Falling Orders Raise Questions About Chip Equipment Stocks

Orders fell again in May, but the stocks remain expensive on a price-to-earnings basis.
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Chip investors searching for signs of sector improvement in semiconductor equipment monthly orders instead found more despair Thursday. And that could hit the chip equipment stocks that have been rising on expectations of a rebound.

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Semiconductor Equipment Orders Plunged in April

The three-month average of worldwide bookings for May came in at $704 million, according to

Semiconductor Equipment and Materials International

, a trade group. The May figure is 3% off the revised April figure of $723 million and 75% below the year-earlier's $2.78 billion. The closely watched book-to-bill ratio was 0.46, meaning that $46 in new orders were received for every $100 worth of products shipped in the month.

With semiconductor companies still struggling with weak demand, overcapacity, decreasing prices and steep inventories, investing in new technology and capacity has fallen to the wayside. Microprocessor giant

Intel

(INTC) - Get Report

, for instance, earlier this week delayed deciding whether to build a $3.5 billion plant in Israel, even as it maintained an overall capital spending budget of $7.5 billion for 2001.

And until semiconductor revenues turn, Intel and other chipmakers won't be sending chip equipment manufacturers orders. So that means chip equipment revenues will remain flat at best. For investors, that makes putting money into these volatile stocks trickier than usual. While most agree that the cyclical semiconductor market will recover at some point in the next 18 months, investors who get in too early may have to wade through some sharp declines before getting to a payoff.

Valuations

Given current valuations, it's clear many investors are taking that risk. Prices on the chip equipment sector have been on a steady upward climb since December, with a few dips here and there. At these levels, the stocks are trading at fairly rich

price-to-earnings ratios for 2001 and 2002.

For instance, industry giant

Applied Materials

(AMAT) - Get Report

is expected to earn $1.06 in 2001 and $1.12 in 2002, meaning it's trading at 46 times 2001 earnings and 43 times 2002 earnings.

KLA-Tencor

(KLAC) - Get Report

is expected to earn $1.85 in 2001 and $1.01 the year after, putting its 2001 P/E at 29 and 2002 P/E at 53.

Novellus

(NVLS)

is expected to earn $1.47 this year and $1.66 next, so it's trading at 34 times 2001 earnings and 30 times 2002 earnings.

But the earnings projections that back up these valuations are in danger. Earlier this week, semiconductor testing company

Teradyne

(TER) - Get Report

said it would fall short of estimates this quarter and instead of breaking even would lose 5 cents to 10 cents a share. Its stock has lost 10% since then. Teradyne's loss may not have been a surprise, but it does signal exactly how weak demand in the semiconductor sector has become.

Byron Walker, chip equipment analyst at

UBS Warburg

, believes more losses are coming in either the second or third quarter, and for more than just Teradyne.

The Problem

"The problem is people have directly moved toward quality with the least amount of fundamental technology risk, but the disconnect between that and earnings is large, because earnings are going south," Walker says. "In fact, more than most analysts believe, because if you look at

First Call

, there are very few analysts who have dialed in losses. We will see losses."

The semiconductor industry hasn't finished bottoming, in part because it typically includes large inventory write-offs industrywide, he says. And while the companies are in the process of bottoming, Walker says, they aren't producing the cash that leads to capital equipment expenditures. One of the problems ahead is that it'll be tough for spending on chip equipment to match the record spending of 2000, which means the year-over-year comparisons aren't going to look good.

The 87% increase in global semiconductor equipment revenue to $47.7 billion in 2000 -- the biggest ever -- won't repeat itself this year. SEMI on Thursday also lowered its outlook for 2001 and now expects a 30% to 32% decline compared with a 27% to 30% decline in revenue -- which will be the worst percentage decline on record.

Fallen Down

Orders have fallen off in part because some of the markets that drove the growth in 2000 have disappeared. Telecom spending, for instance, has all but dried up at the moment as large inventories and capital spending have decreased dramatically.

Eric Ross, an analyst at

Thomas Weisel Partners

, says that in 2000, telecommunications accounted for about 28% of total semiconductor revenues and he expects it to make up 30% of 2001 revenues.

Ross sees semiconductor equipment orders picking up in the fourth quarter as semiconductor companies start planning for equipment they'll need in 2002. Of course, that depends on the personal computer market recovering in the year's second half. Otherwise, the scenario gets pushed out further.

And so do the chip equipment earnings that investors are paying for now.