Photronics (PLAB)

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Ken Nagy

www.zacks.com

Based in Brookfield, CT, Photronics, Inc. (PLAB) is one of the largest original equipment manufacturers (OEMs) of photomasks to the semiconductor manufacturing industry. Semiconductor manufacturers use photomasks during the front-end process of fabricating integrated circuit (IC) devices on a silicon wafer. These photomasks are purchased from merchant suppliers such as PLAB or are internally created from the semiconductor manufacturers' captive photomask manufacturing operations. Photronics builds customized photomasks based on customer circuit designs at strategically located manufacturing facilities. Additionally, the company recently entered the flat panel market and is a major supplier of large area masks (LAMs) used in the construction of LCD panels or glass.

The front-end process begins with device formation. This process begins with a wafer (usually made of silicon) having a layer of photoresist (a chemical that hardens when exposed to an ultraviolet light source) spin-coated onto the surface in liquid form to drive off the excess solvent, and then "soft-baked" or cured. A photomask is then loaded into the lithography system. Photomasks, also called masks or reticles (if the mask is "stepped" across the wafer), are high-purity quartz or glass plates containing precise microscopic images that are used by a photolithography tool, also known as a stepper. An excimer laser is then passed over the photomask and through a reduction lens system that exposes the desired areas of photoresist, which is then subsequently removed, permitting deposition to the surface of the wafer. A strip system is utilized to remove the photoresist or other chemical residues following diffusion processing or film deposition. Thin layers of dopants are then grown or deposited in a precise pattern within the wafer using various chemical, vapor or ion implant techniques. The deposition process alters the atomic structure of the material, and therefore necessarily the electronic properties of the material. Further into the wafer fabrication process, a series of metallization steps are executed, in which conducting materials, that interconnect the semiconductor devices, are deposited. Multiple layers of conducting, semiconducting and insulating materials are constructed on and within the wafer via successive steps of lithography, etching and deposition, utilizing unique masks for each layer. Depending on the geometry and the device, anywhere from 35 to 45 unique masks are used in the device formation process with 10 to 100 layers (or more for microprocessors) being constructed. Typically, the outcome is a wafer with multi-layered semiconducting devices, known as transistors. The transistors are interconnected with conducting materials, and insulating materials are used to electronically isolate the active components. The net result is a silicon wafer that contains multiple copies of integrated circuit devices. PLAB has developed four categories of photomasks that include binary intensity masks, mature masks (including standard, reduction, and ultratech), phase shift masks, and alternating aperture phase shift masks.

The predominant geometry or line resolution of the masks in the industry today is 130nm (0.13 m) or greater. Most photomask manufacturers have capabilities down to this size. Photronics and just a few other leading edge mask producers can design mask sets down to the 90nm node or lower. The Austin plant is currently in production of 65nm node mask sets. The second 65nm node manufacturing line in Korea has been fully tooled and is preparing to start production. Management continued the investment in developing a 45nm node capability at the same facility. The revenue contribution from the higher-end processes has been steadily increasing. Revenue from 130nm and below design rules was 9% of total revenue last quarter. Over the past six quarters, there has been a distinct shift in revenue contribution from greater than 180nm mask sets to the smaller nodes. This is reflective of a more general industry trend, as well as increasing in-house foundry capabilities at larger nodes. Merchant photomask suppliers must continue to push the edge of the technology envelope in order to survive as economically viable standalone entities. Therefore, PLAB must have a product mix that favors a greater proportion of advanced nodes than a captive supplier.

LCD (liquid crystal display) has grown to be the dominant technology in the flat panel display market. The manufacturing process is a derivative of the semiconductor device or IC process. One major difference is the size of the substrate on which materials are deposited to create the semiconductor devices embedded within the display. Typically, multiple copies of semiconductor ICs are constructed on a 200mm (8-inch) wafer, unlike a single flat panel LCD display that could have a diagonal dimension of 17-inches. LCD displays require large area masks (LAMs) that are used to create transistor devices in a substrate that is physically attached to the glass used in the display. These IC devices control the individual pixels (picture element) in the display. PLAB began developing the technology and production capabilities of LAMs in late 2003 and throughout 2004. The revenue contribution was immaterial during fiscal 2004 having generated only $0.8 million during the October 2004 quarter. During the third quarter of fiscal 2005, LAM mask sets contributed 13% of total quarterly sales, having quickly grown to a significant revenue source. We estimate that the current market share for PLAB is 16% in this estimated $550 million market. Management has committed significant resources to this product area, including a new plant scheduled to begin operations in the first-half of 2006 in Tai Chung, Taiwan.

