Chip Equipment: Hitting Bottom?

As pundits debate whether the U.S. economy is in a recession, makers of semiconductor equipment have been living through one. "The chip equipment industry has boom and bust cycles -- it's been in a recession for a year now and 2008 is not looking any better," says Angelo Zino, who follows the group for Standard & Poor's Equity Research.

Sales of semiconductor equipment are expected to drop this year, mainly because of weakness in memory chips, especially dynamic random access memory [DRAM], Zino says. "We think chipmakers will postpone capacity expansion plans until 2009," he says, given the recent excess supply of DRAM and the uncertain economic outlook.

Although many equipment makers' outlook for the next quarter or so is downbeat, investors are starting to look for a bottom. Zino sees supply/demand improvement in the second half of this year, leading to a new spending cycle in early 2009. In the meantime, some chip equipment makers that focus on growth areas, namely the flat panel display and solar panel markets, should get a boost in sales, he says.

BusinessWeek.com's Karyn McCormack recently spoke with Zino about the chip equipment industry and his favorite stocks. Edited excerpts of their conversation follow.

What's your forecast for spending on chip equipment this year? What's the reason for the drop?

We're looking for a sharp decline of 20% to 25% in semiconductor equipment sales this year. That's primarily driven by weakness in the memory segment, mainly DRAM, which we expect to fall by 40% to 50%. The main reason for that is an oversupply issue that's been hanging over the industry for the last year or so. Also, there's poor visibility because of the overall economic environment. Most chipmakers have started to push out orders -- we're looking for orders to be pushed out into late 2008.

When do you see a recovery?

We think a recovery will start in the first half of 2009, after the supply/demand balance improves in the second half of 2008, which will help increase chip prices. In 2009, we look for a new spending cycle to begin for chipmakers.

The biggest risk to this scenario is if we see a similar oversupply situation in NAND flash memory to what is currently being witnessed in the DRAM environment. While we expect robust demand for NAND flash memory chips in the second half of 2008 to prevent this from occurring, we remain wary of greater than anticipated economic weakness.

Are there any companies still spending on equipment despite the tough times?

We expect big customers like Intel (INTC) and Samsung [which we expect will make up about one-third of semiconductor equipment sales this year] to continue to spend. These large companies want to gain a technological advantage so that when an upturn begins they are better positioned to take market share from competitors.

At the same time, the smaller chip companies are prone to postponing orders right now, and will wait until the economy recovers and work down existing inventories. They will wait until they see a considerable rise in demand before they start to order equipment again.

Which products are showing the most growth?

While most of my group revolves around memory equipment, which is clearly deteriorating, there are significant opportunities for companies exposed to flat panel display and solar panels. Applied Materials (AMAT) is in both markets.

In flat panel displays, we're starting to see a cyclical upswing. Although 2007 was a strong year for flat panel displays for companies like Sony (SNE) and Samsung, it was a challenging year for equipment manufacturers, which saw a 36% decline from 2006 levels. This year we expect capital spending for equipment to make flat panel displays to increase more than 40%, given the anticipated strong demand for flat panel products and reduced investment by flat panel makers last year.

And who is leading the way in equipment for solar panels?

The solar energy market is also being led by Applied Materials right now. It has a full stream into this market by making three acquisitions over the last two years. Its goal is to lower the cost per watt of solar electricity from $2 to $3 per watt at the end of 2007 to under $1 by 2010. Applied Materials recently entered into a contract for its SunFab Thin Film Line to produce solar panels intended for large scale applications, for $1.9 billion -- that's more than five times the amount of any other order it has ever received. As Applied Materials goes full-stream into it, we expect smaller companies to follow suit into the market.

MEMC Materials (WFR) makes polysilicon, the raw material used to make solar cells. In the last few years, demand has outstripped supply, causing prices to go through the roof. Rising demand for polysilicon is providing a huge opportunity for MEMC. They're looking at 8,000 metric tons of capacity by yearend and should increase to 15,000 metric tons by 2010.

With stock prices down during this downturn, do you see consolidation in the group?

Due to declining revenue growth and pricing pressure throughout the industry, we expect a good amount of consolidation in the industry this year. We believe the trend has already begun with industry leaders such as Teradyne (TER), LAM Research (LRCX) and KLA-Tencor (KLAC), each of which announced sizable acquisitions in the last six months.

Primary catalysts for acquisitions have been to boost market share, expand into higher growth adjacent markets, and boost overall growth in a slowing market. This group consists of the front end [equipment that makes chips] and back end [packaging and testing]. We expect back-end equipment makers to face more pressure to consolidate over the next couple of years, given the overly competitive and low-growth environment for the segment.

Which stocks do you like?

We have a strong buy on Teradyne. We think the company had its downturn in 2007, with a 24% decline in sales in the system-on-a-chip test market. Teradyne is starting to demonstrate higher bookings and revenues after hitting a low point in bookings this year, in our view. We expect a rebound in 2008 -- we see mid-single digit range growth this year. In addition, Teradyne spent the 2007 downturn developing a new pipeline of products, which we expect to generate $150 million to $200 million in revenues this year.

We also have a strong buy on KLA-Tencor. It has a dominant market position in yield-management products. It has a large backlog and tight expense controls. We also have a positive view of defensive revenue drivers and pricing power. They're able to maintain high pricing power for their products, given their technological advantages and high demand, while others see pricing erode. We expect the transition from the 65-nanometer node to the 45-nanometer node to result in a 30% increase in KLA's total available market [for revenues].

Our third stock ranked strong buy is MEMC Materials. We expect revenue growth to accelerate as the company ramps up production of polysilicon wafers and delivery of solar wafers. It currently has $15.5 billion to $18 billion of solar wafer contracts over a 10-year period. We expect an additional contract to be signed by yearend. While we expect some weakness in semiconductor-wafer demand and pricing, we think this will be more than offset by strength in solar sales.

We have buy opinions on Applied Materials, Varian Semiconductor (VSEA), and LTX (LTXX).