From Individual Investor 9/9:
The year 2000 has been one of smooth sailing for the semiconductor industry. It saw the Philadelphia Semiconductor Index (SOX) advance 60% from 713.2 at the beginning of the year to 1142.6 at the close of trading Friday, September 8.
Yes, there have been patches of rough water along the way - - mid-May and late-July come to mind - - but, for the most part shares of semiconductor companies have been steadily rising as the companies reported quarter after quarter of stellar results driven by voracious demand for all manner of products ranging from mixed signal analog chips to flash memory products to Intel's (NASDAQ: INTC - Quotes, News, Boards) tried and true Pentium processors.
Now, however, there appears to be a storm of confusion brewing that could send shares of semiconductor companies off their proverbial course.
On Tuesday, shares in the sector swooned as Credit Suisse First Boston analyst Charles Glavin downgraded Intel and U.S. Bancorp Piper Jaffray analyst Ashok Kumar warned in a note that Intel's revenue growth might fall short of forecasts.
Adding insult to injury, the very next day Donaldson, Lufkin & Jenrette (DLJ) analyst Boris Peetersik cut his rating on Micron Technology (NYSE: MU - Quotes, News, Boards) from Buy to Underperform and dropped his 12 month price target from $122 to $50, citing concern over softening DRAM spot prices. Over these two days alone, the Philadelphia SOX fell more than 7% before it rallied on Thursday and then plunged again on Friday.
The choppiness exhibited by the sector this week is likely to continue as both Wall Street and investors are at odds over whether the infamous semiconductor cycle has peaked. On one hand you have the sentiment expressed in the DLJ report, on the other you have the fact that seven other analysts have raised their estimates for Micron for fiscal 2000 and 2001 over the past month.
Who's right and who's wrong? Is the semiconductor industry going to run aground or is it going to slip through the rocks into clear water? Most importantly, how should investors react in this confused atmosphere? Here are our thoughts:
The industry's fundamentals remain good as evidenced by the July report released Semiconductor Industry Association, the most recent month for which data is available.
Year-to-year shipment growth was a strong 45% in the month with DRAM growth coming in at 90% on a year/year basis and flash memory shipments growing at a 139% clip.
Overall capacity utilization continued to increase to 95% in the June quarter, up from 89.1% in the prior year's period and a good indication of the health of the industry. Furthermore, it can be argued that the concern over DRAM pricing is overblown due to the fact that summer tends to be seasonally weaker due to soft European demand.
That being said, we believe that the fundamentals of the industry are good but not excellent as certain segments of the market are showing signs of decelerating growth. Some examples include the modest slip in the overall rate of shipment growth from the 61% peak it reached in June.
Similarly, although Flash memory shipments grew 139%, that's significantly below the 200% rate experienced earlier this year. And microprocessors…microprocessors actually posted a 5% decline in shipments in July.
In the face of this decelerating growth, we believe that the majority of semiconductor stocks are too richly valued as they trade at an average 41 times trailing 12 month earnings and that the risk/reward ratio has shifted toward the downside. In general, we would urge investors to sell shares into the inevitable rallies going into earnings season and lock-in the profits from the run over the past year.
There is, however, one segment of the industry that we think does still possess further upside potential - the semiconductor capital equipment manufacturers. The reason? These companies tend to peak about six months after the semiconductor industry overall and thus, despite decelerating growth in some areas of the market, have good visibility for the rest of fiscal 2000 and all of 2001.
According to the report "Equipment and Materials for Sub 0.25 micron Processing: Timing, Trends, Issues, Market Analysis" recently published by The Information Network, the worldwide equipment market will grow 46.1% in calendar 2000 with total revenue reaching $37.1 billion.
Considering that sales for the first half of 2000 totaled $21.9 billion, this implies strong sequential growth. Furthermore, the report indicates that 12 new manufacturing fabs and 16 major expansions are slated for 2000 and an additional 16 new fabs and 15 major expansions in 2001. Hence, worldwide semiconductor capital equipment spending is expected to grow 54.1% in 2000 and 40.6% in 2001, both indications that this segment of the industry has room to run.
Two of our top picks in the equipment market are industry behemoth Applied Materials (NASDAQ: AMAT - Quotes, News, Boards) and small cap Silicon Valley Group (NASDAQ: SVGI - Quotes, News, Boards) .
Applied Materials is the world's leading supplier of wafer fab equipment with strong positions in each of its markets and generated close to $10 billion in revenue over the past four quarters. Compared with non-equipment semiconductor companies, Applied Materials trades at a reasonable multiple of 21 times fiscal 2001 estimates of $3.55 and is expected to grow earnings through 2001 at a 48% clip.
The company's book-to-bill ratio declined sequentially to 1.2 in the third fiscal quarter ended July 20, from 1.34 in the April quarter, but backlog came in at an extremely healthy $3.69 billion. While these numbers aren't as impressive as those recorded by its smaller counterpart Silicon Valley Group, Applied Materials is the leader in the capital equipment market and deserves to trade at a premium.
Silicon Valley Group is another provider of automated wafer-processing equipment to the worldwide semiconductor industry, albeit on a smaller scale as it generated a mere $791 in revenue over the past 12 months. This is a nice conservative play as the company currently trades at a multiple of 14 times fiscal 2001 estimates of $1.85 despite projected earnings growth in excess of 45%. The company also sports a book-to-bill ratio that stood at 1.75 at the end of the June 30 quarter and a backlog that represented 8.9 months of sales.
Bottom Line:
The next couple of quarters may be rough for the semiconductor names that were so dependable through 1999 and the first half of 2000, but focusing on shares of equipment suppliers like Applied Materials and Silicon Valley Group is one way to ride out the storm.
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