Novellus: Thriving in Tough Times


By Colin McArdle 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.

GLOBAL PRESENCE. The company will continue to focus its marketing efforts on major semiconductor manufacturers. Sales to its10 largest customers accounted for 69% of revenue in 2004, vs. 76% in 2003. Intel (INTC) and Taiwan Semiconductor (TSM) each accounted for more than 10% of 2004 revenue. Novellus' customers are also global. Sales to foreign chipmakers accounted for 77% of 2004 revenue, up from 65% in 2003.

We have a strong buy recommendation on Novellus, based on our view of the company's technology leadership and global presence, combined with what we see as strong management and a compelling valuation. We think overall spending on semiconductor capital equipment grew 45% in 2004 and will be followed by an 8% increase in 2005, weighted toward the second half. We believe Novellus' strong footing in deposition equipment for copper interconnects and other leading-edge technology positions it well in the current semiconductor equipment cycle as inventory issues likely unwind.

The company reported 2004 earnings per share of $1.06, and we expect a decline, to 96 cents, in 2005. Primarily reflecting projected stock option expense, our 2005 S&P Core EPS estimate is 70 cents. We believe Novellus shares should trade in line with peers at 33 times our fiscal year 2005 EPS forecast, which leads to our 12-month target price of $32.

Risks to our recommendation and target price include increasing competition and the threat of pricing pressures, as well as technological obsolescence. Demand for semiconductor equipment products from Novellus is also sensitive to worldwide end-demand for chips, which has experienced a recent slowdown. If international economic conditions deteriorate, Novellus' operating results would suffer considerably, in our view. Novellus also has some customer concentration issues.

Required Disclosures

In the U.S.

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.8% of issuers with buy recommendations, 56.7% with hold recommendations and 12.5% with sell recommendations.

In Europe

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 29.2% of issuers with buy recommendations, 50.5% with hold recommendations and 20.3% with sell recommendations.

In Asia

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 34.3% of issuers with buy recommendations, 48.0% with hold recommendations and 17.7% with sell recommendations.

Globally

As of March 31, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.2% with hold recommendations and 13.8% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STAR (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index and in Asia the S&P Asia 50 Index.

For All Regions:

All of the views expressed in this research report 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 in this research report.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC, which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; and in Sweden by Standard & Poor's AB ("S&P AB").

The research and analytical services performed by SPIAS, S&P LLC and S&P AB are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from NVLS during the past 12 months.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results. Analyst McArdle follows semiconductor equipment stocks for Standard & Poor's Equity Research


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