A Dismal Season for Chip Equipment


By Richard Tortoriello With third-quarter earnings season winding down, it's a good time to review what semiconductor-equipment companies had to say. The key measure to watch in this industry is order growth, since it's the best predictor of future sales and profits. For the most part, orders were disappointing for the three largest names that have already reported -- Novellus Systems, Teradyne, and KLA-Tencor. Here's a look at their results, as well as a preview of what to expect from industry giant Applied Materials later in the month.

Novellus Systems (NVLS) is the second-largest maker of deposition equipment and holds the leading market-share position in copper electroplating, used to deposit copper films. Copper forms faster conductive layers than aluminum films. As chipmakers continue to move toward copper interconnects (or wiring) from aluminum, Novellus' strong position in copper gives it a competitive advantage, especially when the industry recovers. In addition, management has proved nimble at matching expense levels to production volume, having incurred a loss during only one quarter of a downturn that has proved to be the most severe in industry history.

In the third quarter, Novellus' sales rose only 4% sequentially, vs. 31% sequential growth in the second quarter, as purchases of leading-edge deposition equipment slowed. Orders fell 27% in the third quarter from the second quarter, after climbing 59% sequentially in the first quarter and 58% in the second. For the fourth quarter, Novellus expects an 8% decline in sales from the third quarter, and a 1% to 11% drop in orders.

"RICHLY VALUED." Novellus earned 3 cents per share (on a GAAP basis) in the third quarter, and it sees EPS of 11 cents, on cost cuts, in the fourth. Due to the recent order decline, we reduced our EPS estimates to 25 cents from 35 cents for 2002 and our 2003 projection to 51 cents from $1.20.

Novellus says it saw continuing strength in the third quarter for tools for copper and next-generation 300mm wafers, but new orders represented primarily small volume buys rather than the massive production buys typically seen when chipmakers are equipping entire fabrication plants. Though we at S&P think Novellus is likely to outperform its peers in an eventual upturn, weak order growth is likely to continue into 2003. We believe the shares, which were recently trading at $31.60, are richly valued on a price-to-sales basis and are vulnerable. We have an avoid ranking on the stock.

Teradyne (TER) is the largest manufacturer of semiconductor test equipment (not including memory chips). It also sells test equipment to the telecommunications and printed circuit-board markets. It sees demand increasing for high-end J750 logic tester as well as for its new Integra FLEX low-cost offering.

NEGATIVE OUTLOOK. Teradyne's sales and order growth from quarter-to-quarter have slowed. Third-quarter sales rose 7%, down from sequential sales growth of 25% in the second quarter and 13% in the first. Teradyne expects fourth-quarter sales to be in a range of down 6% to up 3% from the third quarter. At the same time, orders rose just 1.5% in the third quarter from the previous quarter, a sharp decline from the 65% jump in the first quarter and 9% gain in the second.

While growth in sales and orders has been respectable, Teradyne's earnings have suffered due to high manufacturing and operating costs relative to sales. Over the past four quarters, the company has recorded a cumulative net loss (on a GAAP basis) of $407 million, or about $2.24 per share.

Teradyne estimates that its breakeven level in the fourth quarter will be revenue of $440 million, much higher than its forecast of $310 million to $340 million. Its goal is to cut costs and reduce its breakeven level to $350 million by the middle of 2003. Teradyne noted that this was the most difficult environment it had seen in 42 years of business.

As a result, we forecast significant losses for Teradyne for the next three quarters. With sluggish demand for electronics products, declining consumer confidence, and weak corporate profits, chipmakers have reined in capital spending. After the round of profit warnings in September from semiconductor makers such as Philips and Hitachi (HIT), we downgraded the shares to sell from avoid. Teradyne's stock, currently around $12.50, sells for 2.1 times sales, well above historical cycle troughs of about 0.8 times sales.

PURCHASE PULLBACK. KLA-Tencor (KLAC) is the leading provider of defect-inspection and metrology equipment used to increase yields in semiconductor manufacturing. With process changes -- including copper interconnects, new insulating materials ("low-k dielectrics"), and 0.13 micron design rules (for smaller circuits) -- being rolled out at chipmakers, KLA's tools were seeing good demand earlier in the year. In fact, KLA is one of a very few semiconductor-equipment companies to remain profitable during each quarter of the recent downturn.

KLA reported that September-quarter sales rose 0.6%, quarter-to-quarter, but declined 25% year-to-year. Orders tumbled 37% in September, after rising 31% sequentially in the March quarter and 16% in the June quarter. The order shortfall indicates a pullback in purchases of the latest process technologies by chipmakers. KLA projects revenues to fall 12% quarter-to-quarter and orders to be flat in the December quarter.

Though KLA's EPS of 26 cents beat the Street's estimate, the drop in orders was a surprise. We at S&P cut our fiscal-year 2003 (ending June) EPS forecast to 79 cents from $1.31, and our fiscal-year 2004 estimate to $1.38 from $1.85. We also downgraded the stock, currently trading at $35.61, in light of the unexpectedly steep drop in orders and relatively high valuations on a price-to-sales and price-to-book basis.

SPENDING DROUGHT. The latest quarterly reports and outlooks from these three chip-equipment outfits reflect a marked cutback in capital spending by chipmakers, as end-market electronics demand has remained sluggish. Leading chipmaker Intel (INTC) recently lowered its capital-spending plans to $4.7 billion, from $5.5 billion at the beginning of the year, after spending $7.3 billion in 2001.

Giant foundry Taiwan Semiconductor (TSM) planned to spend $1.65 billion in 2002, then raised this to $2.5 billion by midyear, and then cut the final number back down to $1.65 billion. TSM also indicated that it didn't expect to raise its capital spending budget in 2003.

With excess capacity still high -- we estimate fourth-quarter capacity utilization will be in the low-to-mid 70% range -- it's unlikely that chipmakers will significantly increase capital budgets for 2003. This means spending on chip equipment, which declined 41% in 2001 and will likely fall an additional 30% in 2002, may see only single-digit to low double-digit growth in 2003 -- an unprecedented spending drought for the industry.

UNDER TARGET. More evidence of the sluggish recovery will likely be apparent when the No. 1 player, Applied Materials (AMAT), reports its fiscal year (ended October) results on Nov. 13. Applied has told investors that it expects flat to slightly higher revenues from the prior quarter, an increase in EPS (from 7 cents per share in the July quarter) on cost cuts, and a 10% to 15% decline in orders.

We believe that Applied can make the sales and earnings numbers for the quarter, given its $3.4 billion backlog at the end of the July quarter vs. our estimate of $1.5 billion for the October quarter. However, orders will be tougher to hit, and we estimate Applied will come in at the low end or below its projected order range.

Plus, the consensus fiscal year 2004 EPS estimate of 37 cents per share assumes double-digit revenue growth. With our expectation of flat to slightly improved capital spending in calendar 2003, we see revenue growth in the single-digits and believe consensus estimates need to come down. Following a 45% run-up in the share price in October, to about $15, we downgraded AMAT to sell from avoid. Analyst Tortoriello follows semiconductor equipment stocks for Standard & Poor's


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