Rich Returns in Chip Equipment

S&P's Colin McArdle sees good things ahead for the segment, thanks to new technology and chip-maker upgrades

Chip-equipment stocks are shining lately. The S&P Semiconductor Equipment index has jumped 16.3% in the last 13 weeks (through Feb. 3), vs. gains of 3.1% for the S&P Information Technology index and 3.6% for the broader S&P 500. "We interpret the group's move as anticipation of ongoing improving business conditions and a prolonged up cycle," says Colin McArdle, who follows chip-equipment stocks for Standard & Poor's Equity Research.

McArdle recently upgraded KLA-Tencor (KLAC) to strong buy. He believes that capital spending by chip makers will be strong this year, and the amount of money dedicated to the company's yield-improvement equipment, including inspection and metrology, is increasing due to the transition to smaller line widths, or putting more capacity on chips.

BusinessWeek Online's Karyn McCormack recently spoke with McArdle about KLA-Tencor and what's behind the industry's big move. Edited excerpts of their conversation follow.

Note: Colin McArdle is a Standard & Poor's Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this story.

Why did you recently upgrade KLA-Tencor to strong buy?

We're becoming more bullish on the outlook for the industry. Capital expenditures will increase 10% across the industry in 2006, up from my previous estimate of 8%. That mirrors a forecast from our chip analyst Tom Smith of chip-unit sales to rise 12%, up from his previous outlook for 9% growth.

We believe that within capital expenditures on equipment, there's an increasing focus on spending for inspection and metrology equipment. For example, in the late '90s, we believe spending on that equipment was 5% of total spending, and now it could be as much as 12% this year, as companies transition to smaller line widths. The inspection equipment required for sub-90 nanometer chips is increasing exponentially, in our opinion.

KLA recently reported earnings and offered improving guidance in the current quarter, and we believe that momentum will continue to build throughout the year. We see KLA as a technology leader, and that's reflected in its dominant market share in the market it participates in and in the company's high gross margins.

We acknowledge that KLA's fiscal 2004 return on invested capital was 8%, and we believe that can increase to 20% as the up cycle reaches prior peaks, as indicated by recent order trends.

What are the main drivers of sales for chip-equipment makers?

I mentioned the rise in spending on equipment. We see increasing demand coming from two areas in particular. The first is a return to purchasing by the foundries, particularly in Taiwan. And the second is the proliferation of flash memory in consumer-electronics products. We believe spending on equipment to produce flash memory could double or triple this year.

KLA-Tencor's stock is trading close to its 52-week high. What do you think of its valuation?

We believe it's currently trading at reasonable levels. When we look at the stock's price performance vs. peers, it has been volatile but flat overall in the last 12 months. That compares to Lam Research's (LRCX) 70% rise in that period. For KLA, we apply a peer-based 29 times p-e multiple to our calendar 2006 EPS forecast and derive a $64 12-month target price, representing an upside of 19%.

Why have chip-equipment stocks run up recently?

In January, the industry was up 13%, and my 5-STAR stocks were up 35%. So it was a big month. As a result, I downgraded Lam Research, which rose dramatically. We interpret the group's move as anticipation of ongoing improving business conditions and a prolonged up cycle.

As we look back on the latest earnings season, companies almost unanimously reported improving business conditions and higher order rates. We look for the industry book-to-bill ratio to rise above 1.0 in the coming months, from 0.96 as of December.

Is KLA-Tencor your favorite chip-equipment stock?

We like both KLA and Brooks Automation (BRKS). They play in different market segments but benefit from the same industry trends. Brooks is a leader in factory equipment and software automation, having recently completed the acquisition of Helix Technology. We have a $23 12-month target price on Brooks shares, representing upside of 35% from recent levels.

Are there any other stocks in the group that you like?

Two other stocks that we would highlight are Applied Materials (AMAT), the largest player in the industry benefiting from scale, and Novellus Systems (NVLS), given its technology leadership position in areas it participates in. They are both ranked buy.

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