Relying too heavily on just a handful of customers can be a double-edged sword.

When they’re growing

at a fast clip, the positive effect trickles down the supply chain, bolstering demand for your own products.
But when this growth hits a speed bump, it invariably will slow you down as well. Over the past two years,
Ultra Clean Holdings has seen what it’s like to be cut both ways. With multiple technological advances
driving the wafer fabrication equipment (WFE) market to unprecedented levels, demand for its specialized
outsourced manufacturing solutions by the company’s two biggest customers—which are responsible for
over 80% of annual sales—soared. As a result, sales and earnings jumped 64% and 260% in 2017, and led
to a similar 357% rise in UCTT’s stock price through the first ten and a half months of the year.

But given the historically cyclical nature of this industry, investors began to question the sustainability of
this growth. In fact, despite a strong start to the year, this concern gained further steam as analysts began
ratcheting down their growth forecast for the WFE market due to slower-than-expected investment
spending trends by original equipment manufacturers and semiconductor foundries. If that wasn’t enough,
the customer that had been most responsible for UCTT’s exceptionally strong performance in 2017
confirmed brewing speculation that shipments for the current quarter would be much lower than expected
due to the delay in the production of new memory chips by a leading global electronics manufacturer,
forcing it to slash its outlook for the year. With the trickle-down effect in full force, UCTT provided a
similarly weak near-term forecast after reporting Q2 results last month. Thus, what had started out as a
year with such promise was now looking to some as perhaps the beginning of a cyclical downturn.

Yet we believe such a conclusion is far too premature. After all, given that the slowdown in shipments
anticipated by UCTT’s key customer stems from a pushout of production and not a reduction, this impact
should prove temporary with shipment levels likely to begin recovering next quarter. More importantly,
many of the favorable market trends that led to the exceptionally strong demand for WFE last year—such
as the quickening pace of technology transitions and the increasing complexity in the fabrication of next-
generation chips—remain intact. This has us convinced that the 62% sell-off UCTT’s stock has suffered
from its October 2017 peak has been way overdone and that the growth the company is likely to continue
to see will be strong enough to send its shares to our target price of $19 over the next two years.
Ultra Clean Holdings, Inc. is a leading global maker of production tools, modules and subsystems for highly
complex, highly configurable, limited volume semiconductor capital equipment and certain non-
semiconductor applications. Its products include precision robotic solutions, gas and liquid delivery
systems, a variety of industrial and automation production equipment products, wafer cleaning subsystems,
chemical delivery modules, top-plate assemblies, frame assemblies, and process modules.

The company sells its products primarily to the semiconductor capital equipment industry, with some sales
going to customers operating in the consumer, medical, energy, industrial, and research equipment markets.
Its two largest customers, Lam Research Corporation and Applied Materials, Inc., accounted for 61.9% and
21.6% of total sales in its most recent quarter. UCTT’s biggest competitor is Ichor Systems Holdings,
which is the only other major publicly-traded supplier of gas and chemical delivery systems. To a lesser
extent, the company also competes against other providers of critical subsystems such as Flex Ltd. and
Foxsemicon Integrated Technology, as well as the internal manufacturing groups of its customers.

For UCTT, 2017 proved to be a banner year. Growing demand for smaller, lighter and more portable
electronic devices, the proliferation of the Internet of Things (IoT) and accelerating migration to next-
generation technologies pushed demand for wafer fabrication equipment (WFE) to new highs. In particular,
increasing memory/storage requirements in these advanced devices, coupled with the more dynamic and
stringent quality levels required in production of these more complex products, fueled strong demand for
UCTT’s specialized semiconductor fabrication solutions—such as liquid and gas delivery systems for etch
and deposition platforms—and led to increased outsourcing opportunities. As a result, UCTT’s revenues
soared 64.2% from the prior year to $924.4 million while adjusted earnings nearly quadrupled to $2.34 per
share—both of which easily represented the highest levels in the company’s history.

With the strong industry equipment spending forecasted to continue, 2018 was expected to be another year
of strong growth. And initially that appeared to be the case as Q1 revenues and earnings surged 53.9% and
46.8%, respectively, and easily surpassed their respective consensus estimates. What’s more, emboldened
by Lam Research’s favorable Q2 guidance, UCTT provided a similarly positive outlook for the quarter.
Unfortunately, while sales for the period did exceed expectations once again, earnings came up short due
to weaker-than-expected margin performance. Far more concerning, however, was the company’s guidance
for Q3 revenues and adjusted earnings of $200-220 million and 28-38 cents per share, which were
substantially below the $261.2 million and 48 cents analysts had been projecting.

