While the mega-cap “Fab Five” (Nvidia, Apple, Microsoft, Google, and Amazon) are in the vanguard of the “AI Age,” there are lesser known small-cap companies that are critical enablers of the new transistor architectures and advanced packaging needed to produce the next generation semiconductors that underpin major technological advances. MKS Instruments develops and supplies critical components and subsystems used primarily in semiconductor capital equipment—which accounts for 42% of revenue—and electronics and device packaging, which accounts for 21%. The remaining 37% of its revenue comes from MKS leveraging its original technology investments and diversifies its end markets by selling these same solutions into advanced industrial sectors, such as life sciences, research, and automotive. Through organic investment and strategic M&A activities, MKS has expanded its addressable market and built a broad portfolio around its key platforms of vacuum technologies, photonics, and materials. It holds a number one or number two market share in 20 of the 24 categories in which it competes. This key competitive advantage complements technological innovation fueled by significant R&D investment and MKS’s ability to provide “one-stop shopping” and integrated solutions to its customers. MKS works with these customers as they evolve their own technology roadmaps, often leading to MKS’s vital components being designed into next generation and advanced electronics packaging tools. The high switching costs inherent in MKS’s model are reflected in its consistently high 40% gross margins, which it has maintained despite selling to the world’s dominant semiconductor and tool makers.

MKS Instruments (Nasdaq: MKSI)
12/31/23-11/15/24

Past performance is no guarantee of future results.

We think MKS’s earnings power has meaningful upside because recent results have been depressed due to MKS’s higher exposure to the PC, smartphone, and NAND flash memory¹ markets, where demand has been so far slow to recover in 2024. We believe a return to revenue growth will ultimately be driven by favorable secular demand trends such as technology transitions in leading edge logic and memory chips that will require upgraded or entirely new tools and in greater quantity (higher capital intensity). MKS serves 85% of the semiconductor wafer fabrication process, with particular strength in the steps called deposition and etch but should be able to outpace overall wafer fab equipment spending in the next upcycle for semiconductors thanks to its growing presence in lithography, metrology, and inspection—the result of MKS’s multi-year investment in optics capabilities. Its presence in plating chemistries and laser drilling should also allow MKS to capture the greater share of semiconductor spending that’s going to advanced packaging solutions. These solutions allow multiple types of chips to be packaged and function together to enable applications such as AI that can quickly process massive amounts of data.

FormFactor manufactures test and measurement products for semiconductors and mobile devices. It generates 80% of its sales from the production of advanced probe cards that are critical interfaces between the wafer and the electronic test system used to verify the functionality of individual chips before they are packaged. With a 33% market share, FormFactor is the number one player in a concentrated, rational market where the top three suppliers control 75% of sales. In addition to a favorable industry structure, FormFactor’s above average profitability reflects the high switching cost nature of its products. Each probe card, for example, is customized to the specific type of chip being produced.

Due to chip makers’ long manufacturing qualification process, once a probe card is selected, the manufacturer has that business for the chip’s production lifetime—which can last several years. Probe cards are consumables; the cards must be replaced after the needles of each probe card come into contact with the chips on the wafer a certain number of times. This results in less volatile in cash flows as probe cards are an operating expense tied to production as opposed to a large capital expenditure dependent upon major capacity expansion.

In addition, test intensity and complexity are increasing with the emergence of next generation chips and new packaging techniques. For example, High Bandwidth Memory (“HBM”) is a form of 3D-stacked DRAM memory² used in AI because it can read and store data at faster rates but has a smaller footprint and uses less power. HBM is achieved through a form of advanced packaging in which multiple layers of chips are stacked on top of each other. This design requires greater probe card usage because each component chip must be probed and tested prior to stacking. The stack is then tested at various points as it is being built. HBM probe cards carry higher average selling prices since they are more complex given the more challenging specifications that HBM chips must meet.

FormFactor (Nasdaq: FORM)
12/31/23-11/15/24

Past performance is no guarantee of future results.

FormFactor’s stock has lagged so far in the second half of 2024, hurt by the same slow demand recovery for chips used in PCs and smartphones that’s hampered MKS’s shares, as well as by “inventory digestion” in 3Q24 by its main HBM customer. However, the same secular trends that we think can revitalize MKS’s revenue over time also hold for FormFactor. Moreover, FormFactor expects HBM growth to resume in 4Q24 and into 2025 as its main customer expands production to meet demand. FormFactor’s design wins with another memory manufacturer should also begin to bear fruit as their HBM volume builds. Finally, 2025 should see the advent of the next iteration of HBM, which will have twice the number of chip stacks as the current generation.

Outside of tech, we believe that Brady Corporation, which manufactures industrial identification solutions, is a quality, long-term compounder, and we’ll look to add to our position on any share price weakness. Through continuous innovation and bolt-on acquisitions, Brady has a broad product portfolio of industrial printers, bar code and RFID readers, as well as labels, wire markers, and other consumable media. Its broad product offerings allow it to provide complete solution sets directly to customers and distributors. These materials-science driven, often tailored, solutions target compliance, safety, and identification applications across several industries.

About 80% of Brady’s sales are driven by customers’ need to comply with industry regulations (for example, labels and tags for aerospace tubing and wiring that must withstand extreme temperatures and be resistant to fluids and oils). Ensuring product safety is a related source of demand for Brady’s products such as life sciences specimen laboratory labels that don’t smear or fade and can withstand cryogenic storage. Brady’s product identification solutions help customers improve efficiency through traceability, including bar codes placed on a printed circuit board to track it during production, storage, and installation. Its offerings tend to be a low percentage of its customers’ operating expenses, but offer high value, as reflected in Brady’s gross margins that sustainably hover near 50%.

The company’s intentional focus on niche or customized applications has enabled it to build high product market shares of 30% on average and strong brand name recognition. Its “go-to-market” strategy further insulates it from competition as the smaller to mid-size industrial companies that are the focus of Brady’s direct sales typically don’t generate the volume to be cost effectively served by Brady’s larger peers, while Brady’s smaller competitors often can’t match its portfolio breadth or R&D investments.

Brady Corporation (NYSE: BRC)
12/31/23-11/15/24

Past performance is no guarantee of future results.

These factors, along with the razor (label printers or scanners)/razor blade (printer media) model of its business, are keys to its sustained returns on invested capital of more than 20%. Brady’s current CEO, who took over in 2022 after several years at the helm of the company’s ID Solutions franchise, has been exiting underperforming businesses that prior management teams acquired or pursued in the name of diversification. Brady now seeks to sustain organic growth at least double the pace of GDP via increased investments in new product development, ongoing expansion of its digital sales channel, and geographic expansion, while supplementing its offerings with acquisitions, including several that allowed Brady to become a one-stop shop for track and trace solutions (which various industry regulatory bodies are increasingly mandating, especially in Europe). Its recently closed purchase of Gravotech expands its addressable market by adding direct parts marking and engraving to its product identification portfolio.

¹ “Not and,” or NAND, flash memory is a storage technology that does not require power to retain data.

² Dynamic random-access memory, or DRAM, is a type of random-access memory that stores data and program code in computers and is a key component in many computing devices.

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