GS US SEMI EQ. WEEKLY: HISTORICALLY,
WEAK FUNDAMENTALS PREVENT Q4
STOCK RALLIES
Summary: (1) We believe portfolios are positioned for a Q4 stock rally but history shows
that weak fundamentals make a Q4 rally less likely, (2) A look back at history calls the
likelihood of a brief and painless downturn into question. Orders have declined for 10
consecutive months in the average downturn over the last 10 years. Our supply/demand
model and normalized semi equipment shipment trendline work suggests that this
downturn won't be any different. We believe it will be at least several quarters before the
market discounts the bottom appropriately, (3) LRCX and NVLS are both reporting
earnings after the close on Wednesday. We believe the business outlook deteriorated
meaningfully at the end of the quarter and we therefore expect management tone to be
cautious on the calls. We expect Dec. quarter order guidance of -10% seq. for both
companies, and (4) News, Events and Price Performance.
WE BELIEVE PORTFOLIOS ARE POSITIONED FOR Q4 STOCK RALLY BUT
HISTORY SHOWS THAT WEAK FUNDAMENTALS MAKE A Q4 RALLY LESS
LIKELY. We believe that investor portfolios are now clearly positioned for the typical
seasonal improvement in fundamentals and, in turn, the stocks. While most take the
seasonal rally in fundamentals and stocks for granted, we now believe that a seasonal
stock rally is less likely due to the weak cyclical environment for the semi and semi
equipment companies. The data below show that in the early stages of a cyclical
downturn, stocks don't usually rally in Q4. In Q4s that precede the first year of an
industry downturn (i.e. the first year of below trend semi revenue growth), the SOX or
NDX (before the SOX was available) hasn't had the rally that investors typically expect
For example, in Q4'95, the stocks were down -27% q-q in Q4 as fundamental growth
disappointed (with CQ4'95 semi revenue growth only +5.6% q-q), which drove the
market to focus on the likelihood of weak fundamentals in 1996 (which wound up being
the case as semi revs were down -8.6% y-y in 1996). History repeated itself in 1997 as
stocks were down -31% q-q, as CQ4'97 revenues were -2.9% q-q, which led the market to
(rightly) become concerned with out-year revenue prospects. The markets' fears were
confirmed as semi revs declined -8.5% in 1998. Again in CQ4'00, stocks declined by
-32.3% as semi revs were down -3% in CQ4'00, which was a precursor to the -32% y-y
revenue decline in 2001. Note that the story doesn't hold in the second year of a semi
industry downturn. For example, stocks did rally in CQ4'01 despite the fact that both
CQ4'01 and 2002 y-y semi revs were disappointing, but note that the Street was already
well aware of the severity of the downturn by that time as most investors had given up
hope by that point in the 2nd year of that downturn that the industry would ever see
fundamental improvement again. The same story is true for CQ4'96 as full-year
fundamentals had been weak leading up to that period and the Street understood the
severity of the downturn by that time.
The moral of this story is that the Street is pretty smart over any kind of meaningful
period of time. It's normal for investors to try and add beta to portfolios heading into
year-end, but in years in which CQ4 fundamentals disappoint and the market begins to
focus on the likelihood of negative cyclical trends in the following year, investors should
and do sell the stocks hard exiting the year. We would expect a similar trend as we
approach year-end 2004. Our supply/demand work suggests that CQ4 fundamentals will be weak
for semi and semi equipment companies and we expect that weakness to persist well into 2005
(with the ultimate length and duration of the downturn unclear until we see how quickly the
industry stops adding excess capacity). The stock performance of the last several weeks makes it
crystal clear that investors are playing the beta trade as we approach year-end and the data below
(along with the very weak current fundamental picture) make it clear that there is a great deal of
risk in assuming such positions. We believe the stocks could make new cycle lows as we approach
year-end 2004 and the Street comes to grips with the reality of the current semi equipment
downturn.
Semi SOX/NDX Semi Industry
Rev Growth Quarterly Perf. Q-Q Rev Growth
(y-o-y) (in Q4 of prior year) (in Q4 of prior year)
1990 3.6% -1.1% 0.2%
1991 8.1% 13.3% 4.3%
1992 9.6% 15.1% 0.5%
1993 29.1% 15.0% 3.8%
1994 31.8% 4.1% 1.1%
1995 41.7% 8.8% 8.5%
1996 -8.6% -27.1% 5.6%
1997 4.0% 28.2% 6.8%
1998 -8.5% -30.9% -2.9%
1999 19.1% 64.8% 10.5%
2000 36.8% 41.2% 16.0%
2001 -32.0% -32.3% -3.0%
2002 1.3% 39.7% -0.1%
2003 18.3% 21.4% 1.9%
Source: WSTS Global Semiconductor Sales Report/Blue Book 1985-2003,
FactSet.
