Understanding the Chip Dip

S&P's David Kaplan talks about the semiconductor industry, his negative outlook on chip equipment, and his advice for investors

by Karyn McCormack

The health of companies that make equipment to build and test semiconductors has become more correlated to the health of the overall economy given that chips are now used in everything from airbags to digital music players. If the economy slows next year, as many experts predict, sales for both chipmakers and the equipment suppliers could be crimped, according to David Kaplan, who follows semiconductor equipment stocks for Standard & Poor's Equity Research.

Kaplan, who has a negative outlook for chip equipment stocks, also thinks there is a lot of capacity that needs to be absorbed after the industry's sales jumped 25% so far this year, well above the long-term historical annual average growth rate of 10%. He's also concerned about the above-average inventories at chipmakers.

BusinessWeek.com's Karyn McCormack recently spoke with Kaplan about why he is negative on the industry, as well as the stocks he likes and dislikes. Edited excerpts from their conversation follow.

Note: David Kaplan is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed in this story.

Why do you have a negative outlook on the chip equipment group?

There are a number of reasons. First, we see the economy slowing in 2007. In a slower environment, we see the growth in semiconductor sales near 8% for 2007, below our estimate of long-term annual average growth of around 10%. We think that chipmakers will reduce their capacity spending even more—so a slowdown would hit the equipment companies more than the chipmakers.

Another factor is the chip equipment companies have posted 25% sales growth in the first nine months this year. That compares to the long-term growth rate for equipment estimated at 10%. This means that the industry will have to digest this year's added capacity. Until that capacity gets digested, we see the equipment companies having a slower period in the first half of 2007. It's not so much a problem of declining chip demand as absorbing the new capacity.

Also, the inventory at chipmakers, what's been produced and is in the distribution chain, is above average. Everyone wants to get rid of that inventory before buying more equipment. So that's why we're negative.

What are the main reasons for the slowdown in the industry?

It's based on the fact that the economy is slowing. Chips are not just used in computers, they're in appliances, in air bags and refrigerators, in cars and PDAs—it is a more diversified demand. So to a great degree, the chip market is correlated to the economy. This is an emerging trend. The chip market used to be primarily tied to computers, but now that they're more diversified and in more products, it's more dependent on the economy instead of having its own cycle.

What about flash memory?

One of the bright spots in chips has been memory, in flash and DRAM, where prices have been rising and investment has been strong. Last week, ASML Holdings said it sees an overbuilding for this category. Demand for these chips is expected to grow 30% to 50% in 2007, but we think capacity is growing faster than that, potentially leading to a slowdown. While it has been a bright spot, it seems to be overshooting a bit, which is another reason we're negative on the industry.

How have these stocks performed this year?

It's such a volatile sector. The S&P Semiconductor Equipment index has risen 5.5% year to date through Oct. 20, compared to 9.4% for the S&P 1500 index. However, if you look at the 13-week move, the equipment index has risen 20.3%, compared to 10.3% for the S&P 1500.