Chip Equipment: A Lingering Fog
By Richard Tortoriello
Standard & Poor's expects modest growth -- perhaps 5% to 10% -- in semiconductor equipment sales in 2003. After a nearly 60% decline in industry revenues from 2000 to 2002, growth of 5% to 10% would indicate that the group is stabilizing. However, the environment remains difficult. Very few chipmakers and equipment makers have been able to provide guidance about likely orders and sales trends beyond the current quarter. For instance, in its Mar. 6 update on how the first quarter is shaping up, Intel (INTC ) said that while revenues are in line with expected seasonal trends, it doesn't have enough evidence to call a recovery in corporate information-technology spending.
Recent trends in chipmakers' unit-production volumes, however, have turned modestly favorable. Although chip prices declined in 2002 and worldwide sales grew only 1.3%, unit volume increased 14% for the year. Semiconductor unit volumes are now nearly 90% of 2000 peak production levels. Meanwhile, average selling prices of chips, which have dropped sharply over the past two years, have shown signs of stabilization. As a result, although some high-profile chip companies like Intel have cut capital-spending plans for 2003, other chipmakers have increased them.
What's more, the latest Bureau of Economic Analysis gross domestic product statistics show that business spending on equipment and software rose for the third straight quarter in December (up 6.6% annualized for the quarter), after six straight quarterly declines. This data may signal the beginning of a much-anticipated upgrade in PCs at corporations.
However, prospects of war and terrorism, rising prices for oil and natural gas, and a shaky world economy have begun to put a damper on what S&P viewed as a nascent recovery in electronics markets. As an indicator, the Conference Board's consumer confidence index for February plunged nearly 15 points, to 64, the third consecutive monthly decline. In addition, a number of equipment companies say chipmakers have recently delayed orders as they assess current political and economic trends.
The latest results from chipmaking-equipment leader Applied Materials (AMAT ) underscore the challenging times. It announced that fiscal first-quarter (ended Jan. 31) bookings fell 35% from the fourth quarter, vs. its original projection of a 20% decline. Applied blamed the shortfall on cutbacks in spare parts and service contracts, as well as "timing issues" (which we interpret as order push-outs) in its Etec photomask equipment business. We at S&P believe that chipmakers have simply begun reining in planned spending given the uncertain outlooks for their electronics goods customers.
Applied (ranked 1 S&P STARS, or sell) said it expects slight sales and orders increases in the second quarter and earnings per share of 1 cent or 2 cents. As a result, Wall Street analysts have cut their earnings numbers for Applied, bringing the mean earnings per share estimate for fiscal 2003 (ending Oct. 31) to 14 cents, from 20 cents within the past 30 days.
Direct competitor Novellus Systems (NVLS ), which has more of its product line tied directly to the transition to copper interconnects, saw orders decline only 6% in its fourth quarter, ended Dec. 31. The use of copper, which is rapidly replacing aluminum as the interconnect wiring material on semiconductors, allows improvements in both speed and power efficiency. For the first quarter, ending Mar. 31, Novellus sees sales increasing about 8% from the fourth quarter, with bookings rising about 11%. It expects EPS of 7 cents, vs. 11 cents (excluding acquisition and restructuring charges of 8 cents per share) in the fourth quarter.
However, Novellus (ranked 2 STARS, or avoid) is facing the twin demons of low factory utilization rates (which compress gross margins, since fixed manufacturing costs must be paid regardless of manufacturing volume) and competitive pricing pressure. As a result, gross margins remain mired in the mid- to low-40% range, well below Novellus' historical average of 55%.
On the positive side, we're seeing signs of increased spending on capital equipment in Japan. With falling worldwide market share and huge operating losses, Japan's large electronics makers cut capital spending by an estimated 60% in 2001 and more than 20% in 2002. Many of these companies have restructured their chipmaking subsidiaries (examples include the Hitachi/Mitsubishi joint venture, Renesas, and the NEC/Hitachi memory-chip joint venture, Elpida). Their preliminary budgets call for an increase in capital spending by as much as 32% in 2003 -- and much of this will be spent on new equipment. By Richard Tortoriello
Another area of relative strength is memory chipmakers, particularly in Korea and Taiwan. Samsung, by far the region's largest memory chipmaker, announced plans to increase capital spending on its semiconductor operations in 2003 by 90%, to $3.56 billion. Samsung has benefited from a strong flash-memory market, as well as its vault from ninth place in that market in 2001 to second in 2002.
Offsetting these areas of growth, however, will likely be the Taiwanese foundries and large U.S. integrated device manufacturers (IDMs) such as Intel. After spending more than $18 billion on capital expansion from 2000 to 2002, Intel plans to cut capital expansion by about 20% this year, to a range of $3.5 billion to $3.9 billion. (Intel reaffirmed its 2003 spending forecast on its Mar. 6 mid-quarter update.)
Other large U.S. IDMs, including IBM (IBM ), Texas Instruments (TXN ), Advanced Micro Devices (AMD ), and Motorola (MOT ), plan modest cuts to capital expansion in 2003. With profits sagging, many of these companies are moving to reduce fixed costs by relying more on semiconductor foundries, or contract chipmakers, for future production.
The foundries, which have seen their utilization rates dip to about 60% in the fourth quarter from the low 80% range in the second quarter, also plan to cut capital spending. Taiwan Semiconductor (TSM ), the world's largest foundry, plans to cut spending by 10% to 30% in 2003, to a range of $1.1 billion to $1.5 billion. No. 2 foundry United Microelectronics (UMC ) plans to cut spending by 38%, to $500 million, for the year.
Should the computer, communications, and consumer markets -- where the foundries are strongest -- improve significantly during the year, these budgets could be revised upward. However, given current economic and geopolitical risks, we don't expect this to occur.
It's important to keep in mind that semiconductor equipment companies are at the bottom of a very large food chain. It starts with electronics products sold to corporations and consumers, goes down to electronics parts distributors and semiconductor manufacturers, and ends with capital equipment makers. Cutbacks that occur at the top of the food chain are often magnified as they make their way down it. For example, as electronics products makers respond to slowdowns in their end markets by reducing chip inventories and cutting orders, chipmakers experience overcapacity and declining profits, resulting in even larger cutbacks in spending on capital equipment.
JUST PLAIN CAUTIOUS.
While 5% to 10% capital-spending growth this year -- if it happens -- would be a change for the better, strong future growth depends mainly on a pickup in corporate IT spending. So the bottom line is: Until global corporations envision a solid return to profitability and feel confident that the political environment is likely to support economic growth, current overcapacity in electronics and semiconductor markets will prevail, and capital- equipment orders will remain weak.
For 2003, execs at many chip and equipment manufacturers say they're "cautiously optimistic" -- a phrase, by the way, that they also widely used at the beginning of 2002. We, however, prefer to just use the word "cautious" when describing the industry outlook for 2003. Given stock valuations that are generally well above levels historically seen at cyclical troughs, we remain negative on the semiconductor equipment group.
Analyst Tortoriello follows chip equipment stocks for Standard & Poor's
Edited by Karyn McCormack