"Sober Season for Chip Equipment So Far"
By K.C. Swanson Staff Reporter 01/28/2003 07:24 AM EST
URL: thestreet.com
Investors in chip equipment lately have been voting with their feet, and the results speak volumes about the uninspiring outlook for 2003.
Leading names such as Applied Materials (AMAT:Nasdaq - news - commentary) , KLA-Tencor (KLAC:Nasdaq - news - commentary) and Lam Research (LRCX:Nasdaq - news - commentary) have given up about a quarter of their value since peaking in late November, with Novellus Systems (NVLS:Nasdaq - news - commentary) losing some 20%, as the market digests more sober expectations for the year amid worries about a potential war.
This earnings season did nothing to brighten the mood, given the thriftiness reflected in capital spending plans and subdued comments from chipmakers on their expectations for 2003. Granted, Novellus is expected to meet earnings expectations today after boosting its midquarter guidance -- but that's no great feat, as Wall Street's gearing for a sequential 8% sales drop-off, with further revenue contraction expected in the March quarter.
Though there's reason to think equipment industry bookings are bottoming, investors for the most part remain leery of semiconductor capital hardware, either sticking to the biggest names or avoiding the sector altogether.
John Rutledge, who heads up the Evergreen Technology fund, has steered clear of the space because he thinks customers, the chipmakers, will continue to struggle. "The problem for the industry is there aren't the end products growing massively like PCs did," explains Rutledge. "PCs grew at 18% a year for two decades, and cell phones in the '90s were growing at 60% each year. Now both are pretty mature. PCs will grow at maybe 5% or 7% going forward."
"Therefore we may not be seeing peak revenues again for many, many years," he says. "And if the prospects aren't great for semis, they're not going to have the profitability, the dollars to buy new equipment."
To be sure, plenty of analysts have advanced the more bullish notion that the chip and chip-equipment business will start to firm up in the second half of 2003, as the economy finds its footing.
There's no denying industry orders are on the upswing. In December, bookings for new equipment grew 8% from the prior month and were up 37% from last year's levels, marking the third-straight month of growth, according to trade group SEMI.
And guidance from the two major chip-equipment companies that have reported earnings offers more evidence that at least orders have stopped declining. Lam Research has said bookings likely will show a modest increase in the March quarter, despite uncertain end-market demand, while KLA Tencor has forecast flat orders.
At Independence Investments, an asset management firm with stakes in Novellus and Applied Materials, analyst John Park says he expects to see increasing equipment order momentum over the next two quarters. His firm, which held positions in these and some other equipment stocks for most of last year, bulked up a little around the near-term bottom last fall, though he declines to comment on what it's doing now.
Another marginally good piece of news: Samsung's planned boost to its capital spending should offset much of the pain from Intel's capex cuts.
But there's still plenty of pressure on equipment makers. Lately rumors have circulated that industry leader AMAT will have to close shop for a week in February due to slow business, with added speculation that it might have to shut down for another week in March. The company didn't respond to a request for comment.
In any case, Evergreen's Rutledge isn't buying the second-half-upturn idea. "Hope springs eternal. I don't put too much credence in the idea that the market will turn up in six months," he says. "Right now I'm expecting more of what we saw in '02 until I'm convinced otherwise."
Seconding that critical take is Banc of America's analyst Mark FitzGerald, a relative bear on the semi-equipment industry who says order data are no longer useful in predicting stock performance. "It worked in the 1990s because of the boundless growth in the end markets," he said in a note issued Monday. But now, he writes, "There is no obvious demand scenario that holds the promise of uninterrupted growth. The chip industry will be less profitable, less able to afford the investment in new plant and equipment."
If that's the case, then measures like a company's free cash flow and earnings should matter more to investors than orders, explained FitzGerald in a phone interview. "In prior cycles, there was an inflection point that was a hint that the next two years were going to be great. But in this kind of environment, I think we're going to see companies come in and out of the market in terms of capital equipment. We'll see spurts where there's a quarter or two of good information, then it's going to fade."
If the long-term outlook for the semiconductor industry weren't enough of a concern for chip-equipment investors, lately investors have had to incorporate war worries into the picture as well.
Michael Smith, who manages $75 million in separate accounts as a general partner at the Belvedere Group, an investment management firm, says he thinks "the worst is behind us" for technology names. He sees evidence of some firming in the economy, although he notes it's also true some technology companies may not recover to their boom-era revenues levels for years.
Yet he's holding off adding to any tech positions because of the potential for the U.S. to go to war in Iraq. "If there wasn't any war, we would not hesitate to nibble on the better names," says Smith, citing Applied Materials as a possibility in the equipment space. But individual investors he works with don't want to make any investment moves until the situation in Iraq is resolved, he says.
In light of the pressures weighing on potential hardware purchases, equipment names don't look like a bargain at current levels. "I would argue that even for the good companies I own, valuations are not cheap given the growth prospects," says Rutledge. "The tech market is definitely not cheap yet."
FitzGerald counts himself in the same camp, arguing that investors need to readjust expectations downward. In the past, chip-equipment stocks could see price appreciation of three to fivefold off the bottoms when the industry was on the upturn. But now, "you get maybe a double from the bottom," he says -- and that's assuming companies were able to generate strong earnings numbers.
Some stocks already have nearly run that high amid minimal evidence of strengthening fundamentals. He points out that KLAC, which dipped to just below $27 in October, had leaped to around $40 a few weeks ago. "That makes no sense whatsoever," says FitzGerald.
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