Peripheral Vision

The book-to-bill ratios have gone positive, quarterly earnings reports are in and guidance given during conference calls shows conditions are improving on the semiconductor equipment front. This has been the state for a while, but the most recent news means we can finally say we are in a recovery mode.

I get the sense that this spate of good news has caused the industry players to put their heads down to drive forward with the relentless abandon we have witnessed during past cycles. How many transistors can we put on the wafer? How small can we make the features? How can we make more die per wafer? We must drive forward. We must drive faster. Move those tools out the door!

The problem I have with this is that profitability is hard to find. The end markets are being held together by the consumer. The corporate world is still in a funk — trying desperately to unearth itself from the financial hole dug during the last cycle. In the telecommunications sector, a very large end market, the symptoms are particularly acute. Many of the phone companies, aside from a few of the Baby Bells, look like they are headed for the recycling bin. End demand on this front, despite what Cisco's management team might imply, looks like it will not return until well into 2003.

As an investor I am greatly concerned about the lack of peripheral vision in the semiconductor market. The recent news detailing bookings and shipments of capital equipment highlight a trend where racing along the leading edge supersedes financial responsibility. Granted, several big spenders are supported by governments that consider semiconductor manufacturing a matter of national importance, so that must be taken into account. Even if that is the case, making investments in a business that presents limited financial return — no matter how imperative it is — simply does not make sense. Why on earth would someone consider DRAM manufacturing a national priority? Yes, I understand DRAM is the training wheel product for more advanced semiconductor manufacturing — maybe there is a method to the madness. Making money is the goal though, isn't it?

I suspect that, as we move through the summer months, investors in the semiconductor and semiconductor equipment sector will have their feet held to the fire. I am often questioned by institutional money managers about sustainable profits and the velocity of capital investments. These investors are concerned that the industry is ignoring some of the fundamental elements that drive end demand. I am one of those who believes we have reached a maturation phase in many end-market products. Granted, large advances in, say, personal computing, could drive another purchasing binge. But based on what I am hearing from users, it is going to take a lot to get them to open their pocketbooks.

It is for this reason that I view the valuations in semiconductor and semiconductor equipment stocks with great trepidation. I am invested in the sector. I am in because I still believe that great advances in chipmaking, and the end products we use, will continue to penetrate our everyday lives. But I have only committed a portion of my capital to the sector. I believe the maturing state of the industry has yet to be modeled, or acknowledged, by many industry players.

Investors should tread cautiously. There are signs all around pointing to a change in the historical patterns of new technology consumption. Financial reward is going to be tougher to find.