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A renewed surge of doubt about the semiconductor cycle has accelerated the year-to-date slide in chip-equipment stocks. But some investors are becoming enticed by the sector's beaten-up valuations and the distinct possibility the equipment buying cycle could last longer than conventional wisdom suggests.

Investors certainly haven't shifted into full-scale buying mode, Thursday's bounce notwithstanding. But in the face of downgrades and increasingly dour commentary from analysts, renewed interest in the sector by contrarian investors could help put a floor under some of the stocks.

While there's evidence that order growth for new equipment has slowed, bulls point out that plenty of chip-equipment outfits are putting up healthy results and may still be on track to surpass the profit and revenue levels of the prior peak. Furthermore, earnings reports from


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-- plus raised guidance from


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-- show end-market demand for hardware remains healthy.

Minding the Gap

A day after offering a

fat upside surprise and generous guidance, shares of

Lam Research

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shot up 20% Thursday.

But Lam's earnings report starkly underscored the gap between those who think the equipment cycle has longer to run and the skeptical majority.

In separate research notes, analysts at Susquehanna and American Technology Research both honed in on Lam's slowing order growth rates as a trouble spot. After order growth of 17% in the quarter ending in June, Lam said it expects 5% sequential growth in the September quarter.




predicted last week it will have organic order growth of just 0% to 5% in the current quarter.

But bulls say lumpy order patterns aren't so unusual for the equipment business, and argue that profits and revenue at some companies are on pace to best the bubble era peaks.

ThinkEquity Partners' Suresh Balaraman predicts Lam will net 60 cents in earnings in the quarter now under way, besting its previous record of 48 cents EPS in March 2001. Similarly, he expects


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to exceed its historical peak net margin of 22% over the next few quarters. He upped his ratings on both stocks to a buy in the past week.

Balaraman thinks the semiconductor equipment cycle could last through 2006 or 2007, as expanding markets such as consumer gadgets, autos and high-end cell phones pick up the slack from slower-growing computers.

Balaraman points out the chip industry's recovery has supported a broad expansion of customers for chip-making equipment. In 2002, only three or four companies spent more than $1 billion on semiconductor capital equipment. But 17 customers expect to spend that much this year, including new players like China's

Semiconductor Manufacturing International



"Partly because of new competitors, with plants in places like China, and the pace of

manufacturing innovation, we think there's a chance that the capital equipment cycle goes longer relative to the semi cycle than normal," agreed Michael Mahoney, managing director of the hedge fund EGM Capital, which manages about $500 million.

The notion of an extended, slow-but-steady buying cycle has gained support from some industry executives. On Novellus' conference call, Chief Financial Officer Kevin Royal said customers have grown much more cautious as they expand capacity, opting to build out semiconductor fabrication plants in three or four phases rather than all at once. "Right now, our best visibility is we don't see the downturn," he told analysts.

"There's nothing that tells me this upcycle is over," agreed Dan Niles, chief executive of Neuberger Berman Technology Management, which counts Novellus among its holdings. "Growth is not accelerating and I understand why investors don't like that. But if companies keep beating forecasts it's going to be okay" for equipment stocks.

Balaraman said hand-wringing over the sustainability of the current upcycle reminds him of the early 1990s, when the industry emerged from another ugly downturn. Then as now, "people refuse to believe the industry has any growth left, because they've been burned," he said.

Slow and Steady or Already Gone?

Conversely, bears point out that demand for semiconductor capital equipment has generally followed demand for semiconductors, and chip market growth is expected to taper off sharply by next year.

In early June, the Semiconductor Industry Association projected industry revenue growth will fall to a mere 4% in 2005, down from projected 2004 growth of 28%. This month the chip-equipment trade group, Semiconductor Equipment and Materials International (SEMI), said it expects growth in the equipment industry to top out around the second quarter of 2005.

In addition, SEMI doesn't expect the worldwide chip-equipment industry to match its 2000 revenue peak of $48 billion until 2007, according to its July forecast.

Last week, Merrill Lynch downgraded the chip-equipment sector to neutral, saying orders and revenue could peak by the first half of 2005 and cap the potential for stock price appreciation.

Renewed selling pressure after the Merrill downgrade aroused further interest on the part of some bargain-minded institutional buyers.

EGM Capital's Mahoney said ongoing stock price declines have prompted him to think about investing in the likes of Applied Materials,


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For now, he's hedged his bet on continuing chip-equipment growth with an investment in

Credence Systems

( CMOS), explaining that it's "very cheap -- way, way cheaper than Intel."

Credence trades at seven times expected 2005 earnings, based on Thursday's close, compared to Intel's forward price-to-earnings ratio of 20. Yet Credence earnings are expected to rise 278% in its fiscal 2005 ending in October vs. just 15% in expected calendar 2005 earnings growth for Intel.

Credence trades at an unusually low multiple, but some higher-profile chip-equipment stocks are also looking relatively inexpensive.

Lead chip-equipment maker Applied Materials changes hands for just under 14 times expected fiscal 2005 earnings, below the

S&P 500's

forward multiple of about 16 times earnings, while Novellus trades in line with the broader market. In 2005, earnings growth at both chip-equipment firms is forecast to far surpass the S&P's expected 7% growth.

Bob Lee, manager of the


Sentinel Midcap Growth fund and

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Sentinel Flexcap Opportunities fund, said the out-of-favor chip-equipment sector is probably the first stop he'd make if he decided to increase his modest stakes in technology stocks. But for now he considers the group "about fairly valued" and is looking for "a bit more confirmation" that equipment orders will stay strong.

"It really depends on underlying economic growth," he said. "I had been expecting to continue to see 3.5% or 4% GDP growth through the end of this year. I felt that would be a good backdrop for orders. But it seems like there was a bit of a pause here in June."

The latest economic data has undoubtedly dampened the ardor of value-minded investors mulling over new tech buys. June retail sales and job growth came in softer than expected, while the Institute for Supply Management's manufacturing and services indexes showed declines.

It's too early to tell if the slate of bad news marks a temporary rough spot -- Niles predicts it will be "the pause that refreshes" -- or signals more long-lasting trouble.

In any case, if the bulls are eventually proven right, it likely won't take the form of a single "ah-ha!" moment. Balaraman thinks skepticism will slowly wane over the next few quarters, as companies continue to deliver solid financial results and order growth of 5% to 10% a quarter.

If the bulk of analyst opinion serves as a contrary indicator, he may be on to something.