ISS Wall Street panel: Solid growth, clean financials, alternate markets key to stock evaluations

by Bob Haavind, Editorial Director, Solid State Technology

What makes a process tool or material stock attractive to investors? Will private funds take over some equipment companies? How will the chip industry deal with exponentially rising design costs?

These were some of the tough questions dealt with by an all-star investment analyst panel at the 2008 Industry Strategy Symposium in Half Moon Bay, CA, moderated by Jim Bagley, Lam Research chairman, an executive with a stellar record for growth both at Lam and before that at Applied Materials. The focus was on what’s hot and what’s not, and after a sobering look at how the chipmakers need to develop new business models by Steve Newberry, Lam Research President and CEO (see “Wall Street wary of equipment stocks, but there are some bright spots” — WaferNEWS, V15n3, Jan. 22, 2008), the panel went at it.

Jay Deahna, JP Morgan, described a generally negative investment climate for equipment stocks, with recession fears and projections that chipmakers’ capital spending might go down 10%-12% this year. Equipment stocks are definitely not hot, he said, if there is margin compression, management turmoil, financial restatements, or problems of merger integration, and if their shares have been lagging.

By contrast, there are a few hotter stocks with share gains, product momentum, and above-average growth prospects with rising margins. He also suggested that investors like pure-plays, companies with clean, easy-to-understand stories and financials, stable management, predictability, and a high-impact PR message.

Some of the biggest players, like AMAT and NVLS, have bogged down, he suggested, while a few smaller companies were making gains (see Fig. 1).

Mark FitzGerald, managing director and senior financial analyst, Banc of America Securities, painted a somewhat gloomy picture of what he sees ahead. At each node as the industry progresses to 45nm, 32nm, and 22nm, he expects to see fewer chip designs. Historical returns have been steadily declining in the industry, and he does not see any major end-product drivers ahead that will induce consumers to pay price premiums. Meanwhile, he commented, post-2000 for both logic and foundries, there has been no recovery in equipment buying. He expects TSMC to be stuck at 65nm for some time, and he feels there will be little pickup in equipment buying until 2009.

Even further out, FitzGerald doesn’t see the industry going beyond 22nm with any momentum. Moore’s Law may be running into some technology red brick walls in ten years, but financial walls will hit first in about five years, he asserted, citing 5%-10% growth going forward, and declining even further over the next ten years. As a result, he believes it makes good sense for process toolmakers to explore allied markets, especially in LEDs and solar.

Brett Hodess, deputy director, equity analysis, Merrill Lynch, sees this as a tough year for equipment, down about -13% with a downside of -20%, and he is not even sure that 2009 will be a recovery year. While there has been less volatility in equipment buying, it is a result of offsetting cycles, with memory up while logic and foundries are down (see Fig. 2). If the waves start to coincide, he suggests, there could either be a huge upturn or a horrible downturn.

Hodess pointed out that while there has been 17% more wafer output from foundries, there has been no growth in their capital spending. Even with 85%-90% capacity utilization, they are not driven to expand capacity as in the past, he said — in fact, as they go to 24hr manufacturing and push beyond 100% utilization, he sees the potential for foundries to raise output 20% just with the equipment they now have.

He sees overcapacity in the memory sector due to large recent growth in capex spending, but he doesn’t believe that this will lead to merger and acquisition activity. Instead he sees some memory makers dropping product lines, or selling off parts of their capacity.

While small cap stocks have outperformed the large caps recently, Hodess believes this will reverse going forward because of the trouble smaller companies will have in getting financing. While wafer frontend equipment makers have kept their cash flows up even in downturns, he doesn’t see this as particularly attractive to large institutional investors in EBITDA terms, because the stocks are not swinging as they did under older evaluation methods.

Countering the generally dreary forward outlook, JPMorgan’s Deahna said that the secular growth rate for equipment should follow unit growth rather than revenues, and there has been 12%-13% unit growth, especially with the rapidly growing demand for memory. Thus, he sees a continuing need for maintaining traditional capital intensity.

“We will have cycles,” he said, “but the equipment industry is not a disaster.”

The group was asked about the potential for private equity to move into the equipment sector, and the consensus was that this is unlikely. “Private equity doesn’t like anything big sold in small quantities,” commented Deahna of JPMorgan, so equipment companies are not attractive. BofA’s FitzGerald suggested that private equity looks for stable free cash flow, which ruled out most equipment firms.

Hodess added that while some of the bigger firms have achieved fairly steady free cash flows, they have pretty solid management already, so private investors would find it hard to come up with ways to increase cash flows to make resale attractive, especially in such a complex marketplace. Novellus, for example, could project an 18% rate of return for the next three years, Stephen O’Rourke of Deutsche Bank commented, “but how could private investors position a highly technical product portfolio?” He agreed that such a buyout was unlikely.

While manufacturing costs have been rising, FitzGerald said that the cost of design is rising even faster. This must be dealt with jointly, he believes, by the EDA community and the toolmakers. It was suggested that chipmakers might buy EDA companies, but Hodess disagreed. He felt that joining with chip companies would limit EDA market opportunities, so he believes they will remain independent industries.

Moderator Bagley started the “hot vs. cold” discussion by suggesting that what’s hot is bad clothes, bad hair, and bad morals. What’s not is people working hard to add value to the country. This industry falls into the latter category, and it appears some creative innovation will be needed to get things sparking upward again. — B.H.


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