Chip-Equipment Stocks? Not Yet

Though an industry upturn has been apparent, growth is already slowing. And valuations are still relatively high

By Richard Tortoriello

The S&P semiconductor equipment index has fallen 32% year to date, vs. a 20% decline for the S&P 1500 Super Composite index. Given that the group has received a couple of analyst upgrades recently, most notably from Goldman Sachs on July 26, investors may wonder if the time to buy has arrived.

While we at Standard & Poor's don't believe the initial recovery in semiconductor and semiconductor equipment markets has died, growth has slowed. North American chip-equipment order rates, as tracked by the trade group Semiconductor Materials & Equipment International, declined 80% from October, 2000, to November, 2001. But since November, orders have increased for seven straight months, clearly signaling that a recovery is under way. However, the pace of growth has slowed sharply: The month-to-month increase was 19% in April, 11% in May, and 5% in June.

This slowdown has coincided with reports of slumping PC sales. In early June, Intel (INTC ) lowered its second-quarter sales and earnings guidance, blaming weakness in desktop computers in Europe. A week later, Applied Micro Devices (AMD ) followed suit, citing a broadly sluggish PC market. While semiconductors are used in a variety of electronics goods, PCs still account for the lion's share (estimates range from 30% to 50% of total production).


  In the wireless market, leading cellular handset maker Nokia (NOK ) warned in June that it's projecting 10% year-to-year sales growth in the second half of 2002, down from earlier expectations of 15%. Handset sales are expected to remain flat for the full year.

With corporate information-technology spending at a standstill and other communications markets such as optoelectronics still sinking, only a few bright spots remain. Consumer electronics, such as DVD players and digital cameras, and niche markets, such as automotive electronics and wireless networking, are still showing sales gains.

S&P believes that chipmakers, which had underinvested in new technologies during the latest downturn, have had to purchase new gear over the last several months to stay competitive. For example, orders at equipment maker Novellus Systems (NVLS ), which specializes in tools used to deposit copper on semiconductor wafers, rose 59% in 2002's first quarter from the preceding quarter, and then increased 58% in the second quarter from the first quarter.


  But with few signs of sustained growth in electronics end markets, chipmakers have now turned cautious. In July, Intel reduced its planned capital spending for 2002 to between $5 billion and $5.2 billion from $5.5 billion, representing a 30% decline from record 2001 levels.

Taiwan Semiconductor, the world's largest contract chipmaker, reduced its capital budget to $2 billion from $2.57 billion (a 9% decline from 2001). And Swiss electronics giant STMicroelectronics (STM ) cut its budget to $1 billion from $1.2 billion (a 41% decline from 2001 levels).

This renewed caution at chipmakers has caused projected sales and order rates at chip-equipment makers to level off. Novellus expects orders to decline by about 9% in the third quarter, while metrology/inspection-tool leader KLA-Tencor (KLAC ) sees flat order growth. Etch-equipment maker Lam Research (LRCX ) sees orders flat to down 10%.


  Meanwhile, valuations of chip-equipment companies, which have remained high on a historical basis throughout the recent downturn, have begun to moderate. In January, with orders just beginning to improve, valuations were far above historical trough levels (see ). By July, price-to-book value ratios declined substantially but had still not reached historical lows.

And price-to-sales levels remain high historically. It should be noted, however, that industry revenues have fallen further and taken longer to begin a recovery than in any past downturn.

One industry observer has noted that the time to buy chip-equipment shares is when the "air is thick with gloomy fog." Although we at S&P don't believe that point has been reached yet, we believe it's close. Stock prices have been decimated, PC growth is anemic, corporate IT spending growth is nonexistent, and chip-equipment makers' visibility into future demand trends is very limited.

Before recommending these shares to investors, we would like to see one of two events occur. One would be a continued sell-off in the stocks until valuations -- especially price-to-book value -- reach or come very close to historical lows. The other factor would be the appearance of initial signs of resumed growth in electronics end markets, such as hints of a strong back-to-school or Christmas season. Absent these trends, we remain cautious on the shares.

  1992 Lows   1996 Lows   1998 Lows   Sept. 2001   Jan. 2002   July 2002  
  Prc/Bk* Prc/Sls* Prc/Bk Prc/Sls Prc/Bk Prc/Sls Prc/Bk Prc/Sls Prc/Bk Prc/Sls Prc/Bk Prc/Sls
Applied Materials 1.3 1.0 1.9 1.0 2.8 1.9 3.2 2.6 5.2 4.4 3.3 5.5
KLA-Tencor 1.3 0.9 1.8 1.4 1.6 1.6 3.2 2.6 6.2 4.9 4.1 4.7
Lam Research 1.6 0.8 1.1 0.5 0.7 0.4 2.9 1.2 4.8 2.0 2.3 1.7
Novellus Systems 1.5 1.6 1.8 1.3 2.6 1.4 2.0 2.4 3.5 4.2 2.1 4.6
Teradyne 1.0 0.7 1.3 0.8 1.4 0.9 2.0 1.7 3.5 2.9 1.7 2.7
Average 1.3 1.0 1.6 1.0 1.8 1.2 2.7 2.1 4.6 3.7 2.7 3.8

* Prc/Bk = Price-to-Book Value, Prc/Sls = Price-to-Trailing Twelve-Month Sales

Analyst Tortoriello follows semiconductor equipment stocks for Standard & Poor's

Edited by Karyn McCormack

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