since.

Two of our other shorts, boating stocks and, last month, Tesla (TSLA), haven’t been quite as successful; both calls have posted negative alpha of ~200 bps or so since publication. (We remain confident in both, however; I am short Tesla and OneWater Marine (ONEW) in personal accounts.)

In our call on Carvana, we explained at length the idea that being “late” to a short isn’t a bad thing, with financial history proving that point. In this bearish thesis, on semiconductor equipment manufacturer Kulicke & Soffa (KLIC), we’re returning to a similar theme.

KLIC stock has declined already, declining 40% from December highs and 25% year-to-date. And like the boating space, the stock looks exceptionally cheap: KLIC trades at 5.6x trailing twelve-month earnings per share. Earlier this month, the stock touched a 17-month low.

But there’s still an attractive short here when taking the longer view in terms of valuation. Meanwhile, K&S could be one of the biggest victims of what looks like a coming cyclical shift in the chip space. And, notably, since hitting that closing low on July 1, KLIC has gained 16% in nine trading sessions.

That reversal looks more like a “dead cat bounce” than a true sign of the bottom. And it’s a reversal that provides an opportunity to jump on what already has been a successful short trade.

Kulicke & Soffa At A Glance

Kulicke & Soffa is a so-called ‘semicap,’ a company that manufactures equipment that in turn manufactures semiconductors. K&S’ legacy specialty is in wire, wedge, and ball bonders, used in chip assembly to attach integrated circuits (ICs) to packaging. (In conjunction with Bell Labs, K&S actually helped invent the wire bonder.) The company has dominated that space, with market share in the 60-70% range (depending on the source), though the market itself is smaller than $1 billion (based on KLIC’s own commentary).

More recently, K&S has looked to expand. It’s launched more advanced bonders that can create so-called 2.5D and 3D ICs, in which dies are placed side-by-side (2.5D) or stacked (3D). The company’s Katalyst underpins a move into advanced packaging through either “flip chip” or fan-out wafer level packaging (FOWLP). In FY19, K&S launched PIXALUX, which moved the company into miniLED chips as well.

The Case for KLIC Stock

That expanded product line is part of the bull case for KLIC stock at the moment — and indeed, for the past few years. Yes, KLIC stock is cheap, but it’s pretty much always been cheap. It’s always been cheap because a) semicaps are notoriously and intensely cyclical; b) even by that standards, KLIC stood out; and c) net of cyclical effects, wire bonding was a lower-growth end market relative to other semicap end markets.

In the pre-pandemic era, the industry’s cyclicality led the likes of Applied Materials (AMAT) and Lam Research (LRCX) to pretty much always trade at a discount to the market. But K&S’ own issues led KLIC stock to see often extreme discounts: in September 2015, for instance, shares net of cash traded for less than 3x TTM earnings.

The moves into advanced packaging and miniLEDs ostensibly provide K&S exposure to faster-growing end markets. Even for legacy bonders, technology trends should significantly boost demand for low-cost ICs — the particular chip made by most of Kulicke & Soffa’s end customers. Over 90% of revenue now comes from Asia; the sole 10% customer in FY21 was ASE Technology Holdings (ASX), a Taiwanese chip assembler.

Go back to early 2018, and Credit Suisse was arguing that the perception of semicaps as “highly cyclical with no growth” was all wrong. Bulls would apply that same argument to KLIC at the moment. K&S itself made that argument at last year’s Investor Day: the company projected its FY24 “baseline” at $1.5 billion in revenue and ~$6 in adjusted EPS, both not far below current levels (which have followed a three-year period of sharp growth).

And yet, at least at the moment, KLIC seems to be receiving precisely the valuation applied to a company that is highly cyclical with no growth. Again, shares trade at 5.6x TTM adjusted earnings. But even that understates the case. Kulicke & Soffa closed fiscal Q2 (ending Apr. 2) with just over $11 per share in cash. Adjust for that cash (and, for the sake of completeness, add back stock-based comp) and the TTM P/E multiple drops to just 4.4x.

AMAT and LRCX still are holding double-digit TTM P/E multiples even with their own YTD declines driven by cyclical fears (both stocks are down ~40% so far in 2022). Even before that turn, bulls (see this Value Investors Club article from February 2021) argued that, owing to new markets, KLIC’s multiple should expand to meet those of its larger peers.

