Here it is:
Chip-Equipment Stocks Aren't as Rich as They Seem
By Bill Alpert
Has the semiconductor-equipment business turned up? Smart gains by shares like Applied Materials and KLA-Tencor say yes.
But are these firms selling more of their chipmaking tools? Thanks to the unintended effect of government accounting reforms, it's hard to know. A leading indicator in past business cycles was the industry's book-to-bill ratio -- a comparison of industry orders to sales, compiled monthly by the Semiconductor Equipment and Materials International trade association. This year, however, the book-to-bill ratio became a duller instrument for timing industry turns, as SEMI changed the measure to reflect the way that public companies have changed their sales accounting at the behest of the Securities and Exchange Commission.
Hardware Crash So far this year, the Dow Jones Computers Sector Index has posted a decline that is twice that of the Nasdaq Composite. As IBM's recent slump demonstrates, the sector will remain vulnerable until a pick-up in corporate IT spending finally emerges.
"It's made a difficult industry more difficult to understand," says Byron Walker, an analyst at UBS Warburg. A fast rising book-to-bill number used to be a huge Buy signal, he says. Now, the book-to-bill's new math delays the appearance of a sales upturn. In these cyclical stocks, investors make much of their money by correctly picking inflection points. It would be nice to know where the inflection points are.
Over the last year, many publicly held companies have changed their accounting for revenue, to follow the guidance of the SEC's Staff Accounting Bulletin No. 101. A company should not necessarily book revenues at the time that it ships a product, says SAB 101, but rather when the customer has accepted the product and is sure to pay. In the semi gear business, months can pass between a product's shipment and its final certification. When firms like KLA-Tencor changed over to SAB 101 revenue recognition last year, they started deferring recognition of huge hunks of revenue that they'd previously recognized upon shipment. By the rough calculation of one industry analyst, about half of the earnings of gear makers like KLA-Tencor and Novellus were time-shifted when they stopped counting sales at shipment.
Shipments also formed the bottom part of the book-to-bill ratio that SEMI compiles in the third week of every month, from confidential company submissions. Elizabeth Schumann computes that monthly figure, as SEMI's director of industry research and statistics. Her customers still wanted a monthly measure of shipments, even as SAB 101 obscured shipments in company financial reports. A year ago, most companies said they would continue sharing shipment figures with SEMI.
"But when they actually had to do it," says Schumann, "more and more companies said they could no longer report the monthly value of what they'd shipped." So in January, SEMI started using SAB 101-style revenue numbers in the book-to-bill ratio.
SEMI's Schumann urges people to focus on the "bookings" part of the book-to-bill as the more forward-looking part of the statistic. "Other things people should look at are semiconductor activity and capacity utilization."
March book-to-bill comes out next week. The latest available number, for February, rose modestly from 0.81 to 0.87. The bookings part of the equation rose 10 percentage points over January, after January's rise of three points. But the billings part of the fraction reflects SAB 101's delayed snapshot of industry revenues. So book-to-bill is understating industry sales in the upturn, and will overstate sales even after the start of the next downturn.
The SEC's revenue guidelines apply to companies' financial reports, of course, and those too have become confusing. KLA-Tencor, LAM Research and Novellus all report March quarter results next week. They're expected to say that shipments increased from the December period, but they may nevertheless report sequential declines in revenue.
Since the SEC's accounting prescription understates the rise of sales and earnings, Cowen & Co. analyst Avanish Kant says that stocks like Applied Materials might not be as expensive as they appear. In this first industry upturn measured under SAB 101, the Cowen analyst says that investors should value shares at a 30% higher multiple of earnings than in past cycles. While Kant believes that Novellus and LAM Research are more attractively priced shares, he says that at a recent price of 50, Applied's multiple of 27 times the $1.83 consensus for calendar year 2003 is misleadingly high.
Semiconductor-equipment makers have become the default sector for tech stock buyers, and investors have chased up shares like Applied Materials at the first upturn in orders. But to know whether they're overpaying for the shares, investors can no longer rely on SEC-accountable income statements. They'll have to wait for the statement of cash flows.
The Price of Candor
Last week, the New York State attorney general published damning evidence of the insincerity in Merrill Lynch's Internet stock recommendations. The embarrassed broker called attorney general Eliot Spitzer's case "outrageous." But Merrill's stock analysts clearly treated investment banking clients outrageously better than Merrill's investor clients.
Public outrage over Merrill's duplicity, however, is unfair. They were just the first investment banker whose records the New York AG has processed, in an ambitious inquiry that covers a half dozen brokers. When the AG's office gets around to the analysts at other firms, Merrill is unlikely to look exceptional.
As SEC general counsel David Becker observed, in a speech last year, independent investment research is like legroom on airliners. Everybody complains about it, but few will actually pay extra for it. But the risk of candor goes beyond a company taking its banking business elsewhere. Companies go after critical analysts. Just this year, the Off Wall Street Consulting Group, in Cambridge, Mass., got letters threatening libel suits from Cytyc and Microtune, two Nasdaq-listed firms whose shares the firm rates as Sells. Head analyst Mark Roberts says that Cytyc's lawyers also threatened claims under federal securities law and state laws of deceptive trade, product disparagement and negligence. Its potential remedies, said Cytyc, included treble damages, punitive damages and attorney fees.
The only ones who pay for candor, I guess, are the analysts.
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