When it comes to the manufacturing of advanced semiconductors used in artificial intelligence (AI) systems, there is a little-known segment of the industry that acts as the gatekeeper: metrology equipment.
Chief among metrology equipment providers is KLA Corp., whose stock is sporting an incredible nearly 75% gain in the last one-year stretch. But a smaller peer, Onto Innovation (ONTO 2.06%), is up nearly 105%. Why? And is it still a buy?
A key to making more advanced chips
Metrology (the science of measurements) and process diagnostics and control (PDC, basically quality control on a manufacturing process) is a critical stage after a chip is designed. Early in the chipmaking process, metrology and PDC equipment ensure the new chip functions correctly and is free of defects that impact performance. Companies like Taiwan Semiconductor Manufacturing and Intel rely heavily on metrology and PDC equipment when developing new and more advanced manufacturing processes.
Thus, think of metrology equipment as a type of final step in building AI systems, a type of gatekeeper to unlocking more powerful computing.
While KLA Corp. has received attention over the years as a fantastic dividend growth investment, Onto Innovation is a little-known competitor. It's the product of a 2019 merger between two small metrology companies, a move that helped the business scale up its operations to attain greater efficiency (higher profit), which in turn has helped it invest in and unveil new metrology technologies for its customers.
Data by YCharts.
It's been an incredible run for Onto, and the small business isn't finished. It keeps rolling out new equipment and metrology features to address all steps in the complex chipmaking process, from advanced wafer inspection all the way to the final dicing of those wafers into chips and packaging them into a computing system. Some of Onto's recent equipment announcements are far-reaching, addressing its chip manufacturer customers' product roadmap years from now.
Can the Onto party continue?
After the recent run-up, Onto stock trades for an "expensive" 82 times trailing-12-month earnings per share (EPS) according to generally accepted accounting principles (GAAP), and 72 times trailing-12-month free cash flow (FCF). However, bear in mind that like all manufacturing-based businesses, Onto is cyclical. The EPS and FCF figures from the last year include the effects of the bear market that had dramatically brought Onto's profitability down in 2023.
To illustrate how the rebound in profits (and thus the valuation) can change just as dramatically to the upside, Onto reported a 4.6% quarter-over-quarter sequential increase in revenue in Q1 2024 versus Q4 2023, but an 11% sequential increase in adjusted EPS.
Management is forecasting another step-up in revenue and profitability in Q2, with the high end of revenue guidance of $240 million implying another 4.8% rise from Q1 -- and a 7% sequential increase, and 59% year-over-year increase, in adjusted EPS. Suffice to say the valuation may not be as expensive as it appears on the surface.
Additionally, there are dozens of new chip fab (a facility that makes semiconductors) construction projects underway around the globe, and dozens more of existing fab updates. Industry organization SEMI.org predicts advanced wafer fab equipment, like what Onto provides for AI chipmakers, will reach record levels in 2025 and continue hitting new highs through 2027, growing at a low- to mid-teens percentage. The market is expected to begin heating up in the second half of this year. Onto's sales are poised to follow a similar trajectory.
I don't expect Onto Innovation's stock to perform in the same exceptional fashion as it has over the last 12-month period. However, there could be plenty of upside left in this smaller metrology equipment and under-the-radar AI stock. I'm more than happy to continue holding my position.
