Semiconductor Equipment Makers Still Have a Tough Road Ahead

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In a setting better suited to the Royal Family than a tech conference, the titans of the semiconductor equipment and materials industry assembled Wednesday to discuss their outlook for this year and beyond. While New York's grandiose

Plaza Hotel

was mighty impressive,

Applied Materials

(AMAT) - Get Report

CEO James "J.C." Morgan was clearly the main attraction.

"We make the systems that make the products that make the world," said Morgan, who has been at the helm of the bellwether capital equipment maker for two decades. Saying that the industry was getting over an overdue correction, he argued that it was still in the midst of a short-term "period of uncertainty" thanks to the Asian contagion, with capital spending restraints hampering continued expansion.

Morgan argued, however, that AMAT would weather these problems as it continues to produce its latest generation of manufacturing equipment that allow chip makers to turn out chips with widths of just 0.25 microns. Already, these smaller chips make up 53% of AMAT's sales, compared with 32% for its 0.35 micron chip. Morgan made the persuasive argument that the equipment and materials market had a similar period of hesitation in late 1986, but overcame it quite nicely. "If you invested $10 in our stock back then, it would be worth $500 today," he said. In other words, we've gotten through these kind of seemingly impossible situations before, and we'll do so again.

Applied Materials, even after its move up from a low of 25 1/2 on Dec. 12 to its current 36, is trading at a price-to-earnings ratio of 20. After pushing down Street estimates for its latest January quarter, the company beat

First Call

consensus estimates of 50 cents by 2 cents. And now that much of the bad news is behind the stock -- analysts have lowered earnings estimates from 50 cents to 38 cents for its April quarter -- some believe AMAT can continue to lead this beaten-up sector back to glory.

One thing's for sure: The entire sector has gotten an AMAT-generated bounce over the last month. Many of the bigger names -- including

Novellus Systems

(NVLS)

,

Teradyne

(TER) - Get Report

and

KLA-Tencor

(KLAC) - Get Report

-- are up an average of 20% since mid-January.

These stocks still have a long way to go to match their highs from mid-October, however. While the

Nasdaq Composite Index

has nearly caught up to its October peak, the major semiconductor equipment makers are still significantly down from their highs. AMAT is down 29%, KLA-Tencor is down 40% and Novellus Systems has fallen 33%. But now that many of the problems in Asia have stabilized in this volatile sector for the most part, analysts are starting to believe that this steep, albeit short-lived, run can be sustained.

Jay Deahna, an analyst with

Morgan Stanley Dean Witter

who rates Applied Materials a strong buy, believes that after another round of preannouncements in March, the sector can outperform the

S&P 500

in 1998. (Deahna's firm has done underwriting for Applied Materials.) His recent track record has been on the mark: Deahna pounded the table for two stocks last month just before the entire sector made its rapid move upwards. One was

ASM Lithography

(ASML) - Get Report

, which he backed at 65 and now is trading at 78. The other was

Cymer

(CYMI)

, which was at 15 and now is at 20.

At the

SEMInvest '98

conference this week -- put together by the good people at

Semiconductor Equipment and Materials International

-- analysts argued over when exactly this beleaguered sector's turnaround will be complete.

Lehman Brothers

managing director Edward C. White, who lowered his earnings estimates on AMAT Tuesday, said that the industry is still suffering from excess capacity in memory chips and an Asian slowdown in PC computer sales, particularly in Taiwan.

Another problem is lower capital spending levels. The Pacific Rim, which now contributes 14% of all capital spending to the industry, up from just 6% in 1992, is still hurting and hasn't been contributing as much to the development of the industry as in years past. Also, Japan, which contributes another 36% of all capital spending, has not stepped forward to take advantage of the weakness in Korean investment, and that could lead to a sharp dropoff in capital investment in 1998, say analysts.

"While the Japanese and Korean stories already have been discounted, the falloff in Taiwanese spending on new capital projects has not," said semiconductor analyst Gunnar Miller, who is moving from

PaineWebber

to

Goldman Sachs

this week. Miller sees a 9% drop in capital spending worldwide in 1998 and Deahna believes there will be a 10% drop in industry investment.

The analyst with the most positive view on the sector is Elliott Rogers of

Deutsche Morgan Grenfell

. "I think we are over the hump and that even after the sector's move upwards this year, the industry still presents itself as a good investment opportunity," he said between SEMInvest '98 meetings. His favorites: "Right now, you have to go with the best-of-breed players in this field, AMAT and Teradyne." Rogers, a 1997

Institutional Investor

All-Star, was one of the first to select Teradyne and he still thinks it has more momentum, thanks to a strong fourth quarter that saw revenues jump 62%. First Call estimates also call for a 76% rise in earnings this fiscal year, which more than makes up for the stock's relatively high P/E of 30.

While stock prospects seem to be improving, analysts worry that the overall sector needs a best-case earnings scenario to completely break out. "I don't think we are going to see any change in their fortunes until the sector's problems become more visible by the middle of the year," White said.

So the short-term picture is still cloudy, but the sector's long-term prospects are much improved from just two months ago. Investors can expect one or two more dips over the next couple of quarters and then a broad-based move upwards as semiconductor equipment leaders receive a new round of capital investment. One caveat: If Asian economic problems are still in the headlines by this summer, look for more trouble out of this sector as the capital spending well runs dry.