The Sandbox

Last October, I slammed Lehman Brothers’ downgrade of semiconductor equipment stocks, which at the time, I felt was not called for – however, six months later, it is clearly time to revisit that topic and the facts, following financial results this week from Lam Research Corp and Novellus Systems.

Lam’s revenue for its quarter ended March 30, was $613.8 million, slightly above Q4 2007; gross margin sank to $287.2 million from $307.7 million in Q4 2007; and net income of $103.5 million, or 82 cents per diluted share, compared to Q4 2007’s net income of $115.1 million, or 91 cents per diluted share – and this includes the earnings of the SEZ Group after the March 11, 2008 acquisition date. (The SEZ Group is now known as the “Spin Clean Division.” 

Although Steve Newberry, Lam’s president and CEO said in its statement with the results, “Lam’s March quarter performance met or slightly exceeded our expectations for shipments, revenues, gross margins and operating income,” Lehman Brothers Equity Research analyst for semiconductor equipment, C.J. Muse pointed out in a report this week that Lam guided to a much worse Q2 with revenues between $490 and $530 million (down 16 to 22%) and earnings per share between 32 and 42 cents, due to falloff in shipments (i.e., a slowing in its core business) along with dilution from the SEZ acquisition exacerbated by a deferred revenue policy at SEZ.

“By far the most important takeaway from Lam’s conference call is that not only are shipments and revenues declining in [Q2], but that weakness in the business model is exacerbated by dilution of the recently completed SEZ acquisition as well as the fact revenue recognition at SEZ will occur upon acceptance while costs will be occurred upfront. Add it all together and our estimates and street estimates are likely to decline significantly. We are now modeling EPS of $2.05 in CY08 and $2.80 in CY09 vs. consensus of $3.71 and $4.09, respectively,” Muse said in the report.

He maintained his “Overweight” rating on Lam’s stock, which means that he expects the stock to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.

Next, enter Novellus that reported Q1 revenue of $315 million and EPS of 15 cents, which was generally inline with the company’s preannouncement earlier this month, and was due to a mix shift and delayed customer acceptance in the industrial segment along with inventory write-down on semiconductor evaluation tools. Novellus management guided to Q2 revenues of $245 to $260 million (down 17 to 22% quarter-over-quarter).

Muse noted in a separate report that with management’s guidance for the Q2 revenue drop and orders to decline 10 to 25%, a conference call with financial analysts clearly begs the question whether the weak guidance reflects an industry-wide phenomenon or company-specific weakness.

Assuming Novellus’ Q3 semi revenues remain roughly flat followed by a modest uptick in Q4, this would suggest that the company’s semiconductor revenues are on track to decline approximately 35% year-over-year, he calculates.

“Off already bad 2007 comps (as [Novellus] lost both market share and had limited Taiwan DRAM exposure), this would suggest that either (1) the company continues to lose market share in its key segments and/or (2) 2008 industry capex is not trending to our down 20 to 25% estimate but rather down 25 to 35% year-over-year,” Muse said.

Based on the recently released Gartner data, he reminded that Novellus’ market share declined in nearly all of its key segments in 2007 (particularly in high density plasma chemical vapor deposition tools, where share declined from 39% in 2006 to 31% in 2007), with Novellus ending the year with 15% of its TAM (vs. 17% in 2006).

“Although management continued to emphasize the traction they are getting with their Vector Express and Vector Extreme and their continued focus on both [chemical mechanical planarization and dry strip, the combination of 2007 market share results and much weaker 1Q/2Q results/guidance suggests the story continues to break down,” Muse believes.

Finally, he admitted that his upgrade on Novellus to “Equalweight” several weeks ago may have been somewhat premature given the bleak outlook provided by management on the call with analysts, although the main driver for the upgrade was the company’s trough valuation.

In the end, Muse added, “We continue to remain cautious on Novellus due to market share concerns and growth outlook, but valuation (1.6x book vs. historical trough 1.5x) drives our [Equal Weight] rating. [We] recommend investors continue to look elsewhere for alpha.”

With core business slowing at Lam, coupled with market share and growth outlook concerns at Novellus, it seems that a stern look at total returns is called for (which will benefit the investor of course!). As was kindly pointed out to me recently by an industry insider, for the last three years, total returns on Novellus stock was -4%, for KLA-Tencor (although not discussed otherwise in this blog entry) -7%, while only Applied Materials delivered a total three-year return of positive 18%, thanks to only to solar.

The picture is decidedly grim looking at returns since October 2007, as Novellus returns were down 21%, KLA-Tencor was down 22% and even Applied returns fell 8%.

Hopefully, as the memory market begins to come up out of the bottom of the cycle sometime later this year or early next year, semiconductor equipment stocks will be a better investment, in the short or long term picture.

--Ann Steffora Mutschler, Senior Editor