Capitalizing on the Cycle

One can hardly dispute the velocity capital when it comes to the equity markets. Shares of semiconductor and equipment companies have been soaring as evidence of strengthening end demand and tight manufacturing capacity crosses the newswires. Even the most cautious investor should have been able to capitalize during this bull market run.

I've sat through several forecasting sessions this year and apparently a strong round of investments in leading-edge facilities will take hold in the next year. Wall Street is banking on it. When you think about it, there are no other reasons to move share prices up. Along with a stronger spending outlook, most pundits are anticipating a good 20%+ year of growth for the chip business. I have no real problems with this given the fact that we are headed into an election year (which means the economy is bound to get better), and that semiconductor content continues to penetrate new end markets.

One could also add the pent-up end demand on the corporate side of the ledger. The upgrades that took place three years ago are running out of steam. Corporate purse strings are starting to loosen up. I seriously doubt if we will revisit the boom times of 1999, but I do believe that another round of technology capital spending is imminent.

As we move through earnings season, I am anticipating that we will hear a much more optimistic tone from players in the chip industry. That news, barring any external shocks, should continue to support chip and chip equipment stocks. I expect to hear company management teams talk about better visibility and black ink on their bottom lines. At the same time, I expect to hear caution about the breadth and duration of the coming upturn.

There are many reasons to believe this is true. I have mentioned the exceedingly high cost to manufacture ICs at the leading edge. This cost is prohibitively high for most chip companies. The transition to make devices on 300 mm wafers with features below 100 nm has narrowed the customer base for the capital equipment companies. Capital spending at the leading edge is only viable for a select few. If you simply compare the number of new fabs planned today with the numbers announced during the mid-90s, you can see that many players have been priced out. Granted, today's fab is much larger. But in terms of tool counts, the actual numbers delivered to manufacturers is much lower. The equipment industry still seems to be wrestling with the inflection point.

This trend is prompting many capital equipment companies to revisit their business models. The enhancement and delivery of fab services is an item that is openly discussed. Some equipment companies are thinking about charging a fee for their intellectual property. A few have actually tried to put this model into practice — charging by the wafers processed. I am sure we will hear more about these changes in the coming quarters. I think, over the long term, this model is inevitable.

For the shorter term, the question is whether this will be an abrupt, violent cycle, or a long, smooth upturn. Unfortunately, I am leaning toward the former over the latter. I say unfortunately because a short, violent capital spending cycle has tremendous implications for equipment company shares.

I'm not fighting the tape now because it doesn't look like share prices have peaked. But I think it is wise to note that, once peak earnings and revenue growth become visible, they will quickly be reflected in pricing. If you will recall the last cycle, stocks peaked in March 2000, well before the peak in capital equipment orders and shipments. It would not surprise me, given that Wall Street has been ahead of this cycle by almost a full year, if capital equipment stocks peaked well before we see the meat of the upturn.