A LOOK BACK AT HISTORY CALLS THE LIKELIHOOD OF A BRIEF AND PAINLESS
DOWNTURN INTO QUESTION. ORDERS HAVE DECLINED FOR 10 CONSECUTIVE
MONTHS IN THE AVERAGE DOWNTURN OVER THE LAST 10 YEARS. OUR
SUPPLY/DEMAND MODEL AND NORMALIZED SEMI EQUIPMENT SHIPMENT
TRENDLINE WORK SUGGESTS THAT THIS DOWNTURN WON'T BE ANY DIFFERENT
AND FRONT-END ORDERS DECLINED LAST MONTH FOR THE FIRST TIME IN THIS
CYCLE. WE BELIEVE IT WILL BE SEVERAL QUARTERS BEFORE THE STREET STARTS
TO DISCOUNT THE BOTTOM APPROPRIATELY. We have heard calls for a brief and painless
downturn from so many circles recently that we were forced to take a look back at historical data to
see how long semi equipment downturns typically last. Using the SEMI book-to-bill data, we put
together the following table:
Semi Equip Orders % Decline
Feb.'96 - Sept. '96 -54% 7 months of declines
Dec. '97 - Sept. '98 -71% 10 months of declines
Oct. '00 - Nov. '01 -80% 13 months of declines
Average -68.2% 10 months
Source: SEMI.
The unfortunate fact of the matter is that downturns last a lot longer than anyone wishes they
would. In the recent upturn, the semi industry added as much excess capacity as it has in any cycle
other than the bubble of 1999/2000. Our analysis of normalized semi equipment shipments on a log
scale shows that the area above the curve in the upturn that just ended is greater than the areas
above the curve in all other cycles except the bubble. In other words, the semi industry added too
much capacity during the upturn and this downturn will be normal in either duration, severity, or
both. The book-to-bill data shows that we are only 1 month into a downturn that typically lasts
about 10 months. Given the number of folks on the Street that are trying to hyper-discount the
cyclical bottom (i.e. call the bottom before the downturn even starts), we believe it is likely that
investors will eventually become disenchanted waiting for a cycle bottom and the stocks will make
meaningful new cycle lows.
LAM AND NVLS ARE BOTH REPORTING EARNINGS AFTER THE CLOSE ON
WEDNESDAY. WE BELIEVE THE OUTLOOK DETERIORATED MEANINGFULLY AT
THE END OF THE QUARTER AND WE THEREFORE EXPECT MANAGEMENT TONE TO
BE CAUTIOUS ON THE CALLS. WE EXPECT DEC. QUARTER ORDER GUIDANCE OF
-10% FOR BOTH COMPANIES.
LAM RESEARCH (LRCX; IL/N) earnings expectations: Lam Research will report
September-quarter (first fiscal quarter 2005) earnings on October 13th after the market close. We
model revenues of $410 million (up 24% sequentially) and earnings per share of $0.58, versus the
Street consensus earnings per share estimate of $0.59. We forecast September-quarter orders of
$430 million (up 5% sequentially), in-line with management's guidance for +5% sequential order
growth. While management has been among the most aggressive on the Street, we would expect
the company to guide for a 9% sequential decline in orders in December ($390 million in orders),
as we believe that business conditions weakened incrementally over the last several weeks (for the
entire industry).
We forecast December-quarter revenues of $440 million (up 7% sequentially) with earnings per
share of $0.67, versus the Street consensus EPS estimate of $0.61. Our above-consensus earnings
estimate for CQ4 is driven by our belief that the revenue recognition accounting principle
SAB-101, which allows companies to recognize revenues on systems shipped in previous quarters,
will allow Lam's revenues and earnings to grow for a few more quarters after shipments peak
(which we believe happened in June). Recall that Lam recognizes all revenue upon customer
acceptance (as opposed to the bifurcated method used by the other front-end companies) and
SAB-101 has an exacerbated impact on Lam's revenues.
