As the maker of the brains inside all things digital, the semiconductor industry is booming. Chips now do more, cost less, and show up in more products than ever. With the economy in recovery and tech spending picking up, demand for chips to go into not just computers but cell phones, DVD recorders, and cars is booming. It follows that the companies that sell the equipment used to make chips would likewise be on a tear.
So it was a big surprise to investors, who bid up stocks in the chip-equipment sector 72% in 2003, when bellwether Intel (INTC) said on Jan. 14 that it might just barely increase its spending on equipment in the coming year. Intel, which budgeted $3.7 billion for capital spending in 2003, said in 2004 it plans to spend between $3.6 billion and $4 billion. Leading chip-equipment stocks such as Applied Materials (AMAT) and Novellus (NVLS) fell nearly 5% on the news, as some investors worried that their bullishness might have been misplaced.
Fortunately for chip-equipment makers, when it comes to capital spending, Intel isn't much of a bellwether after all. That's because it spent lavishly on new equipment during the long tech slump -- in stark contrast to most chipmakers. While the industry cut spending on equipment 60% from 2000 to 2002, Intel increased its to a peak of $7.3 billion in 2001. Now it already has a lot of leading-edge equipment in place. "I don't see any other company in the industry that followed Intel's lead in doing this," says Standard & Poor's analyst Richard Tortoriello.
"KNEE-JERK REACTION." Now, other semiconductor makers have a lot of catching up to do. Since the tech recovery had a few false starts along the way, they began ordering new equipment en masse only in 2003's fourth quarter. Spending in 2003 climbed just 5% or so, analysts say, and capacity utilization at chip plants is now running at an uncomfortably high rate of around 95%.
Pacific Crest Securities analyst Mark Bachman says he wasn't surprised by Intel's announcement and notes that the chip king has little incentive to discuss big spending plans, since that would conflict with analysts' forecasts for its gross margins this year. As for the equipment sector's stock-price dip, "it was just a knee-jerk reaction," he says.
As bullish chip-equipment analysts got their message out, the Intel-related slide quickly reversed, and by Jan. 20 stocks in the sector had risen 7% in 2004. It helped that on Jan. 15 South Korea's Samsung Electronics said it was budgeting $4.3 billion on equipment spending, much larger than forecast, says Bachman. Taiwan Semiconductor Manufacturing (TSM) also said recently that it would spend 25% to 30% of sales in 2004 on equipment. Tortoriello estimates that equals $2 billion 2004, up from $1.2 billion in 2003 since Taiwan Semi's sales are rising fast.
BYPASS THE LEADERS? Meantime, a plethora of equipment companies have announced in recent weeks that fourth-quarter revenues will surpass earlier guidance. Axcelis Technologies (ACLS) did so on Jan. 16, after "Applied Materials set the tone last November, when it said orders would be up 20%" over the prior quarter, says Bachman.
Tortoriello expects overall chip-equipment sales to grow 30% to 40% in 2004, and he believes the industry is at the beginning of a cycle that will peak in 2005. "I don't think we'll see the same kind of stock-price increases this year that we saw last year," he says. But he adds that he doesn't believe investors have factored into stock prices the full strength of the recovery.
For investors who want exposure to the rebound, analysts warn that industry leaders may not be the best place to get in at this point. Applied Materials, by far the sector's largest company, is getting expensive, some analysts say, although it's still a good long-term holding since it provides broad exposure to many parts of the equipment industry. Tortoriello calls Applied Materials the least risky stock in a very volatile sector. But his top-rated companies are test-equipment-maker Teradyne (TER) and Lam Research (LRCX), which makes equipment that etches circuitry patterns on silicon. It was recently added to the Nasdaq 100 index.
"MORE ROOM TO MOVE." Bachman's favorites are KLA-Tencor (KLAC), which reports earnings on Jan. 22, Lam Research, and Varian Semiconductor Equipment (VSEA). He upgraded Varian on Jan. 7 to a buy rating and set a 12-month price target of $60, up from its $50 close on Jan. 20, after Varian announced an acceleration in orders for new equipment. Bachman believes it's gaining market share from competitors.
Kevin Vassily, a chip-equipment analyst at Susquehanna Financial Group in San Francisco, has Varian and Lam as his two top picks. He thinks n both can gain market share against competitors and notes that they have "some more room to move up relative to some of the more well-known names in the sector." Schwab Soundview analyst Michael O'Brien upgraded Brooks Automation (BRKS) to an outperform rating on Dec. 12, citing its modest valuation.
All this bullishness doesn't mean it'll be smooth sailing for chip-equipment stocks throughout 2004. Tortoriello cautions that the sharp growth in order rates that began late in 2003 may mean orders in the second and third quarter of 2004 may slow a bit. "Don't expect a linear trend," he warns. "These are highly volatile stocks that aren't for the risk averse."
So, even though 2004 should be a banner year for chip-equipment makers, investors should still be prepared for some bumps along the way. By Amey Stone in New York