M. Murphy agrees with you about AMAT, KLAC, and NVLS, and has them all at a buy at current prices. Below is from his July issue:
More Generational Profits on the Way
The shift to copper I talked about in Tech Talk is a once-in-40-years Generational Innovation that will change the way every semiconductor chip is made over the next five years. We want to be in position to profit by grabbing the key player.
Novellus is one of the four horsemen of the semiconductor equipment business. Applied Materials, with revenues of $7.3 billion last year, does everything. KLA-Tencor, $2.1 billion in sales last year, makes tools to measure results of the manufacturing process. Lam Research ($1.6 billion) etches circuit lines on the wafer. And Novellus ($1.3 billion) deposits thin film metal connecting lines into the miniature trenches etched by Lam, and insulating layers between the metal layers.
Since we already own AMAT and KLAC, and I didn't expect to recommend another stock in this sector for this cycle of the recovery. But the recent decline in the market, especially in anything related to semiconductors, comes at a time the chip business is picking up rapidly and the equipment business is virtually exploding. Due to the convergence of three Generational Innovations-12" wafers, 0.13 micron linewidths and copper interconnects (which all make for faster and cheaper chips)-this cycle will last longer than normal.
The idea that we can get a quality Great Growth Flow company like Novellus at a bargain price after the business has clearly turned up is just too irresistible to pass up. Especially after the company's recent midquarter guidance, during which they raised their forecasts, but after which their stock fell another 10%. All of the elements are in place to make a lot of money in this one.
Thin Film Star
Novellus ("unique" in Latin) was founded in 1984 by a group that left Applied Materials, and I've been following the company since it went public in August 1988. I well remember heading for Bay Meadows Racecourse every summer, not to bet the ponies, but to attend the Western Electronics Show (which evolved into Semicon and now takes up most of the large Moscone Center in San Francisco). Even then, Novellus was the hot name in deposition.
What's deposition? It's basically depositing metal on a wafer. That sounds simple until you realize how little is deposited, how precisely it must be placed, and how important it is not to have gaps, holes, rough spots, varying thickness or anything else that might ruin a wafer full of chips with a street value of $100,000 or more.
Novellus built its business on chemical vapor deposition of insulating layers, then added physical vapor deposition of aluminum circuits via the acquisition of Varian's product lines, and embraced copper and electroplating early through a joint development effort with IBM. (See Tech Talk in article 4 for an expanded discussion of this process and why copper is the wave of the future.) They acquired GaSonics in late 2000 to enter the wafer surface preparation market with residue removal systems for both aluminum and copper. They've formed a consortium with several other companies to offer a complete copper production system competing against Applied Materials' one-stop shop.
Accelerating Growth
It seems to be working; both companies are seeing rapid increases in orders and backlog. On the recent midquarter update conference call, management raised their bookings (or orders) guidance by $25 million to $275 million. They raised their shipment guidance by $10 million to $225 million and said they would have to bust a gut to get all that stuff out the door, but their customers are now accelerating delivery times. Novellus doesn't book revenues until the product is installed, working and accepted by the customer, so they didn't change their revenue guidance of $220 million. (Those extra shipments will be recognized as revenues in the September quarter.) They did raise earnings guidance from 6 cents a share to 8 cents; in this growth environment, they don't have to give many discounts to get an order signed, so profit margins go up. During the call they said that if their customers' current growth in demand continues, quarterly bookings will hit $350 million in a few quarters-that's 27% growth.
Sounds great, right? It is, but the stock went down almost 10% before bouncing. The "reason" given was that management did not give a forecast for the September quarter. Every analyst on that call knows Novellus has a policy of never forecasting more than the current quarter on the midquarter update. You would think raising guidance, talking about customers accelerating orders and dangling that $350 million per quarter order rate out there as a goal would be enough, but Wall Street analysts seem to have turned into reporters parroting whatever management says, and when Novellus' management refused to say anything, they threw up their hands and sold the stock. Perception, not reality.
Also contributing was Goldman Sachs who, just before the midquarter call, downgraded the whole semi equipment sector to "market weight," saying that if computer chip demand dropped, it would leave equipment customers with excess capacity, which is obvious but irrelevant because chip demand is not dropping. They claimed that chipmakers are "easing off the accelerator," which is just plain wrong, and that the demand for 8" equipment is slower than demand for 12" equipment. (Duh!) The most recent Semiconductor Industry Association numbers for April showed growth in all geographic areas, up 3.1% from March to over $11 billion. There's been no change from the steady growth we saw in the first quarter. The SIA recently said they expect growth over the next 10 quarters, with this year as a whole up 3.1% from last year (requiring an accelerating upturn in the second half of the year), soaring 23.2% in 2003, and up 20.9% in 2004. That's "easing off the accelerator"?
