Novellus Undone by Merrill Downgrade

Updated from 9:33 a.m. EDT

Novellus ( NVLS) said Monday morning that second-quarterearnings rose fivefold from a year ago, thanks tomargin improvement leveraged to robustsemiconductor-equipment demand that Wall Streetworries is peaking. Management also forecast a robustfinancial outlook for the quarter under way, and soughtto allay investor fears about what many fear is alooming slowdown in the chip industry.

But the stock was recently down $1.76 or 5.7% to$29.29, as the semiconductor equipment space was the subjectof negative research Monday by Merrill Lynch. The brokerage firm downgraded Intel ( INTC) to neutral from buy and the semiconductor equipment space to neutral from overweight. Other stocks falling included Applied Materials ( AMAT), ASML ( ASML) and KLA-Tencor ( KLAC). The Philadelphia Stock Exchange Semiconductor Index was recently down 3.3%.

Monday morning the San Jose, Calif., company saidit earned $37.8 million, or 25 cents a share, in thethree months to June 26, up from $7.4 million, or 5cents a share, last year. The latest quarter includedan acquisition-related charge, excluding which thecompany earned $43.9 million, or 29 cents a share.Second-quarter sales were $338.2 million, up 41.5%from last year.

Excluding the charge, analysts surveyed by ThomsonFirst Call had been forecasting earnings of 26 centsa share on sales of $331.3 million in the latest quarter.

Novellus forecast revenue of $408 million to $418million for the quarter now under way, which includes$20 million to $25 million of sales from its recentacquisition of Peter Wolters, a private Germanmanufacturer of machine tools. Earnings should rangefrom 37 to 39 cents a share, the company said. Theconsensus estimate was for revenue of $361 millionwith 31 cents in EPS.

At ThinkEquity Partners, analyst Suresh Balaramansaid the likely cause of Novellus' selloff was growingjitters over Tuesday's quarterly report from lead chipmakerIntel, exacerbated byMerrill Lynch's downgrade. "I thinkIntel is carrying the day and putting a pall on thewhole group," he said. "But results from Novellus were very good.The margins were nice, better than what most haveexpected." (Balaraman has an accumulate rating on thestock; his firm hasn't done banking for it.)

On the conference call, analysts peppered Novellusmanagement with questions about whether customerdemand for new equipment may peaking out. "Right now,our best visibility is we don't see the downturn,"said Chief Financial Officer Kevin Royal, addingNovellus has "fairly good visibility through the thirdquarter" and that he remains "cautiously optimistic."He said the company is on track to exceed its 2000peak in revenue and bookings.

Royal said he'd get nervous if he saw a decreasein industrial spending. But so far such buying hasonly continued to accelerate -- albeit at a more modestpace than in the past, reflecting what he called "rational deployment of capital."

Unlike the heady days of the late 1990s, whencapital markets offered companies a seeminglyendlessly supply of easy cash to spend, they must nowfinance spending out of their internal operations, hesaid. That's made companies more cautious aboutexpanding capacity; rather than install a wholesemiconductor factory in one go, they're currently more likelyto add capacity gradually, in three or four phases."We're not getting immediately into an overcapacitysituation," Royal said.

"I believe because actual supply and demand aremore closely mapped together, the downturn will beless severe," he said.

On a geographic basis, Japanese customers arecurrently pushing much of the growth in the equipmentindustry, followed by Chinese suppliers, the companysaid. As for end markets, Novellus sales havebenefited from the high demand for digital consumerelectronics and the expansion of applications forflash memory, along with a generally improvedindustrial investment on computing, management said onthe conference call.

Novellus reported second-quarter shipments of$366.1 million, representing a sequential increase of17.7%, while deferred revenue rose 18.2% from thefirst quarter to $181.1 million at June 26, 2004. Thecompany's gross margin was 50.5% in the most recentquarter, up from 44.1% in the year-ago period. Total operating expenseswere 34.5% of sales in the 2004 period, compared with42.2% a year ago.

"Bookings are strong and we continue to experienceoperating leverage to drive superior financial resultsfor our shareholders," the company said in a statement. "Novellus isexperiencing further strengthening of its 300-millimeter market penetration, particularly inadvanced copper applications, due to our technologicalexcellence and a continued focus on productivity."

Novellus bought back 5.5 million shares during thequarter for $167.1 million.

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