The Tops in Chip-Equipment Stocks
By Richard Tortoriello
Investors in semiconductor-equipment makers -- the companies making the precision process gear used to manufacture today's microscopic chips -- have had a good year so far. Through Apr. 12, the S&P Semiconductor Equipment Index has risen 22.2%, and that follows a 10.1% gain in 2001. By contrast, the Standard & Poor's 1,500-stock index (the combined S&P 500, S&P MidCap 400, and S&P SmallCap 600 indexes) has declined 2.1% year-to-date and was down 11.8% in 2001.
It's all the more surprising that the solid share-price gains come on top of an unusually ugly year for semiconductor and semiconductor-equipment sales. Worldwide semiconductor sales fell to $140 billion in 2001, from $204 billion the previous year, a 31% decline. Not only was this the worst one-year decline in industry history, it was nearly twice as sharp as the previous steepest drop (17%, in 1985). Over the same period, sales of semiconductor equipment plunged an estimated 38%, to $30 billion from $48 billion.
This isn't likely to be a boom year for either group. The Semiconductor Industry Assn. estimates that chip production will increase 6% in 2002, to $148 billion, while SEMI, the trade organization for semiconductor equipment makers, projects that equipment sales will decline slightly, to $28.7 billion. (S&P believes these estimates will prove low.)
So what accounts for the relative strength in semiconductor equipment stocks, which in 2001 not only outperformed the S&P 1500 but all other information-technology groups as well? We believe the answer lies in the relentless march toward smaller, faster chips. Introduced in 1975, Intel's 8080 processor had 4,500 transistors, while its current flagship offering, the Pentium 4, packs 42 million.
This huge increase in complexity is being made possible primarily by advances in manufacturing processes and equipment. As transistor sizes approach the atomic level, the equipment needed to manufacture them is becoming increasingly critical and complex.
Three major technological shifts will drive sales of semiconductor equipment and add value to chips: the continued move toward smaller transistor sizes (from circuit-line widths of 0.18 micron to 0.13 micron and below), the replacement of aluminum wiring with copper wiring (copper is faster but more difficult to work with), and the shift from 200mm (8-inch) to 300mm (12-inch) silicon wafers. Each of these trends will spur major increases in spending on semiconductor equipment.
Finally, the rapidly growing semiconductor industry in China provides opportunity for chip-equipment makers to expand geographically. Chinese officials estimate that the country's chip production now meets only 20% of domestic demand, and China is acting on an aggressive plan not only to supply internal needs but to become a major semiconductor exporter.
Where should investors be looking in the chip-equipment group? Our industry picks, listed below, carry 4 STARS (accumulate) or 5 STARS (buy) rankings, meaning we expect them to outperform the overall market in the coming 6 to 12 months.
Amkor Technology (AMKR ; 4 STARS): This large contract semiconductor-packaging and -testing company is gaining market share in advanced packaging and expanding into several new markets, including Japan, Taiwan, and China. We think the shares are reasonably valued vs. its peers at 2.3 times our 2003 sales estimate.
Brooks Automation (BRKS ; 5 STARS): Automation will be increasingly important in 300mm wafer-fabrication facilities, or fabs, and its pending merger with PRI Automation would make Brooks the leading supplier of semiconductor factory-automation hardware and software. The shares are attractive at 1.9 times book value and 1.9 times our 2003 sales estimate, below historical highs of 4 to 5 times sales.
DuPont Photomasks (DPMI ; 4 STARS): Transistor sizes have become much smaller than the smallest wavelength of light currently used to transfer their images onto silicon wafers. Such limitations in the transfer, or photolithography, process are among the most critical roadblocks in the continuing shrinkage of transistor sizes.
Photomasks (clear crystal plates imprinted with circuit patterns) are one way to solve the problem. Essentially, advanced photomasks can "trick" light into resolving at finer resolutions than its wavelength. DuPont shares the advanced-mask market with competitor Photronics (see below), and we believe the shares are attractively valued at 26 times our fiscal 2003 (ending in June) estimate of $1.90.
FEI (FEIC ; 5 STARS): FEI, a maker of high-powered microscopes, has seen rapid growth in sales to the chip market as semiconductor features become smaller and smaller. With a p-e ratio of 18 on our 2003 EPS estimate of $1.90, vs. our long-term EPS growth forecast of 23%, we currently see the shares as the best value in the equipment group.
Keithley Instruments (KEI ; 4 STARS): In the mid-1990s, this old-line maker of electronics test and measurement equipment successfully adapted its products to high-growth markets, including semiconductors, optoelectronics, and wireless communications. With an extensive product line, a well-recognized brand name, and a solid track record, Keithley is well-positioned for growth. With a p-e of 23 times our fiscal 2003 EPS estimate of $0.97, vs. our long-term EPS growth estimate of 22%, we view the shares as attractive.
Kulicke & Soffa (KLIC ; 5 STARS): This leading provider of wire bonders and other semiconductor assembly equipment has a 33% share of overall industry revenues. K&S has recently received several large orders for its wire bonders, and we see the shares as undervalued at three times book value, vs. historical peaks of five to six times book value.
Novellus Systems (NVLS ; 4 STARS): Novellus is a leading player in the large market for thin-film deposition, in which extremely thin layers of conductive or insulating material are applied to a wafer to form its circuitry. Novellus has strong product offerings in the emerging markets for copper and low-K dielectric deposition, which enable chips to operate faster than current aluminum and silicon oxide technologies. Orders increased 59% in the March quarter from the prior quarter, and we think the shares are attractive at 27 times our 2003 EPS estimate of $1.97, vs. our long-term EPS growth rate of 25%.
Photronics (PLAB ; 4 STARS): Due to an aggressive expansion program -- with acquisitions in Europe, Taiwan and the Pacific Rim, and Korea -- we believe Photronics has edged ahead of DuPont Photomasks in world photomask market share. Advanced-mask sales increased 25% quarter-over-quarter in the January period and 65% the previous quarter. We see the shares as attractive at 1.9 times our 2003 sales estimate and 24 times our fiscal 2003 (ending in October) EPS estimate of $1.48.
Ultratech Stepper (UTEK ; 4 STARS): By focusing on niche markets, this scrappy maker of photolithography equipment ("step-and-scan" systems) has held its own against giants Nikon, Canon, and ASML. We view the shares as attractive at 22 times our 2003 EPS estimate of $0.90 and 2.3 times book value, a discount to that of Ultratech's small-cap equipment peers.
Analyst Tortoriello covers semiconductor capital equipment stocks for Standard & Poor's