Second-Half Fears Sink Makers of Chip Equipment

Updated from 4:07 p.m. EDT

A downbeat report from Goldman Sachs citing fears of a second-half pause in demand sent chip-equipment stocks spiraling lower across the board today.

Analyst James Covello said it's possible that a drop-off in demand from foundries could cause orders to stay flat for a quarter or two in the second half of the year.

Though Covello downgraded a batch of stocks in the sector, he added that his worries were about a "potential pause in the semiconductor cycle, nothing company specific." He downgraded the semi-equipment sector to market weight from market overweight, suggesting it would be smart to sit on the sidelines until the second-half demand picture clears up and/or stock prices in the sector drop by 20% to 25%.

In the wake of the downgrade, industry leader Applied Materials (AMAT) closed Friday down 6.9%; ATMI (AMTI) down 8%; KLA-Tencor (KLAC) off 4.7%; Novellus (NVLS) down 3.5%; and Lam Research (LRCX) off 5.5%.

The slumping stocks also helped take down the Philadelphia Stock Exchange Semiconductor Index, which dropped 3.3%.

Today, slumping chip equipment stocks helped take down the Philadelphia Stock Exchange Semiconductor Index, which fell 3.3%.

Some investors agree that stocks such as Applied are cruising for a fall. "I don't think AMAT is going to have a horrendous year next year, but they aren't going to justify next year's numbers," said money manager Anthony Italiano of the Italiano Capital Group in Tampa, a limited partnership which runs the Italiano family assets of more than $60 million. He's been shorting the stock on and off since 2000. He began shorting it again in January, increasing that stake leading up to AMAT's quarterly report on May 14.

"We took the position because the stock [is] trading at peak earnings while end demand is stagnant and pricing poor," he said. "There is no sign business will return to its previous peak anytime soon. Investors shouldn't pay a premium when they have no idea where the stock is going to be in 18 months."

As proof of Wall Street's wishful thinking, he points to the consensus estimate of 76 cents per share for fiscal 2003, which would be a 300% increase over the forecast fiscal 2002 earnings of 19 cents per share.

A Rained-Out Parade

Covello's gloomy note came after several buoyant reports from the sector had recently fueled bullish sentiment. Last week industry leader Applied Materials reported a startling 51% sequential increase in order growth, well above analysts' estimates. In April, newly released numbers showed that the March book-to-bill ratio for the chip-equipment sector rose above 1.0 for the first time in more than a year, supporting the notion that recovery was under way.

In fact, Goldman itself hiked its 2002 and 2003 estimates for Applied Materials as recently as May 13.

But since then, Covello has turned up worrying signs of a drop-off in demand for chip equipment at foundries, which he said "seem to be easing off the accelerator on installation of new capacity." That could complicate matters for a company such as Applied Materials, which takes more than 40% of its orders from foundries.

Covello added that any slowdown is likely to affect orders for 200mm wafer equipment rather than for the newer 300mm technology, for which demand should remain strong.

In light of the recent hefty gains in stock prices, any signs of weakness down the road could cause the sector to take a dunking. Chip-equipment stocks have outperformed the Nasdaq by nearly 30% since February.

To be sure, not everyone thinks chip equipment will encounter demand hiccups. At Salomon Smith Barney, analyst Glen Yeung points out that utilization of semiconductor facilities -- a measure of how much productive capacity is being used at any moment in time -- jumped to 76% in the first quarter, up from 65% in the fourth quarter. "Historically, at an 80% rate of utilization and going up, we start an up cycle," he says. "So in my mind, we're in a good trend. Nothing that we're seeing in the market has fundamentally changed our view on the space. We continue to believe that tech-oriented buys are building momentum now."

Even Covello said he wouldn't expect demand to moderate until the third quarter at the earliest. Second-quarter order growth should show strong sequential gains, he predicts. In the very short term, he noted, the Novellus midquarter update next Tuesday could also give chip-equipment stocks a boost.

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