To all: my apologies if this has already been posted
from Briefing.com........
StreetBeat
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Updated 04/03/98
StreetBeat is designed to provide you with additional insights on the market from recognized financial experts on (and off) Wall Street. Please note that the views and opinions expressed by the panelists below are not necessarily those of Briefing.com.
This week's topic: Semiconductor Equipment Companies
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Panelists
Gus Richard, Technology Analyst at Hambrecht & Quist. John Pitzer, Vice President and Semiconductor Equipment Analyst at Needham & Co. Brett Berry, Senior Vice President and Co-Manager of Equity Portfolios at Bailard, Biehl, & Kaiser.
Q&A
Briefing: Do you agree with the assumption that Asia's impact has been fully discounted in stock prices? Has the sell-off been warranted?
Gus Richard: Yes, I think that Asia was discounted in prices last fall. I began to get negative last June when I ran across foundries such as AlphaTech in Thailand and Innerconnect in Malaysia that could not get financing. Further research revealed that debt-to-equity ratios for Korean companies were rising and the Korean economy was faltering. DRAM prices were on a precipitous declining slope. I chose the unpopular path of turning negative. When the Asian crisis finally hit in late October, it came as a shock to investors. However, I think that maximum investor uncertainty was not felt until December. It was clear by that point that capital spending out of Asia, which comprises 50% of spending in the equipment sector, was slowing dramatically. When history is reviewed, I think that the maximum impact of this crisis will have been felt in the March and June quarters of this year.
One needs to understand the nature of commodity products. There is a tendency for producers of commodity products initially to increase production in an effort to offset slumping prices when oversupply is reached. This creates a supply/demand imbalance which is what we have seen happen in the DRAM market. Oversupply means greater pricing pressure. This ultimately results in a radical reduction in capital spending and eventually drives supply and demand into balance as inventories are consumed. A latency develops between "oh no, we have no money" and "oh no, we have no products". That time is roughly 9-18 months and usually shortages develop as demand continues to grow.
In the past year, we have seen rapid price reductions in PCs, cell phones and other chip-dependent products which has caused an inventory compression because no one wants to hold older inventory. Lead times have been reduced from 4-8 weeks to just-in-time. Lean inventory will work until demand for chip parts gets rolled back from just-in-time to delays that cause companies to be late shipping a product then customers will begin to double-order to build inventory. Presently, semiconductor companies are trying to work off excess inventories while they get an understanding of the impact of Asia, the first quarter (always a sloppy time for inventories), and the impact of the sub-$1000 PC on the industry. As PCs continue to proliferate, I think that elasticity will take over and cause chip demand to overtake supply. The problem is no one knows when this will happen . The aggressive stance is that it could happen as early as fall 1998 because of seasonal factors. The conservative stance is that it will happen in fall 1999. My suspicion is that fourth quarter of this year and first quarter of next year will mark the reversal.
John Pitzer: Clearly, Asia has had an impact on stock prices, yet it probably has not been completely factored into fundamentals just yet. Nevertheless, investors are choosing to look past the next several quarters to growth prospects in 1999, and as a result, share prices have begun to move higher. This mentality, however, is only possible because this is a cash-rich market.
Considering that this sector derives 40%-50% of its revenue from Asia, the selloff has been warranted, but I do think it has probably been overdone. The question now is, has the recent run-up been unwarranted? Relative to the broader indices, valuations for the chip equipment makers appeared cheap in January and February. Today, these stocks are trading on the expectations of a turn-around in order rates in Q4C98 or Q1C99, leading to a strong growth year for the industry in 1999. However, this makes the stocks vulnerable to another downturn if the turn-around does not materialize as expected.
Brett Berry: I agree that all "known" news has been factored into stock prices, what may not be factored in is a second round of currency devaluations or breakdowns in countries that have held up so far. I agree that the selloff has been warranted.
Briefing: Which companies hold a competitive advantage as chip makers adopt new process technology and require next generation devices?
Gus Richard: The big winners will be KLA-Tencor, Applied Materials and Novellus, and Teradyne - the big get bigger and the small roll over and die in this business. It is an oligoloply with market share aggregating to 2-3 dominant players. Success requires scale and critical mass to leverage channels and the research and development effort. However, a few small niche players will be able to survive and I think that ATMI, Inc (ATMI) is one such player. They have a strong patent position in new and existing materials and materials delivery systems. I believe that ATMI is well positioned to benefit from the adoption of new materials that will be required in the transition to 0.18 micron and 0.13 micron process technology.
