November 23, 1998

SECTOR SCOPE by James A. Anderson


If you've been following semiconductor equipment stocks the past few months, you're probably suffering from neck strain about now. First came nearly a year of dizzying descent in the face of the Asian meltdown, a global semiconductor glut, and the advent of the sub-$1,000 personal computer. Those events conspired to damage the fortunes of chipmakers such as Intel (INTC) and Samsung, which in turn lowered revenues and earnings at equipment makers such as Applied Materials (AMAT), Novellus Systems (NVLS), and KLA-Tencor (KLAC). By the end of September, the Standard & Poor's semiconductor equipment index had dropped 27% since the beginning of the year.

Then the winds changed. In just one month, October, the S&P index shot up 39%. Investors are still scratching their heads over what caused the surge. And indeed, the rally in semiconductor equipment stocks doesn't quite compute -- at least, not yet.

True enough, there is good news. For one, analysts and money managers say the sector is starting to climb out of the rut it has been mired in since late 1997. And chip demand, on which the equipment industry depends, is expected to show a 9% bounce in 1999, compared with a 11% drop this year, according to estimates from the Semiconductor Industry Assn.

As heartening as that may be, though, it might be a bit too soon to jump into a sector that hasn't yet put up the solid numbers associated with a legitimate recovery. Last week, for instance, industry bellwether Applied Materials said earnings in its fiscal fourth quarter, which ended on Oct. 25, fell from 49 cents a share to 7 cents. Earnings like that don't smell like a turnaround.

Industry statistics aren't rosy either. Orders for new chipmaking equipment fell nearly 70% in September from a year earlier, and earnings for the group, which have spent the year in retreat, were disappointing, too. In Asia, meanwhile, where half the world's semiconductor equipment is sold, chipmakers in Taiwan, Korea, and Japan are still reeling from the region's economic malaise.

None of which seems to have fazed the market one kilobit in the last few months. Thanks to October's boost, the group is up more than 10% in 1998, at least respectable compared with the 16% total return for the S&P 500-stock index. The stampede has led semiconductor equipment makers back to an average price-earnings multiple roughly equal to that of the broad market. Analysts who follow the industry say that level is still well below the group's good-times valuations, which can range as high as twice the market's overall p-e.

The recent mania, then, is rooted in one thing: anticipation. Analysts who track seminconductor equipment say the industry will enjoy a major growth spurt once it regains its bearings. According to Dataquest analyst Clark Fuhs, spending on equipment has fallen from $5 billion a quarter less than year ago to $3 billion in the third quarter of 1998. "That's an unsustainably low rate for this industry, especially as semiconductor companies start to migrate to smaller chip widths in 1999 and 2000," he says. In fact, Fuhs estimates that orders should climb to somewhere between $7.5 billion and $8 billion a quarter by 2001. Wall Street thinks those kinds of projections portend great things for the sector -- average earnings growth of nearly 25% a year, according to a survey by Zacks Investment Research.

Have chip equipment makers found the path to that glowing future? When Applied Materials released its earnings on Nov. 17, CEO James C. Morgan said the worst seemed to be over, even as his company took a $293 million charge for the fourth quarter. Asian memory-chip makers such as Samsung and Hyundai have crept back to the chip equipment industry's showrooms and are starting to buy. And semiconductor kingpin Intel has charmed investors with predictions that the fourth quarter is shaping up nicely. As the conventional wisdom goes, more chips stuffed into a larger number of PCs eventually pushes manufacturers to ante up for equipment to help meet demand.

One clue to the immediate future of these stocks is that industry insiders haven't been clamoring for their companies' shares. That could be because their cash registers haven't started filling up yet. Or it could be because insiders know that the upturn in production won't be as dramatic as the market is anticipating. One potential reason for the latter could be that after a boom in 1996, semiconductor players stocked up on new equipment, much of which was mothballed when demand dried up this past year.

In addition, chipmakers still aren't running at peak efficiency. "Industrywide, almost every player has between 10% and 15% excess capacity," says Merrill Lynch analyst Mike Fitzgerald. "We probably won't see semiconductor makers go shopping in earnest for another six months." Then, there are worries that chipmakers may opt to be miserly in the coming year. Fitzgerald says Intel doesn't plan to build any new factories next year and will probably spend the next 12 months retooling existing plants, even as the chip industry upgrades to more advanced 0.18-micron chips. All told, look for Intel's capital spending to retreat to a range of $2.8 billion to $3.5 billion in 1999, says Fitzgerald, compared with $4.2 billion in 1998.

So what should an investor do now? The best bet is to wait another six months -- just as much of the semiconductor industry is doing. The next two quarters could be disappointing if capital spending by chipmakers doesn't explode. Also, investors need to be picky. The industry is in a transitional phase as chips get smaller and narrower and new equipment is needed. Money managers and analysts say your best bet will be to stick with the leading companies in the equipment business, such as Applied Materials and Novellus.

Applied Materials is poised to benefit from any major upswing, if only because of the breadth of its product line. "Applied Materials is the unquestioned market dominator," Kevin Landis, portfolio manager for Firsthand Investors. "It's pretty close to impossible to build a fab [a chip fabrication plant] and not pay them a lot of money." Applied Materials has also won a fair share of kudos for cost-cutting during the hard times. Currently, 18 of the 22 analysts covering the stock rate it a buy or strong buy, according to Zacks Investment Research.

Analysts characterize Novellus as an innovator within the industry and say the company has an array of technology that positions it well for when copper replaces aluminum as the metal of choice in chips, which should happen over the next two years. According to estimates by Value Line, Novellus' earnings should rebound in 1999 to $1.70 per share from an estimated $1.53 in 1998, though that would still be below the $2.17 a share the company posted in 1997. Of the 15 analysts covering the stock, 11 currently rate the company a buy or strong buy.

Mutual-fund investors will find that the selection of chip equipment funds is slim. One intriguing possibility, however, is the no-load Firsthand Technology Leaders fund (TLFQX), run by Landis. Although it isn't specifically designed to be a semiconductor equipment fund, Landis has stocked up on those companies. Right now, of his 21 holdings, three are equipment stocks and seven are semiconductor manufacturers. The fund is only 11 months old but has already blazed its way to a 56.6% return this year, according to Morningstar. That's a rather short track record to pin any conclusions on, however.

Clearly, investors will have will have to keep a sharp eye on this sector to avoid anymore neck strain.

Anderson writes the Sector Scope column every other week in addition to teaching journalism at the City University of New York

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