However, this outlook—while certainly disappointing—shouldn’t have come as much of a surprise. After
all, speculation of slowing growth had already been brewing—driven in part by concerns that the delay in
the production of next-generation 3D NAND memory chips by global electronics giant Samsung would
negatively impact shipments by Lam Research in the upcoming quarter. Given the company’s heavy
dependence on the latter, this was almost certain to hurt UCTT as well. Nevertheless, despite already
having been hit by selling pressure from this speculation, as well as from escalating concerns over a possible
trade war between the U.S. and China—which has been weighing on the entire semiconductor industry—
UCTT’s stock suffered another leg down following its Q2 report last month. As a result, it has now fallen
over 50% from its late-January high and is down 62% from its record closing price in mid-October.

In our view, the magnitude of this sell-off strongly suggests investors believe that the soft Q3 outlook could
be the start of an extended downturn in UCTT’s operating prospects. To put it more bluntly, that the good
times are over. Yet while we agree that capital equipment spending will not trend as strongly as the
company had initially anticipated, we also believe that the current growth cycle in WFE is far from finished.
Ironically, the biggest reason for this stems from one of the very concerns that contributed to the stock’s
recent decline—its heavy dependence on Lam Research. Indeed, while this key customer essentially
confirmed that shipments will be down significantly in the current quarter due to adjustments in short-term
investment plans by certain customers that will delay the start of production of new memory modules and
other semiconductor products, it also believes that this period will mark the low point with shipments
expected to rebound and strengthen sequentially in upcoming quarters. This implies that the weakness
UCTT is currently seeing should also prove temporary.

More importantly, while demand for semiconductors can be highly cyclical and has generally been difficult
to forecast, we see enough favorable market trends to support further growth in the years ahead as well.
Most notably, the ongoing consumer demand for products with greater functionality is likely to continue to
compel chipmakers to quicken the pace at which they adopt next-generation technologies and result in
increasingly more sophisticated production requirements. We believe this will force UCTT’s capital
equipment customers to focus more of their resources on developing and incorporating these newer
technologies, thereby driving greater demand for the kind of specialized semiconductor manufacturing
systems and integrated outsourced solutions the company offers. The same holds true for its non-
semiconductor display business as the flat panel industry continues to pursue bigger displays and as newer
display technologies like OLED gain further traction. Also not to be ignored is UCTT’s pending acquisition
of Quantum Global Technologies (QGT), a leading provider of semiconductor manufacturing optimization
solutions, which will bring a stable, richer-margin and highly-accretive revenue stream with an addressable
market of more than $1 billion. Thus, even if UCTT’s growth prospects aren’t as strong as they once were,
we think they are more than sufficient to justify a much higher value than where its stock now trades.

Semiconductor – The Semiconductor segment (93.7% of Q3 sales) provides semiconductor capital

equipment producers with a complete outsourced solution for the development, design, procurement,
prototyping, engineering, turnkey manufacturing and testing of advanced semiconductors used in a host of
electronic devices, which continue to get smaller, faster, and demand lower power consumption. These
specialized engineering and manufacturing systems are capable of handling major volume and design
changes during the manufacturing process, providing customers extreme flexibility when responding to
dynamic market changes and enabling them to realize lower production costs and reduced design-to-
delivery cycle times while maintaining high quality standards.

Non-Semiconductor – Using proven deposition, lithography, and etch processes that meet ultrahigh purity
(UHP) requirements, its Non-Semiconductor segment (6.3% of Q3 sales) ensures that modules and
subsystems used in liquid crystal displays (LCDs) will meet the stringent cleanliness that today’s leading-
edge manufacturing processes require. This segment also offers design and manufacturing expertise for
medical devices and certain other applications.

UCTT’s pending $342 million acquisition of QGT represents a significant departure from the smaller
business additions the company has historically made to augment its operations and supplement organic
growth. Moreover, while QGT serves similar markets, the solutions it provides are quite different. This
limits the amount of synergies that can be realized and may also result in unanticipated integration
challenges that negatively impact the company’s operating results—which would be further exacerbated by
the significant increase in leverage stemming from the debt that will be assumed to fund the transaction.

