FEI: A Chip Inspector's Gadget

By Colin McArdle Nanotechnology, a buzzword perking investors' attention these days, can generally be described as the technology that studies extremely small things. While it's being incorporated into many industries, we believe nanotechnology is critical for Moore's Law (the theory that the number of transistors per square inch on integrated circuits doubles every 18 months) to continue in the development of semiconductors. Line widths on a microprocessor are a major determinant of chip speed. Lines measuring less than 100 nanometers represent cutting-edge chip sizes that aren't in mass production yet. A nanometer is roughly one-billionth of a meter and is more molecular or atomic in size.

In the design process for semiconductor equipment at these geometries, leading manufacturers are using scientific equipment -- namely the electron microscope -- that has been used by the life sciences and other research professions. One company that's looking to benefit from the commercialization of such scientific instruments is FEI (FEIC

; 4 STARS, or accumulate; recent price: $22).

Founded more than 30 years ago, FEI specializes in the design and manufacture of electron microscopes and other advanced equipment for metrology and inspection. In 1997, FEI acquired the electron-microscope operations of Philips (PHG), which now owns 25% of FEI common shares. Through various strategic developments, we believe FEI has successfully established diverse revenue streams serving the semiconductor, data storage, industry, and institute markets, which account for a wide range of corporate and academic research and development programs in the life-sciences field.

TWO BEAMS ARE BETTER. Despite an abandoned merger with competitor Veeco Instruments (VECO) due to market weakness and other issues, FEI is a formidable technology leader, in our view. It holds 116 U.S. patents and has 334 R&D personnel worldwide. FEI has an installed base of approximately 5,620 systems, which we think bodes well for future business.

It makes equipment that sees and modifies structures that are thousands of times smaller than the diameter of a human hair. FEI equipment is used in the inspection and metrology process at these small levels. For Moore's Law to continue to hold true, this technology is increasingly important, in our opinion. Nanotechnology has been around for decades, but now it's changing the way we live and work (see BW Online, 5/6/04, "Nanotech: Beyond the Hype -- and Fear").

One technology that distinguishes FEI from its limited competition is its dual-beam products. Combining the electron beam that allows imaging, analysis, and measurement of structures with an ion beam that manipulates structures at submicron levels, FEI enables customers to "cut in and look" at a miniaturized structure.

SERVICE REVENUES. FEI also makes computer-aided design (CAD) software known as FEI-Knight, which was developed last year. CAD navigation software reduces time and cost for chipmakers. Additionally, yield-management software enables manufacturers to collect, analyze, and share data to improve overall yield, which is vital.

In 2003, FEI's sales to industry and institute markets accounted for approximately 50% of total sales. The semiconductor market accounted for an additional 43%, with the remainder going to data-storage customers. After the standard 12-month warranty, approximately 85% of FEI's customers sign service contracts of one or more years, making them a source of recurring revenue.

During the technology downturn, FEI saw the benefits of this strategy. Industry and institute demand picked up some of the tech-related slack. And while overall revenue declined a relatively modest 10% from 2001 to 2002, FEI never entered the red on an operating basis. Remarkably, in our view, for a high fixed-cost business, gross margins hovered above 40% throughout the three-year tech downturn. Based upon sequential growth of 7.6% in the first quarter, we see FEI's full-year 2004 revenue rising 24%, to $446 million.

HIGH-END ESTIMATE. The biggest upside opportunity for FEI, we believe, would be if the electron microscope and other complex instruments can make the quantum leap from research labs to manufacturing lines. In our opinion, this would dramatically increase demand for FEI's equipment, as it would correlate more closely with semiconductor volume increases and new market opportunities, such as foundries. We believe this should happen gradually throughout this year as new chip-fabrication plants come online and sub-100 nanometer production increases.

We project 2004 earnings per share of 62 cents, at the high end of the Street's estimates of 58 cents to 62 cents. We believe the installation of FEI inspection equipment on the manufacturing floor will gain traction late this year and next, leading to improved revenues and margins. As a result, we're setting our 2005 EPS estimate at $1.16, vs. the Street's $1.07 forecast.

Applying a 35 multiple, in line with our expected EPS growth rate, to our 12-month forward EPS estimate of 84 cents, we derive a 12-month target price of $29, representing potential upside of about 32% from recent levels.

Our FEI investment recommendation and target price have several investment risks. First, the company derived 31% of its total revenue from its top-10 customers in 2003, a percentage that has steadily increased over the last four years. FEI also competes directly with other much larger companies in various areas, including Applied Materials (AMAT

; 5 STARS, or buy; $19) and KLA-Tencor (KLAC

; 4 STARS; $44), which we believe can support much bigger R&D budgets. An additional concern is that the data-storage end market could soften. Lastly, a significant portion of FEI's incremental growth comes from Asia, particularly China and Taiwan, resulting in inherent country or geographic risk.

Note: Colin McArdle has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Affiliates of Standard & Poor's Securities, Inc., a registered broker-dealer, received non-investment-banking compensation from Applied Materials and KLA-Tencor during the past 12 months. Analyst McArdle follows semiconductor equipment stocks for Standard & Poor's

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