Shares in chip equipment makers quietly surge

Until turmoil swept through the major stock markets this week--the Nasdaq shed nearly 7 percent on Monday and Tuesday--shares of the major companies that manufacture equipment used by computer chipmakers were trading at 52-week highs.

Three of the larger companies in the sector--KLA-Tencor, Novellus and Applied Material--peaked on Friday. And although the shares have followed the broader markets lower this week, analysts remain bullish about the prospects for this traditionally cyclical sector.

"It's a broader market issue," Glen Yeung, a vice president of research at Deutsche Bank Alex Brown, said of this week's slide in the companies' shares. "There's certainly a sell-off in technology, but the fundamentals in the equipment sector couldn't be stronger."

That strength has been reflected in the rapidly rising share prices of the three companies, and others.

Since the beginning of the year, Novellus shares have jumped 65 percent, KLA has gained 37 percent and Applied Materials has climbed 41 percent--gains that are even more impressive considering the sharp drops of the past two days.

The CNET Semiconductor Capital Equipment Index has gained 45 percent since the beginning of the year. By comparison, the Dow Jones Industrial Average has declined nearly 15 percent and the Nasdaq has gained 15 percent.

The shares are being propelled by increased spending by the major chipmakers, such as Intel and several foreign companies.

According to the Semiconductor Equipment and Materials International (SEMI) group, the worldwide chip industry will grow 25 percent in 2000 and 40 percent in 2001, compared with a growth rate of 19 percent in 1999.

The surge will be fueled not only by the traditional PC market, but also by telecom and communications companies that are building mobile phones with Web browsers, personal digital assistants and other gadgets that require chips.

SEMI also reports that book-to-bill ratios are steadily increasing, an indicator of growing demand. Last August, the ratio was 1.09, which means $109 worth of chip orders were received for every $100 worth of orders shipped. The ratio jumped to 1.34 last January.

"The industry is in a sweet spot right now," said Dick Greene, principal analyst for SEMI. "We see every region being relatively aggressive (in buying), but the Taiwan companies are by far the most aggressive.

"The Taiwan companies are in a foundry business mode," said Greene. "They focus on the manufacturing of chips as a separate operation."

"Originally, chipmakers were vertically integrated, but now it's more efficient for others to do the design and marketing, and others to do the manufacturing, and still others to do the testing and assembly of the chips," he added. "My guess is that the Taiwan companies are making an effort to increase their market share in the manufacturing sector."

Switch to larger wafers
A switch to making larger wafers is boosting business. Because the wafers are essentially cut into individual chips, larger wafers are more efficient.

Greater precision in the manufacturing process also allows the makers to squeeze more chip functions into each wafer.

"More and more precise geometry allows (chip manufacturers) to put the same value on a smaller area of wafer which allows them to reduce their unit costs," said Greene.

The process is not unlike baking cookies. If you increase the size of the cookie sheet, then you'll fit more cookie dough on the pan.

Precision geometry "is as useful as larger wafers, so it's the equivalent of making smaller cookies as well as using a larger cookie sheet," said Greene.

The bottom line is that chipmakers are buying the more efficient manufacturing and test equipment from companies such as KLA-Tencor, Novellus and Applied Materials.

"We see very aggressive spending by the chipmakers, which translates to very aggressive order bookings," said Yeung of Deutsche Bank Alex Brown.

According to Yeung, chipmakers spent $50 million to $70 million on KLA equipment per fabrication facility in 1995, when the sector was last on an upswing. In 2000, he expects manufactures to spend $100 million to $125 million.

"Chipmakers realize the benefits they get from yield-improvement equipment so they are willing to spend more," he said.

As for how the shares will perform in the future, "It's going to be choppy in the near term, but we're waiting until the companies release earnings, which we expect will be strong," said Eric Chen, an analyst at Chase H&Q.

Novellus and KLA-Tencor report earnings on April 12 and 17, respectively. Applied Materials is scheduled to report its earnings on May 10.

Further out, Ed White, an analyst at Lehman Brothers, does not see a reduction in capacity spending this year.

"There's a concern that companies will buy the equipment they need in the short term then hold back later on," said White, "But I don't see that. Some companies are buying now, and some are holding back and will probably buy later on."

White said Taiwan-based companies such as Taiwan Semiconductor Manufacturing Company and United Microelectronics, as well as Chartered Semiconductor of Singapore, are the major buyers today. Purchases by Japanese companies have been restrained.

Downturn coming?
While business is strong today, there are dark clouds on the horizon.

"We could see a slowdown if there is lower demand (for products) in the communication and telecom sectors, as well as reduced demand for digital consumer equipment like DVD players, camcorders and audio equipment," said White.

Yeung also warned that the sector could cool off in late 2001.

"It's a cyclical industry, so we will be seeing a cyclical downturn. But that's very hard to predict."