It’s no secret that we are in a semiconductor shortage. The pandemic has accelerated trends already present in 5G, artificial intelligence, cloud computing and automation in industrial factories and automobiles. This means growing demand not only for proprietary chips, but also for component manufacturers that support these chips and smart machines.
Component companies are related to semiconductors, but are more like industrial stocks or even commodities, which should also do well in this strong and growing economy. Two leaders in industrial technology are Micron technology (NASDAQ: MU) and II-VI (NASDAQ: IIVI). This is the type of environment these types of businesses should do well in, but both are way above this year’s highs. It could be a great opportunity – but what’s the best buy right now?
What Micron and II-VI do
Micron is a world leader in the production of DRAM and NAND flash memory chips. DRAM stores data at power-on and is a necessary step in getting data from storage to the processor. Basically, it’s the firepower that increases the speed and volume of computing. NAND flash is non-volatile, which means it stores bits even when the power is off, but it’s not as fast as DRAM. NAND shares the world of non-volatile storage with hard drives, which are older, but cheaper, technology. As the price of NAND has come down, its higher speeds, greater resilience, and smaller form factors have allowed it to take a significant share of hard drives.
As the backbone of the data economy, DRAM and NAND is expected to experience strong growth in the coming years. DRAM bits are expected to increase in adolescents in the medium term, while NAND flash bits are expected to grow in the order of 30%. Currently, Micron’s business is roughly two-thirds DRAM, one-third NAND flash.
II-VI also manufactures components, but of different types. The company manufactures a variety of components and subsystems that generally fall into two categories: photonics for optical communications and industrial lasers. About two-thirds of II-VI’s sales are in the communications segment, where it produces a mix of optical transceivers and materials. The other third of laser technology is spread over semiconductor capital goods, consumer electronics, industrial applications, aerospace and defense, and life sciences. All of these end markets are also expected to experience strong growth at a double-digit annual rate over the next five years, so II-VI is playing strong markets as well.
Both companies will therefore grow over the long term, but they also have very cyclical qualities, which makes them cheaper than most other tech stocks. Yet both have managed to take advantage of this cyclicality, buying out weaker competitors in times of downturn. Today both have an incredible global scale and each has improved their profitability over time.
While II-VI and Micron are consolidators in their industry, consolidation in DRAM and NAND industries is largely complete. Micron’s last acquisition dates back to 2016 with the purchase of Inotera. Since then, Micron has significantly improved its cost structure, repaid debt to a strong net cash position, and has progressed rapidly through technology transitions to become among the most efficient in the industry. In recent months, Micron has outperformed its South Korean competitors as the first memory company to achieve 176-layer NAND and 1-alpha node in DRAM.
However, the optical and laser markets are still in consolidation mode, and II-VI just won a bidding war for its rival. Coherent (NASDAQ: COHR), agreeing to buy the laser rival for around $ 7 billion, using a combination of debt, preferred stock issued by Bain Capital, and stocks. Coherent will offer II-VI greater diversification, particularly in the industrial laser market, as well as impressive cost and revenue synergies. However, at closing, the combined company will have a high level of debt. After the transaction, the company will have a debt to EBITDA ratio of 4.4, which is quite high.
II-VI is currently profitable, has a strong history of integrating acquisitions and has just won a high level contract with Apple for 3D detection and potential AR / VR applications. However, this debt figure may make some investors nervous, which is why the stock is down about 35% from recent all-time highs.
What is the best buy?
Both stocks are pretty cheap at the moment; II-VI, minus the effect of the Coherent acquisition, is trading at a P / E ratio of approximately 17 based on this year’s earnings estimates. Micron is much more cyclical and volatile than II-VI, but due to the current rise in the cycle, it only trades at a forward P / E ratio of 8.
Given the strong growth prospects for both over the next decade, along with the strength of the economy and below-market valuations, both stocks appear to be good buys today. However, the big difference between the two is that II-VI will have to use its free cash flow to deleverage its balance sheet over the next few years. If interest rates rise, it will be more difficult for highly indebted companies to perform.
In contrast, Micron, with its net cash position, will be able to return an enormous amount of liquidity to shareholders in the form of share buybacks, as management has announced. And if Micron proves it can generate cash flow in the next cycle, it has more room for a better multiple. As such, Micron is the safest and best buy today.
However, I’m a fan of both companies and happy to own these two top-notch tech industries.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.