Axcelis Technologies: Closing The Short Position (NASDAQ:ACLS)

Investment Thesis

I covered Axcelis Technologies (NASDAQ:ACLS) two months ago with this article and explained how the company and the semiconductor industry had been more resilient than most people had thought.

Axcelis has a crucial position in the industry, providing ion implantation equipment to chip manufacturers. While it performs strongly in good times, it is a company that struggles in bad times. There were (and still are) numerous headwinds such as a recession looming and tensions between the U.S. and China increasing, which could quickly alter investor sentiment. That is why I rated the company a “Sell”.

Even though my “Sell” positions are usually short-term anyhow, my thesis played out more quickly than I anticipated, and the short position yielded a 17% return before costs. At the same time, the S&P 500 is up 6%. Now, investor sentiment shifted again due to the better-than-expected inflation data, and it became more difficult to predict how this name would perform. Because of the increased risk of taking any position in this name in the near term, I am changing my rating from “Sell” to “Hold”.

Company Description

The semiconductor industry is a complex one. There is a complicated supply chain with many players involved. Therefore, a recap is necessary to understand the essential position Axcelis has.

Semiconductor chips are used in a wide range of electronic products, including mobile devices, personal computers, sensors, automobiles, storage devices, and many more. Having so many end markets, the industry gets deserved attention. While some of these end markets are exposed to consumer spending, some get bigger driven by a higher need for data storage with emerging technologies such as artificial intelligence.

Manufacturing these chips is a difficult and asset-heavy business. That is why only those with immense operating scales can afford to start manufacturing. These pure-play manufacturers are called foundries. While most of them are located in Asia, there are efforts from big Western companies like Intel (INTC) to become foundries operating in the Western Hemisphere.

Axcelis supplies ion implantation and other processing equipment to chip manufacturers. Ion implantation equipment is a high-technology product, and similar to chips, few players manufacture them. Being one of the few and most innovative implanters in the market gives Axcelis its competitive advantage.

The company has customers from all around the world, but most of these customers are located in Asia. According to the Q3 2023 earnings call, 35% of its system shipments in the quarter were done to China, 38% to the U.S. and Europe, 12% to Korea, 4% to Taiwan, 3% to Japan, and 8% to the rest of the world.

While the barriers to entry are high, Axcelis has been facing serious competition from Applied Materials (AMAT), which has a much higher market capitalization.

The Short Thesis

Despite Axcelis’ crucial position in its market, I published the September 26 Short thesis.

In that article, I explained how Axcelis had been performing very well for the last decade. Sales increased due to higher demand, government policies helped improve operations and mitigate headwinds stemming from the pandemic and risky geopolitical environment, and margins were increasing consistently. This outperformance is shown below.

The market loved this strong performance and thought it would continue for longer. Between the beginning of the pandemic and the day I published my article, the company has outperformed the S&P 500 (SP500) and its main competitor, Applied Materials.

Everything seemed to be going well. Management was positive, past performance had been perfect, and expectations were too high. That was the point of maximum optimism.

Axcelis is a great business when times are good, interest rates are high, employment is high, and people still have the purchasing power. However, investors realizing we are not in such an environment anymore would have been a great catalyst for this positive sentiment to disappear and for the stock to drop. Axcelis is a high-technology growth company that has to maintain its revenue growth to keep valuations high. As soon as it doesn’t go the way the management wants, the stock price falls.

With expectations, multiples, and the stock price high, I explained that the market was going to realize the upcoming headwinds and the sentiment would change. Therefore, I rated the company as a “Sell”. And it went just as I expected, although more quickly…

The market realized increasing headwinds, and the company massively underperformed Applied Materials and the broader market. Have a look at the performance chart below:

Thesis Update

I don’t like to take Short positions unless I see a huge sentiment change coming or a structural concern with the company. And I don’t like to hold them long. With its strong position in the industry, there is no structural concern in my opinion, and the sentiment change has already occurred. Regardless of my previous target price, I believe the downside potential has become a lot smaller and riskier. The main reason for this is the new inflation report.

The Consumer Price Index increased 3.2% in October, slightly lower than the 3.3% the market expected. While the difference is only 10bps, it triggered a huge surge in investor sentiment. The Fed chair, Jerome Powell, signaled that they might increase rates one more time this year and they expect that rates will be higher for longer. However, this inflation report seems to have altered those expectations. Investors are more hopeful that the Fed is done with rate hikes.

Don’t be mistaken here. I still believe that Axcelis is an expensive company with big headwinds. There is still a high probability that we have a recession, the artificial intelligence hype is causing inflated valuations, and increasing tensions between the U.S. and China are a big threat, despite the recent visit by the Chinese leader.

Despite all these concerns, the improving investor sentiment makes this sell position extremely risky.

Valuation

The numbers have only slightly changed since the previous article due to new management guidance and the changed analyst forecasts. Even the very positive scenario I explained earlier shows a downside potential.

For this positive scenario, I assume that the company will manage to maintain its post-pandemic revenue growth, resulting in estimated revenue of $1.1 billion in 2023 and nearly $1.7 billion in 2027. See below:

After adjusting for capital expenditures and changes in net working capital, this revenue expectation translates to an adjusted free cash flow of $231 million in fiscal year 2023 and $381 million in 2027.

I am using an above long-term inflation growth rate of 3%, considering the long-term growth opportunity of the industry. The cost of equity is slightly higher than my previous analysis, due to increased equity beta. Using a long-term risk-free rate of 2%, a market risk premium of 5.7%, and the stock’s 5-year equity beta of 1.79, the cost of equity is 12.2%. The company has no debt, which gives us a discount rate of 12.2%.

It is important to explain here that I separate cash and short-term investments into operating and excess in my calculations. There are many ways of calculating operating cash, but I use a certain percentage of revenue, typically between 5% and 10%. This is going to be spent on the day-to-day operations of the company for a year. The rest (if there is any) is excess cash. In my opinion, shareholders have a claim on the excess cash, but not the operating one, because the business needs it. Based on these calculations, Axcelis has an excess cash of $61 million.

Using these numbers, we find an equity value of $3.58 billion, which means a target share price of $107.89. This is a 15.2% downside over the current share price at the time of this article’s writing.

The analysis shows us that the margin of safety of this short position has become a lot smaller with the stock price falling 17%.

Conclusion

Axcelis Technologies has an essential place in the semiconductor manufacturing industry, supplying the necessary equipment. While the company has been doing great over the last few years and sales have grown immensely, I think tough times are ahead.

I published my short thesis two months ago, explaining the near-term headwinds, such as the looming recession, increasing tensions between the U.S. and China, weakening customers, and unjustifiably positive investor sentiment. While most of the macroeconomic arguments are the same, investor sentiment has already pushed the stock price down, making this a profitable trade.

In light of the new inflation report and improving market sentiment, I do not feel confident enough to keep holding this short position. Additionally, I don’t have the same margin of safety anymore. That is why I am changing my rating to “Hold”.

Due to upcoming headwinds and the elevated valuation, investors should still avoid buying this company.