From here, even a smaller, yet still-significant, upgrade suggests the stock can double. 10x earnings plus cash gets KLIC to $89, almost exactly 100% upside.

The Short Case Is That The Bull Case Is Wrong

That case doesn’t appear to hold up, however, for a few key reasons.

The first is that the impact of new markets will be far less than bulls might expect. At the Investor Day, K&S noted that the miniLED opportunity still was in front of it — and projected about $150 million in opportunity for baseline revenue, ~10% of the projected FY24 total. That projection obviously is not a guarantee, but even if K&S hits — the company does cite leading market share, but it’s still early — the miniLED opportunity is far from transformative.

As far as advanced packaging goes, there’s a big problem: advanced packaging is taking revenue from the legacy bonding business. Certainly, if overall demand for packaging tools grows, that’s good news for K&S, but the move into AP is not being done to generate incremental revenue.

Rather, it’s a defensive move, and like most defensive moves it leaves the company moving into a far more competitive field. Again, K&S has something like two-thirds of the wire bonding market; it hasn’t broken out market share in newer packaging solutions, and that alone says something.

There simply isn’t a lot of evidence here that K&S’ overall competitive positioning has changed. Its total addressable market may have expanded, as the company noted repeatedly at its Investor Day, but the expansion is coming in markets where K&S’ legacy dominance does not exist.

The second issue is that the argument that the chip space as a whole is no longer cyclical seems like it’s breaking down. “I’ve seen gluts not followed by shortages, but I’ve never seen a shortage not followed by a glut,” Tweeted Nassim Taleb last September. And indeed, the chip shortage seems like it’s abating, per recent commentary from Texas Instruments (TXN) and Volkswagen AG (VWAGY), among others. (Note that K&S, per management at Investor Day, overindexes in the auto space.) That’s at the same time that fabs, notably Taiwan Semiconductor (TSM) and (possibly) Intel are pumping in tens of billions to build out capacity.

It does seem like history is going to repeat — at some point.

A Sober Look At Valuation

The biggest issue, however, is just how extreme the upcycle has been for Kulicke & Soffa. Again, the wire bonding market historically has been roughly zero-growth, as K&S’ revenue performance (which included a 2015 acquisition of some size) shows:

source: Macrotrends; TTM revenue 2010-2022

In calendar 2021, the wire bonding market doubled, per an estimate cited by Semiconductor Engineering. That bears repeating with emphasis: it doubled.

K&S was a huge beneficiary of the market growth; again, because of its dominance in the space (dominance echoed in few, if any, segments of the industry), it was far and away the biggest beneficiary.

The industry simply went nuts last year. As Needham analyst Charles Shi put it in an interview with SE:

There was panic buying of wire bonders in 2021. OSATs and others were placing orders even for 2022, as they feared being too late in the ordering queue. Lead times are probably shorter than six months now. The demand is still strong, but ordering is moving towards more moderate levels.

Between Oct. 3, 2020, and Jul. 3, 2021, Kulicke & Soffa’s backlog rose sevenfold. It’s steadily come down since — though at $631.3 million, it’s still sharply elevated relative to past levels ($115 million at the end of CY19).

Despite K&S’s protestations at Investor Day that revenue would be relatively flat through FY24, it seems likely that there’s a big, big crash coming. Almost literally, the wire bonding market went from 0 to 100 in a couple of quarters. That market is going to reverse — and not to zero, but most likely to something below that.

That’s the way the semicap market works. K&S has said in the past that it only takes utilization to drop below 85% for its cycle to turn; as of fiscal Q1, utilization was in the high 80s. (Management didn’t give that detail after Q2.) And while it’s easy to do some backlog math — $1.5 billion in revenue isn’t a difficult target to hit when backlog is over $600 million — customer orders are cancellable mostly without penalty.

CEO Fusen Chen did say after Q1 that “we probably don’t feel like double-booking is a big issue for us,” but cyclical companies in general aren’t great at calling tops in their businesses. And when an analyst is citing “panic buying,” the risk of cancellations does seem at least elevated.