As noted earlier, UCTT relies on its two largest customers, Lam Research and Applied Materials, for the
lion’s share of its total sales. As a result, a slowdown in business activity by these customers would have
a similarly negative impact on UCTT’s own operations. Furthermore, due to this tight concentration, these
customers exert a significant amount of negotiating leverage on the company, which may require it to accept
lower operating margins, increased liability risks or changes in its operations in order to retain or expand
market share with them. It also makes UCTT susceptible to adverse changes in its relationships with these
customers, including their decision not to continue to outsource critical subsystems to UCTT or to give
market share to one of its competitors.
On July 24, 2018, UCTT announced that it has signed an agreement to acquire Quantum Global
Technologies (QGT) for approximately $342.0 million in cash. As a leading global provider of ultra-high
purity, sub-10nm outsourced tool chamber parts cleaning and coating services, tool part life extension,
microcontamination analytical services, and other optimization solutions to OEM and IDM customers,
QGT will diversify UCTT’s customer base and expand the company’s addressable market by over $1
billion. Additionally, the stable, recurring and higher-margin nature of QGT’s wafer starts-based service
offerings, which produced $217 million in revenues and $50.5 million in adjusted EBITDA in 2017, should
also help lessen the sales and earnings volatility inherent in its more cyclical existing operations. The
transaction is expected to close in the current quarter and be accretive to adjusted earnings beginning in Q4.

Given the steep sell-off in shares of semiconductor capital equipment-related stocks so far this year, we
found several that offer good value at current levels. For example, shares of Ichor Holdings, UCTT’s most
direct competitor, are down about 37% from their late January high. However, UCTT’s shares have fallen
by a larger 51% over the same period despite the fact that ICHR is actually more reliant on its top two
customers than UCTT. Moreover, while both stocks have similarly attractive price-to-expected earnings
ratios, UCTT’s price-to-sales and price-to-book ratios are substantially lower. You also need to consider
that UCTT currently enjoys a net cash position of $2.20 per share, which in theory should add to its value,
versus a net debt position $4.68 per share for ICHR.

In fact, the company plans on using some of this excess cash to fund a portion of the QGT acquisition
announced last month. As this is likely to add over $200 million in annual sales and be immediately and
materially accretive to earnings on an adjusted basis, UCTT’s P/E and P/S ratios following this transaction
will be even lower on a pro forma basis.

Our more important discounted cash flow analysis can better capture the positive impact on UCTT’s value
from the QGT acquisition. But since this acquisition is still pending, we believe it is more prudent to value
the stock based solely on the company’s existing operations. What’s more, due to the softer-than-expected
outlook UCTT provided for the current quarter and the generally cyclical nature of its market, we were far
more conservative in our assumptions than is normally the case. Despite this, our analysis, which follows
below, leaves little doubt as to just how significantly undervalued UCTT’s stock has become.

In terms of the top-line, UCTT’s net sales in the first half of 2018 climbed 39.8% from the prior year to
$605.1 million—extending the strong growth the company enjoyed in 2017. This was driven by increased
demand from its semiconductor equipment customers—most notably Lam Research, whose own sales grew
33.8% over the same period. However, a recent softening in capital equipment spending trends—especially
from the memory and foundry markets—resulted in this key customer providing a soft near-term outlook.
Predictably, this led to UCTT issuing similarly disappointing revenue guidance of just $200-220 million
for the current quarter, which is down substantially from the $242.6 million realized in the prior year period.
Much of this expected near-term weakness stems from adjustments in short-term investment plans by
certain Lam Research customers that will delay the production of semiconductor products the company had
been anticipating to startup in the current quarter. In particular, global electronics giant Samsung, which is
Lam Research’s biggest customer, pushed back the production of its new 3D NAND memory chips.
Yet as these delays largely represent timing issues and not a loss in business, Lam Research expects this
weakness to be temporary and anticipates demand to pick back up starting next quarter. This is likely to
drive a similar sequential rebound in UCTT’s sales in Q4. This view is clearly shared by the analysts who
cover the stock with the current consensus estimate for the final quarter indicating sales will rise 8.0% to
$238.8 million from the low of $221.1 million projected in the current period. Collectively, this implies
net sales of $1.065 billion for the full year—which we view as well within reach. However, we assumed
net sales of just $1.015 billion for 2018, which reflects revenues at the low end of UCTT’s guided range
for Q3 and just a $10 million sequential improvement from this depressed level in Q4.