John Pitzer: With chip makers shifting to new technology, we feel Applied Materials and Novellus Systems hold an advantage among the large-cap players. The former gained market share and outperformed the rest of the industry in 1997, and is well-positioned to capitalize on the shift to 0.25 micron process technology. As for Novellus Systems, it stands out above the rest given its focus on copper deposition-- a technology which should become more prevalent in the first half of 1999 as chip makers make the transition from aluminum to copper. Unlike many of its competitors, Novellus provides a complete suite of copper deposition tools.
Electro Scientific is a mid-cap name that also stands to benefit. The Company has successfully diversified its revenue stream which helps to mitigate the slowdown in the semiconductor industry. Given its solid growth prospects, this stock is cheap relative to its peers. Finally, Speedfam International, another mid-cap company, should benefit from its good position in the chemical mechanical planarization (CMP) market. With the shift to 0.25 micron, we'll see greater use of CMP as it is critical to get to the next generation chip.
Brett Berry: Well, Applied Materials is the obvious choice here. Their financial strength is unrivaled in the industry giving them a leg up in the consolidation game that I think is about to unfold. Also, they have a history of coming out of downturns in better shape than their competitors.
Briefing: What is your outlook for the second half of the year?
Gus Richard: The first and second quarters will be marked by weak orders and revenues. However, when capital spending has been substantially reduced for a couple of quarters it usually means that capacity ages. At this point, we typically see a resurgence in R&D because manufacturers must continue to invest in new technology. It is imperative that the equipment companies be positioned with the latest technological advances as it drives low cost manufacturing. We will probably see orders pick up in the summer driven by this, by seasonal factors, and by Intel's move to the 0.18 micron chip. Foundries will pick up again as the pattern of build-in-the-summer for delivery-in-the-fall to meet expected sales at Christmas takes affect.
John Pitzer: January and February were abysmal months for orders. In March, things stabilized, but at lower levels, so there really wasn't much improvement. Unfortunately, the June quarter doesn't look much better, and we anticipate that orders are likely to remain at depressed levels as the industry is still in a state of overcapacity, especially in the commodity memory market. However, against the backdrop of a healthy PC market, along with the need to drive to the next technology nodes, o.25 micron and then later 0.18 micron, we would expect to see an increase in order activity in the fall going into 4QC98.
Brett Berry: I think the second half of 1998 will see continued weakness but not to the degree we've seen in the past six months. Then I believe we'll see industry consolidation, the strong companies getting stronger through acquisitions of weaker, niche competitors. Toward the end of the year, I expect stabilization but still very little growth. This will set us up for a good 1999 however.
Briefing: Which stocks are you recommending and/or avoiding?
Gus Richard: The only company in the equipment or material sector that I have a STRONG BUY on is ATMI, Inc (ATMI). Among the large cap companies in this group, I like Applied Materials (AMAT), Novellus (NVLS), and KLA-Tencor (KLAC).
John Pitzer: I have BUY ratings on Applied Materials (AMAT), Novellus Systems (NVLS), Electro Scientific Industries (ESIO), and Speedfam International (SFAM).
It is important to keep in mind, though, that stock sentiment at the moment is running contrary to fundamentals, and I don't expect fundamentals to improve for another 6-9 months. Subsequently, it would behoove investors to gravitate to large-cap names as opposed to small-cap companies which are less liquid given how quickly sentiment can turn. If looking to commit new money, I would suggest building only a partial position at this time with the realization that you may have to average down later. Investors need to remember, too, that chip equipment is a cyclical industry, and downturns provide great entry points to buy industry leaders who always emerge from downturns in a stronger competitive position than before.
Brett Berry: We currently have no chip equipment stocks in our portfolios and will probably maintain that position for the next few months. If we get another big pullback in the stocks, the names I would look hard at are Applied Materials (AMAT) and KLA-Tencor (KLAC). The stocks I would avoid are those second-tier players that may be undercapitalized. It's going to take a strong balance sheet to get through the hard times we've already seen and those that I foresee up the road.
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