By Richard Tortoriello
Back in December, in S&P's 2003 Tech Outlook, we said that in order for us to change our underweight recommendation on semiconductor-equipment stocks, we would have to see signs of a sustainable increase in equipment orders supported by clear signals of growth in electronics end-markets. Or valuations for the stocks would need to fall closer to those seen at the weakest point of an industry cycle.
In the last few weeks, Standard & Poor's has seen modest improvement in semiconductor-industry fundamentals, and we believe better times are coming. Plus, we think valuations have become more reasonable.
Considering the improved conditions, we've upgraded several names in the group. In particular, we like MKS Instruments (MKSI ), Advanced Energy Industries (AEIS ), Photronics (PLAB ), ASM Lithography (ASMI ), Applied Materials (AMAT ), Novellus Systems (NVLS ), and ATMI Inc (ATMI ).
On the fundamental side, a number of chipmakers have issued improved forecasts. While the improvement isn't across the board, it is more broad-based than we've seen in a long time, and we believe it's being driven by demand rather than by changes in inventory. Among companies issuing better forecasts, Altera (ALTR ), a maker of programmable logic chips, said sales rose 8% in the March quarter from the December quarter, and it expects another 1% to 4% increase in the June quarter.
Almost half of Altera's sales come from the communications market, and the rest come from a broad variety of other markets. Texas Instruments (TXN ), which also gets a large portion of its sales from communications chips, expects sales to rise 7% sequentially in the June quarter, following a 2% rise in the March quarter.
Cypress Semiconductor (CY ), which supplies memory and nonmemory chips to a broad mix of markets, sees sales rising 10% in the June quarter from the previous quarter, following a 4% increase in the March quarter. International Rectifier (IRF ), a provider of power semiconductors, expects a 4% to 8% sequential rise in June-quarter sales, following a 2% rise in the March quarter.
Taiwan Semiconductor (TSM ), the world's largest contract chipmaker, expects sequential sales growth of 20% in the June quarter, following a 2.8% decrease in the March quarter. In addition, Intel (INTC ), Samsung, and Taiwan Semiconductor -- the three largest chipmakers based on this year's budgeted capital spending -- have reaffirmed their 2003 budgets.
We at S&P expect semiconductor sales to rise between 10% and 15% this year, led by growth in wireless-communications chips. In 2004, we expect stronger growth, based on our expectation of modest economic improvement, thanks to increased consumer confidence, and a recovery in information-technology spending. A large number of PCs purchased by corporations in 1998 and 1999 are nearing obsolescence. Although corporations are stretching the use of older computers to four years and even five years, we believe a replacement cycle will begin in 2004.
We forecast that semiconductor-equipment sales will rise by 5% to 10% in 2003, with increases coming largely from memory-chip makers, which are aggressively moving to next-generation 300-millimeter (mm) wafer sizes and 110-nanometer (nm, or 1 billionth of a meter) device sizes, and from chipmakers in Japan that have restructured operations and are beginning to buy new chipmaking gear after two years of severe underinvestment.
Wafer-fab capacity utilization should gradually increase to the mid- to high-80% range by yearend, from 82% in the fourth quarter of 2002. Utilization of leading-edge (150nm and lower) production lines has been running at 90% for the past year. We expect chip makers to add modestly to capacity in 2004, and buy more equipment to make both 200mm and 300mm wafers. We forecast capital equipment spending to rise by 20% from current depressed levels.
On the valuation side, we at S&P like to compare current price-to-sales ratios to those typically found at the troughs of previous industry cycles. Over the past few cycles, the average low price-to-sales valuations have been between 1 to 2 times (larger-cap companies typically have higher valuations). By Richard Tortoriello In March, shares of Advanced Energy reached a trough valuation of about 1.2 times sales, while MKS Instruments traded at 2.0 times sales. Both companies are leading suppliers of subsystems used to manufacture semiconductor-process equipment. Since MKS has more than doubled the number of markets it serves over the past three years (primarily through acquisitions), we believe the shares deserve a premium to those of Advanced Energy.
Both companies should benefit from consolidation among subsystems suppliers, with original equipment manufacturers preferring global suppliers with wide product lines and well-funded research and development operations. Advanced Energy currently trades at 1.3 times sales, and MKS is at 2.4 times.
Photronics, one of two leading photomask makers, is currently selling at 1.1 times sales, vs. an all-time low valuation of 0.8 times sales hit last September. Photomasks are quartz plates used to transfer circuit patterns onto semiconductor wafers. As a result of acquisitions, Photronics now records nearly 40% of its sales from Asia, which is quickly becoming the largest region for both semiconductor production and consumption. The company has also won important qualifications for 0.13-micron photomasks at Samsung and United Microelectronics (UMC ).
ASML Holding (ASML ), the world's largest lithography-equipment maker, reached a valuation low of 1.5 times sales last September and currently trades at 2.2 times sales. ASML has been gaining share in the critical photolithography market against competitors Nikon and Canon, and average selling prices on its machines have increased substantially over the past two years as the industry has moved to lithography equipment for both larger 300mm wafer sizes and finer (193nm) light wavelengths.
ATMI sells both materials (67% of March quarter sales) and equipment (33% of sales) to the semiconductor industry. The shares reached a low of 2.5 times sales in March, and currently trade at 3.0 times sales. ATMI's materials business has been growing at about twice the pace of industry wafer starts (new wafers going into production), as the company gains market share. This relatively small company holds over 330 U.S. patents, and we expect its equipment business to pick up significantly in 2004.
Two large-cap equipment companies, Applied Materials and Novellus, sell at a significant premium to the small-caps based on price-to-sales. Both of these stocks trade at about 5.0 times sales, which is closer to their average historical values than trough levels. We believe the premium reflects the companies' ability to generate much wider margins than their smaller peers, particularly in a slow-growth environment, since they get significant research, selling, and manufacturing efficiencies when selling large volumes of equipment.
We think both companies are attractive on a price-to-peak earnings basis. Applied sells at 14 times our 2005 cycle-peak EPS estimate of $1.10, while Novellus is at 14 times our peak estimate of $2.10. Past high-price to cycle-peak estimates have ranged from 16 times to 43 times.
NO SAFE BET.
Despite the attractive valuations, we don't expect chip-equipment stocks to perform nearly as well as they did coming out of the 1996 and 1998 market lows. The semiconductor industry is recovering from one of worst periods of overcapacity in history. In addition, we believe that long-term growth rates for the semiconductor and semiconductor equipment industries have slowed, given that the overall technology industry has matured.
Overall, we expect these semiconductor-equipment shares to outperform the broader market over the next six months, if our outlook for the industry recovery unfolds. Keep in mind that the equipment stocks are high beta, which means that while they're likely to outperform the overall stock market when the market is rising, the group usually underperforms significantly when the market declines. We recommend these stocks only for investors that can tolerate high risk.
Analyst Tortoriello follows semiconductor-equipment stocks for Standard & Poor's