A Bright Note Amidst the Chip Gloom


By Colin McArdle A stream of worrisome comments regarding slowing demand for semiconductors and rising inventories has put shares of semiconductor-equipment companies under pressure. Intel (INTC

; ranked 3 STARS, or hold; recent price: $20) cited these trends during its midquarter update in August, sending the semiconductor-equipment group to year lows. The question that remains: Will investor disdain persist throughout the second half of this year? And what catalyst could reverse the trend?

According to the Semiconductor Equipment & Materials International trade association (SEMI), the key book-to-bill ratio has steadily declined in recent months. The latest August level of 1.0 -- down from 1.04 in July and well below April's 1.13 -- suggests minimal near-term growth. The downtrend could continue because of macroeconomic concerns. We believe the September report could show a book-to-bill posting below 1 for the first time this year, which could exacerbate the current negative sentiment.

However, the same trade organization also raised its expected industry growth rate to 60%, from 40%, earlier this year. We believe this is too aggressive and that the earlier expectation is more realistic.

INDUSTRY LEADER WITH PROMISE.Despite these swings in expectations and the monthly book-to-bill gyrations, we note that the S&P Semiconductor Equipment Index is down almost 32% this year through Sept. 26, suggesting that the market is discounting extraordinarily weak earnings expectations for 2005. This implies that recent increases in semiconductor manufacturers' inventory and general declining demand for chips worldwide are longer-term issues that reflect the cyclical downturn. If that were the case, the best-case scenario for these stocks would be a minimal relief rally.

An alternative scenario holds that this is a temporary slowdown from the strong revenue gains already made in the last year. Higher inventories could be eliminated relatively quickly if fourth-quarter demand is stronger than is currently anticipated. Higher inventories can also be interpreted as managers stocking in anticipation of stronger sales and not wanting to be caught with empty shelves.

While a clear catalyst for investors returning to the group eludes us, we think that a leader in the industry could be a potential investment. Applied Materials (AMAT

; 4 STARS, or accumulate; $17) currently has a market cap of approximately $28 billion, well below its high for the year of approximately $40 billion and much higher than its closest U.S. semiconductor-equipment competitor, KLA-Tencor (KLAC

; accumulate, $41.50), at just over $8 billion.

HEAVY R&D INVESTMENTS. Applied Materials is the most diversified equipment supplier in the world, from both a product and geographic standpoint. Approximately 70% of the company's revenue is generated outside North America. A particularly large portion of it comes from Asia, and recently, the outfit has seen weak demand in China. We see this as a primary risk to our recommendation and target price.

Applied Materials leads the semiconductor capital-equipment market, with 2003 sales of $4.48 billion, nearly twice those of its nearest competitor, Tokyo Electron (TOELF). It sells equipment to the front end of the semiconductor-fabrication process, encompassing those steps necessary to build the transistors and wiring for integrated circuits.

As the semiconductor industry moves to smaller and smaller geometries in compliance with Moore's Law (computing power per chip doubles about every 18 months), it needs to buy new equipment that supports the wafers' manufacturing. Applied Materials maintains its leadership position through heavy investment in research and development. During 2003, the outfit spent well over 20% of annual revenues on R&D.

ACCUMULATE RECOMMENDATION. Applied Materials produces a broad range of equipment, and it holds dominant positions in deposition (more than a 45% share in 2003), etch (25% share), and chemical mechanical planarization, or CMP (more than 60% share). It also holds a 25% share of the ion-implantation market and a 25% share of the smaller mask-exposure equipment market. Other areas in which Applied Materials sells tools include rapid thermal processing, wafer wet cleaning, metrology and wafer/reticle inspection, and deposition for flat-panel displays.

Despite our current neutral stance on the semiconductor-equipment industry, we think shares of Applied Materials are trading at a low price-earnings multiple. We apply peer group average p-e multiple of 18 -- a conservative, risk-weighted figure -- to our 12-month forward earnings-per-share estimate of $1.15 to derive our 12-month target price of $21. We suggest that investors accumulate the shares.

Risks to our recommendation include potentially weak demand from China and other countries and chipmakers' rising inventory levels.

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. (SPSI). All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst McArdle follows semiconductor-equipment stocks for Standard & Poor's Equity Research


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