And independant sources are saying the same thing. VLSI Research, the market research firm, says the overall semiconductor equipment market was $26.9 billion in 1999 and, after this dip, will recover to $65.1 billion in 2004. That's 19.3% compounded annual growth. The deposition market overall during the same time will grow from $4.0 billion to $9.6 billion, a similar growth rate of 18.9%. That's plenty healthy. However, copper deposition, where Novellus is king, is expected to grow from $97 million in 1998 to $789 million in 2004. I suspect it will grow even faster now that we know copper is the way to transition to 0.13 and 0.09 micron chips, or migrate to 12" wafers. Novellus and Applied Materials are the two key players in copper.
Big Potential
I expect revenues to hit $250 to $260 million in the September quarter, up about 16% from the current quarter, and earnings will double to 16 cents as they continue to ship equipment as fast as they can make it. In their December fourth quarter, often a big one, they should do just over $300 million and increase earnings another 50% to 24 cents a share as the trend continues. That would bring them in at 46 cents for this year, but they'd exit the year earning at a 96-cents-per-share rate. That should put Novellus in good shape to hit my 2003 estimate of $1.70 as the equipment industry continues to recover.
Research and development at Novellus runs around 20% of sales, a high percentage I like to see. They'll spend about $225 million on R&D this year, or $1.55 a share-more than they'll earn. Next year they'll do about $250 million, or $1.72 per share-the same as their earnings. This is a classic growth flow company, with a 2002 growth flow of $2.01 and 2003 growth flow of $3.42. (Remember, growth flow is earnings per share plus R&D per share, which helps us identify companies wisely investing in their future.)
After the recent hit, the stock is trading at a P/E ratio around 91.6X this year's earnings, which seems high at first glance. But the Price/Growth Flow ratio is just 21.0X this year and only 12.3X next year, which is much more appealing. The P/E ratio on next year's earnings is 24.5X. Is that high? Consider that the S&P 500 sells for 18.9X next year's earnings with a long-term growth rate of 12.5%. Novellus has a 24% long-term growth rate, so the PEG ratio (Price/Earnings ratio divided by the growth rate) is only 1.0X compared with the S&P at 1.5X, and the PGFG ratio (Price/Growth Flow divided by the growth rate) is 0.5X for Novellus. We can make good money at those levels.
NVLS sells for about 6.5X this year's sales and 3.8X next year-not especially cheap, but not outrageous in light of their profitability. For you hard asset fans, it's at a little over 3X book value-again, in the neutral zone.
I want you to buy NVLS up to $42 a share. I don't think it will trade much below $37 in a market downturn, and we should see $55 or better by the end of this year. The bigger payoff will come in 2003, when I think the stock can get back to its all-time high of $70 set in March 2000. That's about an 85% profit for current prices around $38.
At current prices, I wouldn't sell either AMAT or KLAC to buy NVLS. They will all move up together. I'd rather see you add NVLS for further exposure to the sector. Normally I wouldn't recommend three stocks in the same area of technology, but this one is going great guns, and we're getting in at the very beginning of the Generational Innovation that's driving it.
On the other hand Harry Newton has them all as shorts.
From Today's column: technologyinvestor.com (not sure you will be able to see the page).
My recommendation remains the same: You should NOT be in tech stocks specifically or any stocks in general. I will make two exceptions: A teeny tiny bit in shorts. A teeny tiny bit in stocks you feel very comfortable with. I recently bought some Qwest. It should still have some legs.
Here is my list of recommended shorts. ADBE, AMAT, BBOX, BRCM, ESRX, EXPE, HPQ, ROOM, IBM, INTC, IRF, KLAC, MXIM, MU, MSFT, NSM, NVLS, TXM, XMRS, AND XLNX.
Here are Harry's short Selling Rules:
1. Don't short or buy puts with money you can't afford to lose.
2. If you short, make sure you adhere to the 15% stop loss; i.e. cover yourself when you've lost 15%.
3. Be aware that being short is a rocky emotional ride. Get lots of rest and play lots of sport. Otherwise your psyche can be damaged big-time.
4. Short only on those days when the market goes through roof.
5. Don't be greedy. If you get a point or two, take your profits and be happy |