Photronics operates principally from 11 facilities: five in the U.S., three in Europe, and one each in Korea, Singapore and Taiwan. Photronics sells its products primarily to leading worldwide semiconductor manufacturers. The company's five largest customers contribute 40% to total revenue. Samsung Electronics accounts for 18% of sales. The worldwide market for photomasks was estimated at $2.0 billion in 2004. According to the research firm, The Information Network, the photomask market grew by 18.7% in 2004 and 9.7% in 2005 and the growth will only reach 4.3% at US$3.2 billion in 2006.

Although merchant photomask supplier's growth is expected to be lower than the overall semiconductor industry growth rate, certain leading edge and specialized emerging technologies are expected to earn above-average growth rates. Suppliers in these areas will generate higher gross margins than suppliers producing masks for mature semiconductor production technologies. One trend is the transition to larger 300mm (12-inch) wafers. Additionally, there has been a simultaneous drive to smaller design geometries. The larger wafers and smaller technology nodes provide production cost benefits to manufacturers. It is also clear that there is broad acceptance of LCD technology and that it is the current dominant flat panel display technology. Flat panel displays have already surpassed CRTs in terms of revenue, and exceeded unit volume during 2005. The company is hoping to benefit in the future from these trends by investing heavily into production capability at the smaller nodes and LAM areas. Manufacturing photomasks is an expensive process, requiring significant process expertise and capital investment, which act as a barrier to entry.

As a merchant supplier, the company has had to compete with in-house mask generation operations at the much larger and less resource-constrained manufacturing foundries. Merchant suppliers are increasingly focusing on advanced technology areas. As the 180nm and above technology node matures, more of the mask construction business has shifted in-house. Revenue from this segment of the market continues to decline for PLAB, but has been offset by the rise in sales in the smaller than 180nm sub-segment. Management announced significant strength in the high end area (130nm, 90 nm and transition into 90nm) across all market segments and regions. This quarter marked the first shipment of a 65nm product. Although it will not significantly contribute to revenue until probably fiscal year 2008, the development of the product does speak to PLAB's technology leadership. Advanced masks represented 40% of revenue in the fourth quarter of 2006 up from 32% a quarter ago.

In conjunction with management's focused effort, the company is also expanding its presence in China by increasing the deployment of capital equipment into its Greenfield facility. Japanese customers are increasingly utilizing services provided by this facility. PLAB has been actively allocating resources to qualify the products at new customer facilities, with the intention of expanding the present customer base and increasing market penetration. The qualification process requires the company to absorb costs with the hope of future sales. This will drive margins higher after a period of significant spending.

In two separate transactions over the previous few quarters, PLAB invested $52.4 million in acquiring an incremental 20.5% share of PK Ltd. (PKL), the Korean subsidiary, and now controls 90% of that company. The company has announced a tender offer to purchase the remaining outstanding shares. PKL has particular expertise in the LAM area. Management believes that there is plenty of opportunity in this high-growth advanced technology market segment to further penetrate and increase market share. The company also broke ground on a new LAM facility in Taiwan that is scheduled to begin operations in the first-half of 2006 and contribute to revenue significantly in 2007.

The company paid off its 4.75% convertible bonds when they matured on December 15. The payoff amount will came from the cash and investments account, which will has $110 million left after it was paid down.

Photomask specialty firms have experienced lower growth rates than those of the overall semiconductor industry. As a general trend, pure-play semiconductor foundries continue to design a greater amount of photomasks in-house, rather than outsourcing to photomask specialty firms. These foundries have acquired a number of smaller photomask firms, and are now capable of providing a bundled offering to their captive customers. Procuring manufactured wafers is simplified for fabless companies under this arrangement, since there is only a single vendor delivering the final product rather than a foundry and merchant photomask supplier. Therefore, the merchant photomask market continues to shrink, as more companies go the fables route and foundries take on an increasingly larger portion of the semiconductor manufacturing business. It is apparent that this trend will continue in the foreseeable future, since many Asian and European semiconductor manufacturers have not yet embraced the fabless business model.

Merchant photomask companies have difficulty competing with these in-house operations, since their access to resources is relatively smaller, and they have less pricing flexibility. In a semiconductor manufacturer's bundled offering, mask services can be offered at predatory levels or as loss leaders to the core foundry business. The company is beginning to experience gross margin pressure and declining revenue at the mature, greater-than-180nm nodes, which is evidence of this ongoing trend. It is therefore apparent that merchant photomask companies will only survive as standalone entities in leading edge or specialty areas. PLAB was slow to develop advanced process technology because of the industry slowdown and management's decision to conserve resources and produce better near-term financial results. Consequently, Photronics' proportion of revenue from advanced nodes (130 m and lower) is lower than that of leading competitors.

Another major concern investors need to consider is the heavy debt leverage on the company's balance sheet. Management is making an effort to reduce debt, having extinguished 30% or $96 million in long-term debt over the past four quarters. Finally, Samsung contributed 24% of the company's sales in 2005, while the top five customers together accounted for 42%, adding key customer risk to the list of potentially problematic issues.

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