Novellus: Thriving in Tough Times

Based on its global customer base and an expected rebound in demand for semiconductor equipment, S&P rates the company a strong buy

We see semiconductor equipment demand rebounding during the second half of 2005. Leading chip-equipment manufacturers including Novellus Systems (NVLS: Strong Buy; $27) have indicated they are seeing recent order increases due to expanding capital-spending budgets. Novellus also stated that current-quarter revenue and earnings would be modestly higher than expected.

In our opinion, the buildup of inventories during 2004 has been reduced during the first half of this year. We estimate that overall semiconductor factory utilization hovers in a range of 75% to 80%, after climbing to more than 95% in 2004. For equipment makers, we see overall sales growth of 5%, with slightly higher rates for technology leaders in the front end of the manufacturing process, as we think customers need to invest more to make the transition to smaller nodes in the future.

STRONG LEVERAGE. From a geographic standpoint, Asia continues to serve as a major source of both semiconductors and semiconductor equipment sales. This region, including Japan and Taiwan, accounts for as much as 70% of sales for some of the larger companies we follow. As a result, we tend to favor companies with scale that can support worldwide distribution.

We view equipment company shares as trading at relatively low multiples in general, reflecting the current risk environment. However, we see potentially strong operating leverage in the event of an industry upturn.

The S&P Semiconductor Equipment Index declined 4.3% year-to-date through May 31, vs. a drop of 1.5% for the S&P 1500 index. In the three months through April, the North American semiconductor equipment industry's preliminary book-to-bill ratio was 0.8, a modest decline from March's 0.81 and an increase from the 0.78 level for the three months through February, reflecting, we believe, the ongoing chip-inventory correction. In the last six months of 2004, the ratio was consistently around 1, in a range of 0.94 to 1.06, suggesting limited growth, in our opinion.

ENTERING NEW MARKETS. Given our overall industry outlook, one of our favorite stocks in the group is Novellus Systems. The company recently raised its quarterly revenue and earnings guidance during its scheduled mid-quarter update. Management suggested that second-quarter earnings per share would fall within a range of 20 cents to 22 cents, above Street consensus expectations and leaving our estimate of 20 cents at the low end of the range. Corresponding revenue guidance was also modestly raised to $325 million to $330 million -- $3 million above our expectation.

So the question remains: Why is Novellus thriving in what appears a challenging operating environment for many equipment makers? Novellus is the second-largest maker of equipment used to deposit conductive and insulating layers on semiconductor wafers to form integrated circuits (ICs). In addition, through the 2001 acquisition of GaSonics International, the company entered the market for wafer surface preparation equipment. Through the 2002 acquisition of SpeedFam-IPEC, Novellus entered the chemical mechanical planarization (CMP) equipment market. These two types of equipment complement deposition equipment.

The company's product line of deposition equipment includes chemical vapor deposition (CVD), physical vapor deposition (PVD), and electroplating (ECD) equipment, all of which are used to form the layers of wiring and insulation, known as the interconnect, of ICs. High-density plasma (HDP) CVD and plasma-enhanced CVD (PECVD) systems employ a chemical plasma to deposit all the insulating layers and some conductive layers on the surface of a wafer. PVD systems deposit conductive layers through a process known as sputtering. ECD systems deposit conductive layers of copper on wafers, through a process known as electrochemical deposition.

COPPER CHALLENGE. Surface preparation products, including photoresist strip and clean, are becoming increasingly important with the industry's migration to copper interconnects. Surface preparation systems remove potential contaminants from a wafer before proceeding with the next deposition step. CMP systems polish the surface of a wafer after a deposition step to create a flat topography before moving on to subsequent manufacturing steps.

Because copper is more difficult to polish and smoother than previous-generation aluminum interconnects, and because low-k dielectrics (a relatively new technology that offers insulation for copper lines, as opposed to aluminum, and is becoming the industry standard) are much more porous than their predecessors, Novellus' product offerings in this category have taken on critical importance, in our view.

The company aims to increase its market share in the worldwide thin film deposition market and strengthen its position as a leading supplier of semiconductor processing equipment. Novellus' strategy is to provide customers with systems that achieve the highest levels of wafer throughput, yield (the percentage of functioning ICs to the total produced), and film quality.

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