So here’s the problem from a valuation perspective. On trailing twelve-month results, KLIC looks ridiculously priced. But if you cut out the 2021 frenzy, it looks expensive.

In fiscal 2019 (ending Sept. 28), Kulicke & Soffa’s adjusted EPS was just 46 cents. To be sure, that was at a cyclical trough, as revenue declined 39% to $540 million. But the four-year average from FY16 to FY19 (roughly a full cycle, as it turns out) was just $1.28.

And, again, investors weren’t terribly interested in putting a high valuation on the business then. KLIC did rally toward the tail end of the decade, along with larger semicaps, likely as the argument from Credit Suisse — that the industry was no longer cyclical, or at least no longer as cyclical — took hold. (A strong FY18 no doubt helped change the story as well.)

But since the beginning of 2020, KLIC still has rallied some 67% — and it’s outperformed its larger peers:

source: YCharts

Particularly given the cash on the balance sheet, this outperformance doesn’t make a lot of sense. Even if an investor believes the broader story about cyclicality in the chip space, it’s abundantly clear that K&S is headed for a big reckoning in the not-too-distant future.

Yet since the start of 2020, Kulicke & Soffa’s enterprise value has almost exactly doubled. Again, assume that cyclicality will lighten going forward. That alone doesn’t support a 100% increase in the value of this business — and nothing else seems too, either.

The Risks To A Short

There are risks to a short, of course. Standard risks certainly apply. Short-selling is inherently risky. Timing is difficult. The strength in recent sessions is worth noting, and probably respecting: traders don’t need to jump it at the open on Monday. It’s possible that the entire market has bottomed, in which case KLIC might have done the same (though I’d still argue the stock should underperform, and maybe even decline regardless).

The cash balance is worth noting as well; quite obviously, this is not a short to zero case, or anything close. The lack of leverage probably maxes out downside in the 60% range, though a) that’s good money if you can get it and b) leverage cuts both ways, and should (in theory) limit upside risk.

The short-term risk is that the cycle probably isn’t going to turn immediately. Fiscal Q3 earnings arrive early next month — and their impact isn’t clear. Comparisons are getting notably tougher starting this quarter, but at ~6x reported earnings flattish performance on a tough comp might be enough for this rally to continue. Add in further broad market stability/strength and the snapback rally from early-month lows might have legs.

The longer-term risk is that K&S management was right in September, when it forecast $1.5 billion in revenue and $6 in EPS for fiscal 2024. This is a company that understands how cyclical its business is — that appears to be one reason why the company has built cash so aggressively over the years, to the point that an activist once asked for it back — and it believes the new opportunities will offset the coming cyclical downturn, or at least stabilization.

The latter risk seems worth taking. It’s difficult for executives, no matter the depth of their experience or the cyclicality of their industries, to attribute strong performance entirely or even mostly to external factors. Yet that seems to be what happened here (again, the company’s biggest end market doubled). It’s also common for executives to believe that new initiatives will work1. I’d be much more comfortable betting against Investor Day predictions than on them.

The short-term risk is a bit more difficult to parse. Recent history suggests earnings might not lead to a big move. KLIC fell 2.7% after the Q1 report in early February, and 1.4% (on a day the S&P 500 plunged almost 4%) following Q2 earnings three months later.

That aside, pegging near-term direction in this market isn’t easy; our general sense remains negative, but we’re also acutely aware of how steep a bear market rally can be. It’s possible KLIC’s outperformance this month (the Philadelphia Semiconductor Index is up 9%) was driven by short-covering as well; nearly 14% of the float remains sold short (though cost to borrow remains near zero). The options market doesn’t help on this front, as liquidity is low and spreads high (though some longer-dated expirations still look a bit tempting, particularly at a mid-spread price).

All that said, this still seems like a trade worth putting on at some point. Earnings here most likely are going to plunge, someway, somehow. The bull case here is one that tempts investors who don’t quite understand the story and/or those who see the stock as somehow ‘safer’2, and those investors tend to get pushed out when a bear market takes another leg down. It’d be best to get this timed perfectly, but timing shouldn’t have to be perfect for the trade to work out.

As of this writing, Vince Martin is short TSLA and ONEW. He may initiate a short position in KLIC this week.

Tickers mentioned: KLIC

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