By Colin McArdle This year's growth in the economy and stock market have left the semiconductor-equipment business far behind. Chip inventories rose throughout the second half of the year, in anticipation of demand that never quite lived up to expectations.
Consumers and business markets both turned out to be disappointing in the fourth quarter. With little need to ramp up production of semiconductors, orders for chip-making machines slowed. The S&P Semiconductor Equipment Index dropped 25.3% year to date through December 10, vs. a gain of 7.6% for the S&P 1500.
ASIAN GROWTH. The inventory buildup has dampened orders for new equipment, but that problem will be relatively short-lived. Near-term uncertainties likely will persist in the first half of 2005, as semiconductor manufacturers defer incremental capital spending, but the second half of the year should be stronger. In 2005, we expect sales growth of roughly 10% for semiconductors. Orders for equipment should be roughly the same.
Applied Materials (AMAT
; S&P investment rank 5 STARS, Buy; $17) is well-positioned to benefit from the upturn. We favor diversified front-end equipment suppliers with economies of scale, as global demand continues to shift outside North America. We expect Asia, particularly China, to continue to grow at a significantly faster pace than the rest of the world, over the next few years. Applied Materials can capture that growth. It's the industry leader by a wide margin. Its sales are nearly twice as large as those of the No. 2 player, Tokyo Electron.
The product portfolio includes a broad range of cutting-edge technology. Applied Materials sells equipment primarily to the front end of the semiconductor-fabrication process, which consists of those steps necessary to build the transistors and wiring needed for integrated circuits.
EYE FOR OPPORTUNITY. Considering the stock's shaky recent performance, the risk-reward profile for Applied Materials still looks compelling. The shares are trading at 19 times our estimate of 2005 earnings, which we expect to be 91 cents a share. Since the company's peers command higher multiples, we expect Applied Materials to hit $21 over the next 12 months.
The company ought to be valued similarly to leaders in other sectors of the tech market. But that's not the case. Applied Materials sells for 4.4 times its cash balance. Further, the stock currently trades at roughly 3.7 times our estimate of fiscal 2004 revenue. We believe these are conservative multiples for a technology leader. Given its prominent position, Applied Materials should receive higher multiples awarded to companies like Microsoft (MSFT
: Strong Buy; $27, Cisco (CSCO
; 5 STARS; $19) and Intel (INTC
; 3 STARS, hold; $23).
The semiconductor-equipment industry is highly fragmented, and we believe that impaired valuations often bring about acquisition opportunities. We think Applied Materials' management is continually reviewing strategic opportunities. We would also favorably view the return of cash to shareholders in the form of either a one-time or periodic dividends. While this is less likely in a volatile and highly cyclical industry, in our view it is an instrument that management should be evaluating as other tech companies have charted this new territory.
DOWN, BUT NOT MUCH. Risks to our recommendation and target price include a prolonged slowdown in demand for semiconductor equipment due to global economic conditions, particularly in faster-growing markets like China. Additionally, intense competition could ignite price wars, which would tend to cut margins for all equipment suppliers.
The industry has seen worse downturns. The book-to-bill ratio, a closely watched metric that compares the volume of new orders to the volume of goods shipped and billed, dropped to 0.96 during the three month period August-through-October. It was the first reading this year that was below 1, the neutral point at which new orders and shipments are in balance. All the same, the reading remains well above the all-time low of 0.78 recorded in October, 2002. S&P has a neutral rating on the industry.
Investors should be looking ahead for signs of recovery. As they do, Applied Materials is a company to watch.
Note: Colin McArdle has no stock ownership or financial interest in any of the companies in his coverage area. 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