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ANALYSIS: What&#039&#039s behind this chip-equipment rally?

Despite a gloomy outlook for chip and PC sales through the first half of 2001, chip equipment stocks have quietly provided a good portion of the gains that have boosted the Nasdaq Composite Index more than 10 percent so far this year.

On the surface, it doesn’t seem to make much sense considering the obvious economic slowdown and reduced bookings from major microprocessor manufacturers.

But Intel (Nasdaq: INTC) gave the sector an unexpected spark this week. While it posted disappointing fourth quarter results and offered a bleak outlook for at least the first half of 2001, it also said it will spend around $7.5 billion for capital equipment this year.

That amounts to approximately 23 percent of its projected sales for the year.

“Intel’s announcement certainly surprised everyone,” said Chris Chaney, an analyst at A.G. Edwards. “But to stay on the leading edge, these companies realize they need to keep investing, especially in copper and 300 millimeter tools.”

In fact, the magnitude of Intel’s commitment to capital expenditures this year was so surprising that at least one analyst didn’t believe it.

Was Intel exaggerating?

CS First Boston’s Charles Glavin said terrible visibility in the sector combined with pricing pressures and the weak economy make the $7.5 billion figure hard to believe.

“We do not believe Intel will actually spend the shockingly high $7.5 billion capex it projects for 2001,” he said in a research note. “None of the major capex suppliers seem to believe it -- even for 0.13-micron and 300mm. We believe Intel will re-evaluate the market and its products before committing the majority of this.”

Glavin said $5 billion, plus or minus $1 billion, is far more realistic.

Investors sure seemed to believe, or at least wanted to believe.

Applied Materials (Nasdaq: AMAT), the Intel of the chip equipment group, along with Novellus Systems (Nasdaq: NVLS), KLA-Tencor (Nasdaq: KLAC) and Lam Research (Nasdaq: LRCX) all added to their already strong gains following the Intel announcement.

Equipment stocks on fire

In fact, after losing 21 percent of their value in 2000, semiconductor-equipment stocks as a whole are up 21 percent after the first three weeks of 2001. Applied Materials is up 26 percent for the year through Wednesday while Lam Research and Novellus have jumped 56 percent and 31 percent, respectively.

The general consensus from financial analysts and market research firms is that semiconductor equipment sales will be flat or perhaps slightly down from 2000’s breakneck pace. Keep in mind chip equipment sales jumped more than 80 percent last year.

Adding fuel to this unexpected rally were strong earnings reports from Novellus and KLA-Tencor this week.

Novellus topped the Wall Street's expectation by 6 cents per share, earning $104.4 million, or 76 cents a share, on sales of $425.1 million. Many analysts were bracing for sales closer to $400 million.

KLA-Tencor beat the Street estimate by a couple of cents per share in its second quarter, earning $109 million, or 57 cents a share, on sales of $573 million. It also raised its third-quarter earnings estimate to 58 cents from 51 cents per share and predicted sales of $570 million to $580, in line with analysts’ estimates.

But why are institutional investors snapping up these chip equipment stocks not only in the early stages of what most are calling a recession but when Intel, AMD (NYSE: AMD) and every other major chipmaker is scaling back estimates?

“I think people are buying them now with the intention of holding them for a year or more and then possibly selling late in 2002 when we expect demand to decline,” Chaney said. “Short-term investors might want to sell now otherwise they should hold on to them for at least another year.”

Salomon Smith Barney analyst Glen Yeung said he was “impressed” by the KLA-Tencor report, but recommended that investors sell into the strength ahead of the downturn.

“The earnings are encouraging but not enough to ward off an industry downturn,” he said.

Outlook fuzzy

Analysts are mixed on just how severe and prolonged this downturn will be. Most agree the first half of 2001 will be tough for everyone from Applied Materials down to the second- and third-tier capital equipment makers.

Sue Billat, an analyst at Robertson Stephens, reiterated her "strong buy" rating on Applied Materials last month while many of her colleagues were cutting the stock, but she did lower her fiscal 2001 earnings estimate to $2.89 per share from $3.29 while slashing her sales target from $12.57 billion to $11.46.

"We note that most chipmakers are reviewing their 2001 capital budgets, which we believe are still very much in flux, as visibility remains low," she wrote in a research note. "In our experience, Applied Materials has a track record of making market share gains during downturns and achieving high levels of profitability during upturns. In 2001, we expect the company to continue in this vein."

Despite their dissention on the sector as a whole, analysts universally agree that equipment makers who manufacture copper and 300mm tools will be the first to recover or build on their gains in the second half of the year.

Novellus, KLA-Tencor, Lam and Applied Materials all fall into this category and should provide investors decent returns in the long run.

Novellus posted gross profit margins of 56.7 percent in its most recent quarter, the company’s highest level in more than four years.

CEO Richard Hill told analysts to expect bookings to decline 30 percent to 35 percent from the year-ago period in its second. Bookings for the quarter will come in around $320 million, flat from the year-ago quarter. He said booking will re-accelerate in the third and fourth quarters.

When Applied Materials reports earnings in February, investors will get a better idea of just how severe this slowdown is and what to expect in the next few quarters.

Valuations aren’t too bad either. Applied trades at a price-to-earnings ratio of 20.3. Novellus stands at 25.3 while KLA-Tencor and Lam Research are trading at 20.6 and 12.4, respectively.

At this point, it’s clear that institutional investors prefer to buy these stocks during these uncertain times and ahead of the expected second-half surge rather than leaving their money in PC, software or even networking stocks.