Where in the Semi Cycle Are We? (well ...down more from last post)
S&P thinks chip demand will continue strong, but it suggests that investors stick with big names, such as Applied Materials
The divergence between stock returns and company fundamentals for the semiconductor-equipment industry has been startling this year, in our opinion at Standard & Poor's. Allowing for the obvious exogenous variables that have penalized technology companies overall -- including terrorism, oil prices, worries over interest rate hikes, and potential stock-option expensing, among others -- there's a wide range of opinions on where we are in the semiconductor cycle. Advertisement
It's generally believed that this cycle consists of four-year intervals of upturns and downturns. As such, demand for manufacturing equipment also ebbs and flows, driving business for front- and back-end products. Given the economic sensitivity of this cyclical industry, we aren't surprised about the wide range of opinion on where in the cycle the industry is any given time.
A case could be made that the extreme volatility of the last two cycles -- an upturn from 1996-2000, followed by a severe downturn through 2003 -- could be followed by an unpredictable period that doesn't follow the historical cycle trends. We believe a lack of visibility could explain much of the price-earnings multiple contraction we've seen throughout this year, despite positive operational performance.
NEW EQUIPMENT NEEDED. We believe that demand for chips worldwide is strong and should continue, assuming the global economy remains intact. Beyond computers, chips are increasingly ubiquitous in our daily lives, used in everything from autos to multimedia products.
To meet the demand for increasingly complex chips, semiconductor manufacturers need to buy new manufacturing equipment. Intel (INTC : 3 S&P STARS, or hold; recent price: $23) has invested substantially throughout the downturn. Other companies, such as Taiwan Semiconductor (TSM : 5 STARS, or buy; $7) and United Microelectronics (UMC : 4 STARS, or accumulate; $4), are reporting record revenue in recent quarters, and we believe capacity utilization is in the high 90% range. Therefore, we think production capacity must rise.
In our view, across-the-board capacity utilization appears to be too high, and additional spending is needed to raise production capacity. This represents maintenance equipment purchases that do not include the large number of new wafer-fabrication plants slated to come on line over the next two or three years.
NOT TOO HOT. The Semiconductor Equipment & Materials (SEMI) trade group recently increased its expectation for industry growth this year from almost 40% to 60%, and indicated that it saw no signs of a slowdown through mid-2005. SEMI also released June book-to-bill data that remained above parity at 1.08, though slightly below May's 1.10.
We believe this trend of healthy order-flow bodes well for a sustainable upturn that's less likely to overheat, as we think customers are spending more rationally this cycle. We would also note that while the ratio has declined modestly over the last three months, from 1.13 in April, the absolute value of orders in each of those periods has increased, and June's $1.6 billion represents a more than doubling from the prior year. We think it's important to point out that this represents just over half the booking level of $3 billion reached in the prior peak month of October, 2000, suggesting there's plenty of room for expansion.
The anecdotal evidence from individual companies is somewhat murky. On the bullish front are a recent earnings report and update from Novellus (NVLS : 4 STARS; $27), a leader in equipment that forms interconnections on a chip. The company reported a year-over-year revenue increase of 42% and corresponding operating earnings per share of 29 cents, vs. our 27-cents expectation. Novellus cited strong bookings in the current quarter, combined with improved operating leverage as a basis for increasing guidance for the current quarter. We now look for Novellus to earn $1.22 a share in 2004, vs. our previous estimate of $1.07. Similar positive comments were echoed by ASML Holding (ASML : 3 STARS; $15) in Europe.
OBTUSE REACTION. A bearish case that recently took the group down can be found in KLA-Tencor (KLAC : 4 STARS; $41), a supplier of back-end inspection and yield-management systems. It originally suggested in April that second-quarter orders could be anywhere from up 10% to down 15%. The company cited the timing of two large Asia orders as the basis for the wide range. In early July, KLA-Tencor stated that orders would be flat, which we believe suggested one order was completed. We think the second order was completed earlier this month. As a sign of investor skittishness, the stock retreated approximately 16% from its June 30 closing price of $48.59.
What does this suggest? As we wade through the volumes of earnings reports over the next few weeks, culminating with industry leader Applied Materials (AMAT : 5 STARS, or buy; $17) in August, second-half visibility and any 2005 comments from the companies have become the focal point of our sector outlook. While the tenor of business has been solid during the first half of 2004, debate rages as to its sustainability.
We believe much of the uncertainty is already discounted in the stocks, but investor reaction is likely to be obtuse. Within the context of negative sentiment, there appears to be little near-term catalyst as the seasonal technology slowdown unwinds. Also, we believe investors have largely ignored the strong operating environment these companies have enjoyed throughout the last year.
We see the classic "growth at a reasonable price" scenario playing out amid one very large, unclear assumption: that the earnings of these companies will continue to grow. We don't argue with the lack of visibility and necessary discount that implies. However, given the strong macroeconomic drivers combined with our outlook for strong operating leverage, we believe the recent share-price declines may be overdone. In this period of uncertainty, we prefer the more diversified front-end providers with economies of scale, and suggest investors choose the quality names including Applied Materials.
Note: Colin McArdle has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. (SPSI). Affiliates of SPSI received noninvestment-banking compensation from Intel, KLA-Tencor, and Applied Materials during the past 12 months. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com
Analyst McArdle follows semiconductor equipment stocks for Standard & Poor's Equity Research |