With the production of the delayed chips likely to ramp up in subsequent periods, UCTT’s sales should
continue to improve on a sequential basis in 2019. Combined with the favorable growth prospects in its
non-semiconductor display business—where capital intensity is anticipated to remain high through at least
2020 as the flat panel industry continues to pursue bigger, brighter, slimmer, faster and cheaper displays,
and as newer display technologies, such as OLED, gain further traction—we believe UCTT’s top line
growth will resume next year and deliver at a level that is consistent with the 7.4% rise implicit in the
consensus estimate of $1.144 billion.

Over the longer term, the cyclical nature of the semiconductor industry suggests there will inevitably be
some years where UCTT’s sales levels will be down. Nevertheless, we expect growth to still trend
positively overall—supported by the constant demand for electronic devices and applications with greater
content and higher functionality, which will likely shorten product cycles and continue to quicken the pace
at which next-generation technologies, as well as the manufacturing processes required to produce these
increasingly complex chips, are adopted. This should drive greater demand for UCTT’s more specialized
semiconductor manufacturing systems. Yet to remain conservative, we assumed flat annual growth of just
1%—which is lower than the historical rate of inflation—throughout our analysis.

As for profit performance, UCTT’s adjusted operating margin (excludes amortization of intangible assets
and other special items) surged to 10.26% last year from just 5.41% in 2016 as the company benefited from
the favorable sales leverage stemming from the 64.3% jump in revenues, which led to increased factory
utilization, greater labor efficiency, and lower levels of research & development, sales & marketing and
general & administrative costs (as a percentage of sales). Despite the continuation of strong sales growth
in the first half of 2018, UCTT’s adjusted operating margin contracted to 9.22% in Q1 and 8.67% in Q2
due to a change in mix towards products with higher costs required to meet the increasing customer demand
and an acceleration in the ramp of new products. However, this was still within the 8-10% range targeted
by the company at those revenue levels.

That is not likely to be the case in the second half. Indeed, at the lower revenue levels now anticipated for
Q3, we think UCTT’s adjusted operating margin will slip under 7%, which would mark the lowest quarterly
rate since Q3 of 2016, before improving sequentially as sales begin to rebound in Q4. Nevertheless, on the
strength of its first half performance, the adjusted operating margin for the full-year is still likely to come
in above 8%. More importantly, given our expectations for a return to year-over-year sales growth in 2019,
UCTT’s operating margin should continue to recover sequentially. And while profitability over the longer
term will fluctuate with the level of sales—with cyclical market troughs resulting in performance similar to
what’s expected in the second half of this year and periods of strong demand mirroring the rates UCTT
enjoyed in 2017—we believe the flexibility provided by the company’s variable cost model will still allow
it to maintain an average operating margin within its 8-10% target range—albeit at the lower end. Despite
this, we modeled in a more conservative annual operating margin of only 7.5% throughout our analysis.

Depreciation and amortization expense was $10.7 million in 2017 with about half stemming from internally
purchased depreciable assets and the rest coming from the amortization of acquired intangible assets. As
the latter is expected to steadily decline and unwind substantially over the next five years, it has already
been excluded from our adjusted operating margin assumptions. The remaining depreciation component,
which was $5.3 million in 2017, will be a function of UCTT’s capital spending activity and should generally
move in line with the level of sales. But since this noncash charge actually contributes to our cash flow
projections, we often go with an unrealistically low estimate in order to minimize this favorable impact. To
keep things even simpler this time, we projected no depreciation expense at all throughout our analysis.

UCTT employs a judicious level of debt, which has resulted in low annual interest expense in the $2 million
range over the last several years. This will change following the acquisition of QCT. But since our analysis
is based strictly on UCTT’s existing operations, we assumed this trend continues and modelled accordingly.

In terms of taxes, the company expects its effective tax rate for the current year to be 14-16%. While this
estimate reflects the high level of income UCTT generates from lower tax rate foreign jurisdictions, it is
actually above the 13.6% the company enjoyed in 2017 despite the decline in the U.S. federal statutory rate
from 35% to 21% resulting from the passage of tax reform. That’s because the new tax legislation also
resulted in the release of the company’s valuation allowance against which UCTT had been able to
substantially offset its U.S. tax liabilities in prior years. As the range for this year assumes it will now have
to pay U.S. tax on a quarterly basis, it probably represents a good run-rate going forward. Yet we went
with a higher effective rate of 20% in our analysis.