NOVELLUS SYSTEMS (NVLS; IL/N) earnings expectations: Novellus will report
September-quarter earnings on October 13th after the market close. We model 3Q2004 revenues of
$415 million (up 23% sequentially) and earnings per share of $0.39, versus the Street consensus
earnings per share estimate of $0.38. We also project 3Q net orders of $420 million, up 6%
sequentially. Note that we are estimating flat organic order growth during the quarter. We expect
the company to guide for an approximate 10% sequential decline in orders for the
December-quarter to about $380 million. We believe that management is likely to be more cautious
in its tone on its earnings call as our quarter-end checks suggested that the business outlook
deteriorated meaningfully (for the entire industry)during the last few weeks of the quarter. Note
that in terms of revenue and earnings guidance, we forecast December-quarter sales of $430
million (up 3% sequentially) with earnings per share of $0.44, versus the Street consensus EPS
estimate of $0.38. We are modeling above consensus earnings for the December-quarter due to the
impact of SAB-101, a revenue recognition accounting principle that allows companies to recognize
revenues on systems previously shipped, which we believe will allow the company's revenues and
earnings to sustain for a few more quarters after orders peak. Also, we are modeling a lower
sharecount then the rest of the Street for the out-quarters as management has been aggressively
buying back shares during the quarter and we don't believe the Street has accounted for this
buyback in its models yet.
News, Events and Price Performance
Last week
Monday 4 October (1) KLA-Tencor signed an agreement to acquire Candela Instruments, a
supplier of laser-based surface inspection systems to the data storage industry. (2) Teradyne's
manufacturing operations in Shanghai, China and Penang, Malaysia received certification to the
ISO 14001 Environmental Management Standard.
Tuesday 5 October (1) Credence Systems negatively preannounced its CQ3 results. The company
now expects revenues to be in the range of $110 million - $115 million, compared to previous
guidance of $140 million to $150 million. LPS is expected to range from -$0.17 to -$0.21 vs.
previous EPS guidance of $0.05 to $0.10. Please see our 10/6 note for additional details.
Wednesday 6 October (1) Varian shipped its 100th single wafer VIISta high current ion implanter.
(2) Veeco completed the acquisition of Manufacturing Technology, a privately held manufacturer
of slicing and dicing equipment for the data storage industry, for $9.5 million in cash.
Thursday 7 October (1) KLA-Tencor and IMEC, a nanotechnology research center in Belgium,
entered into a project to accelerate the adoption of optical critical dimension metrology technology
for next-generation semiconductor applications. The project will focus on extending the use of
optical CD metrology in current applications to the sub-65-nm node and expanding the
proliferation of optical CD metrology into new applications (3-D contact and via layers). (3) Varian
received a $22 million payment from Applied Materials as a result of an arbitration panel ruling in
a patent infringement case involving the two companies.
This week's calendar:
Wednesday 13 October: (1) Novellus Systems (NVLS-$26; IL/N) reporting earnings. GS $0.39;
Street $0.38. (2) Lam Research (LRCX-$22; IL/N) reporting earnings. GS $0.58; Street $0.59.
GS Universe Price Performance 10/8/04 Price performance
Ticker Company Name Rtg Close Week MTD QTD YTD Y-Y
Semiconductor Capital Equipment
AEIS Advanced Energy Industries IL/N 10 -2% 7% 7% -62% -54%
AMAT Applied Materials IL/N 16 -6% -2% -2% -28% -19%
ATMI ATMI Inc. IL/N 20 -7% -2% -2% -13% -18%
ACLS Axcelis Technologies IL/N 8 -8% -1% -1% -20% -13%
BRKS Brooks Automation IL/N 14 -4% 1% 1% -40% -38%
CMOS Credence Systems U/N 7 -7% -1% -1% -46% -45%
ENTG Entegris IL/N 9 -7% 3% 3% -33% -33%
FORM FormFactor OP/N 20 0% 4% 4% 2% -21%
KLAC KLA-Tencor OP/N 41 -5% -1% -1% -30% -28%
LRCX Lam Research IL/N 22 -4% -1% -1% -33% -16%
MKSI MKS Instruments IL/N 16 -3% 4% 4% -45% -32%
NVLS Novellus Systems IL/N 26 -6% -1% -1% -37% -27%
TER Teradyne Inc. U/N 14 -2% 5% 5% -45% -27%
Mean -- -- -5% 1% 1% -33% -28%
Median -- -- -5% -1% -1% -33% -27%
Source: Factset.
I, Jim Covello, hereby certify that all of the views expre |
