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Don't Overlook the Chip Manufacturing Sector

March 05, 2012 | About:
With all the news of Apple hitting $500 a share and the recent rally in technology shares, one sector seems to have been forgotten. Technology today runs on semiconductors and the equipment manufacturers that produce it are a vital component for any tech rally. Predicting the next great killer application or consumer electronic product is exceedingly difficult, but the odds that this game changing product will require faster and more robust computer chips are nearly 100%. One approach to participating in the technology stock rally while maintaining limited risk is through investing in the shares of chip equipment manufacturers. Three of the largest and best known chip manufacturers are KLA-Tencor (KLAC), Novellus Systems (NVLS), and Applied Materials (AMAT).

KLA-Tencor (KLAC) is a chip equipment manufacturer that specializes in process diagnostic and control equipment (PDC). Semiconductor manufacturers do not use these tools to specifically manufacture chips, but rather to detect and analyze defects during the manufacturing process. Like all chip equipment manufacturers, KLA-Tencor endures a cyclical business tied ultimately to semiconductor purchases. Historically, the biggest driver of semiconductor purchases was consumer and business demand for personal computers, laptops and servers. Demand markets have widened with the roll-out of silicon based solar panels and the explosive growth in smart phones and related products. The company has a large research and development budget, which was approximately $386 million in fiscal year 2011. The company currently trades at a price to forward earnings of nearly 11 times. Although at a discount to the broader S&P 500 market, the cyclicality of the business does not justify a higher multiple. KLA-Tencor has an excellent franchise in the PDC space, but for investors looking to enter the stock a multiple below 9 times earnings would provide a more secure margin of safety.

Novellus Systems (NVLS) is primarily a semiconductor equipment manufacturer with a focus on building machines for the deposition and strip portion of the chip manufacturing process. Sales in fiscal year 2010 were $1,349 million and virtually unchanged in 2011 at $1,350 million. The company did report that bookings, an indicator of future revenue, increased to $286.9 million from $226.9 million in the 3rd quarter of 2011. The semiconductor equipment manufacturers have faced a difficult two years as semiconductor manufacturers have held off on capital expenditures in light of weak demand for chips. Although the trend is nascent, bookings indicate a positive change. Net income declined from 2010 to 2011, but the company reported essentially unchanged operating profit of approximately $300 million. The company currently trades at nearly 13 times earnings and close to 2.4 times 2011 sales. Assuming a modest improvement in sales during 2012, the stock seems fully priced at today’s levels of close to $47 a share. Investors should keep an eye on Novellus and use any pull back towards a price to 2011 sales of 1.8 times or less as a potential opportunity to purchase.

Applied Materials (AMAT) is the world’s largest semiconductor equipment manufacturer. Its scale and product breadth is unmatched in the industry. For semiconductor manufacturers looking for a one stop shop, Applied Materials is the only provider available. The company has expanded its markets in recent years to include the photovoltaic (solar) industries, but its core customer remains semiconductor manufacturers. The company reported 1st quarter 2012 sales of 53% to $1,420 million. The company currently trades at approximately 9 times 2011 earnings versus Novellus at 13 and KLA-Tencor at 11 times. On a price to 2011 sales, Applied Materials trades at a mere 1.4 times. Following the collapse of the internet bubble in 2001, the company maintained a price to sales in excess of 3 times through 2006. Global GDP growth may slow in the second half of 2012, however semiconductor manufacturers will likely still need to invest in capital expenditures in order to maintain their relative positions in chip manufacturing. At current prices, Applied Materials looks to be an excellent purchase for investors willing to provide the company some time to benefit from the eventual re-tooling by the chip manufacturers.


About the author:

Dividend King
I am primarily an investor interested in creating passive income streams through dividends. I focus on finding and analyzing dividend paying stocks, MLPs and REITs that are a good fit for income investors.

I practice Judaism and my faith is very important to me. I visit family in Israel once a year, but I am educated and work in the United States where I hold an MBA and a bachelor’s in English. I am a patient man, enjoy wine but am not a connoisseur, and I listen more than I speak.

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