Despite operating in a highly cyclical industry, UCTT’s stock has historically displayed a low level of price
volatility or systematic risk versus the overall equity market—as evidenced by its beta of just 0.86. This
results in a relatively low cost of equity when compared to higher beta firms. Yet as the cost of equity is
typically more expensive than the cost of debt, the low level of the latter in its capital structure still results
in a fairly high weighted average cost of capital of close to 8%. To be safe, we discounted our projected
cash flows at a higher 9% rate. Despite this, and all of our other conservative assumptions, our analysis
indicates that UCTT’s stock is worth at least $17.97, which is 36% higher than its current price.

(We want to reiterate that this analysis does not factor in the pending acquisition of QGT, which we expect
UCTT to successfully close on later in the quarter. QGT had revenues and net income of $217.9 million
and $22.0 million, respectively, in 2017. Thus, it will add materially to UCTT’s annual net sales, raise the
company’s margin profile, and should contribute to higher annual cash flows even after taking into account
the sharp increase in debt and associated interest expense following the transaction. In fact, our preliminary
analysis suggests that the acquisition would bolster our intrinsic value on the stock by at least $1.11 to
$19.08. Once UCTT completes this acquisition and provides its expectations for the combined company,
we will formally update our valuation.)
Q2 sales were up 27.1% year-over-year to $290.2 million. This was primarily driven by a 29.3% jump in
sales from its Semiconductor segment to $272.0 million resulting from strong demand from its existing
customers. Non-Semiconductor segment sales grew 1.1% to $18.2 million. Hurt by an unfavorable mix
and higher costs required to meet increased customer demand and for the accelerated ramping of new
products, the adjusted operating margin (excludes amortization of intangible assets and executive transition
costs) shrank 256 basis points to 8.67%. While adjusted net income still rose 0.9% to $21.5 million, a
higher share count stemming from its follow-on stock offering in February led to an 11.3% drop in adjusted
earnings per share to 55 cents, which was 2 cents lower than what analysts had been projecting.

UCTT’s finances are in excellent shape. Not only did it have ample short-term liquidity with a current ratio
of 2.6 at the end of Q2, the company’s cash balance of $141.1 million was enough to pay down its entire
debt load of $54.8 million nearly three times over. This position will change once it closes on its acquisition
of QGT later in the quarter. Specifically, to fund the $342 million transaction and refinance its existing
debt, UCTT has secured a commitment from Barclays to provide it with a term loan of $350 million. Thus,
we expect the company’s debt balance to increase to roughly this same amount following the acquisition.
However, as UCTT should still have a comfortable cash cushion of about $100 million afterwards, net debt
will be closer to $250 million. Additionally, while this will obviously increase the company’s financial
leverage, we expect the inclusion of QGT operations to also boost annual adjusted EBITDA by about $50
million and result in a very manageable pro forma net leverage ratio of less than 2. More importantly, with
the transaction anticipated to be materially accretive to earnings on a cash basis even after accounting for
the sharp increase in interest expense, UCTT’s free cash flow production is likely to increase. Thus, not
only should the company have no difficulty servicing this debt, it should be able to quickly reduce it. For
good measure, UCTT also secured a new $50.0 million revolving credit facility from Barclays, which
should satisfy any additional capital needs that may arise.

UCTT currently does not pay any dividends. We do not expect this policy to change in the near future as
free cash flows are likely to be used to fund the growth of its business and to pay down debt.

For UCTT, 2017 was always going to be a tough act to follow. After all, net sales and adjusted earnings
surged 64% and 260% from the prior year and blew past even the most optimistic of analysts’ forecast as
global spending on wafer fabrication equipment proved much better than expected. Nevertheless, the strong
start to 2018 provided the company with optimism that it could continue to build on this fantastic year.
Unfortunately, slower-than-anticipated spending trends by semiconductor OEMs, coupled with the sizable
decline in shipments expected by UCTT’s largest capital equipment customer for the current quarter—
driven primarily by the delayed start of production on next-generation memory modules by a major global
electronics manufacturer—forced the company to issue disappointing guidance for Q3 last month. But with
shipments by this key customer likely to rebound in short order, many of the favorable market trends that
drove UCTT’s strong performance last year still in place, and a pending acquisition projected to greatly
expand its total addressable market, we view the company’s weaker near-term outlook as more of a
temporary lull rather than the start of a longer downturn in the market. That makes the more than 50%
tumble its stock has endured since late January far too severe in our view. This is backed by our
conservative discounted cash flow analysis, which finds UCTT’s shares to be grossly undervalued, and
provides us with confidence that UCTT’s shares can rise to our target price of $19 over the next two years.