Smaller Circuits Could Lead to Bigger Profits

 | May 16, 2013 | 10:00 AM EDT
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Does anybody remember the days when Applied Materials (AMAT) was loved? In the 1990s, I followed Applied around like a puppy. No more. I can hardly bring myself to dial in to the conference calls. But with the stock 1 point away from its 52-week high, I guess I'll crawl off the couch and make the sacrifice to listen in. Tonight, after the close, Applied Materials is expected to report its second fiscal quarter and investors are expecting great things.

Applied Materials isn't the only wafer fab name on the move. On Wednesday, Lam Research LRCX hit a 52-week high. Even lowered guidance can't keep KLA-Tencor (KLAC) down. KLAC is just 2 points off its 52-week high. Kulick & Soffa (KLIC) is the only name on my list of favorites that is flat on its back.

The wafer fabrication business used to be driven by the PC hardware upgrade cycle, but no longer. The PC business has been stale over the last few years. Nowadays, the semiconductor equipment business is driven by mobile. There are approximately 4.3 billion unique mobile phone users worldwide, which equates to about 60% of the human population with at least one mobile phone. In the U.S., about 60% of the population has a smartphone and in the last year, about 30% of those users upgraded. In the first quarter, worldwide semiconductor sales went up 2% vs. last year, but sales are still down from 2011.

With increased chip demand, wafer starts turn in to new orders as fabrication capacity gets booked up. Applied estimated wafer fabrication spending will be flat-to-down 10%, year-over-year, from 2012's $30 billion level. That forecast is actually better than expected, since most analysts were projecting a spending decline as much as 15% this year. With major fabrication projects under way by the likes of Intel (INTC), Global Foundries and Taiwan Semiconductor Manufacturing (TSM), investors are expecting strong equipment sales over the next year.

In fact, I think the equipment market will grow faster than expected as semiconductor makers are determined to move to smaller dimensions. Intel, for example, is expected to make its "Ivy Bridge" processor at 22-nanometers and plans to manufacture its Airmont chips on a super tiny 14-nanometer process. TSMC has announced it plans to begin volume production of a 20-nanmeter CMOS chip in the second half of the year. In addition, other foundries are known to be considering shifting their wafer production to either 20 or 22-nanometers. Global Foundries, for example, has recently demonstrated a 14-nanometer ARM (ARMH) processor.

I think Applied Materials will report a slightly better-than-expected quarter, but the stock is really trading on the promise of a strong second half and serious growth next year. For fiscal 2013, the Street is expecting revenue of $7.8 billion and earnings per share of $0.61. But next year, investors are expecting revenue to grow 18.8% to $9.32 billion and looking for the company to produce earnings per share of $1.06.

At the end of last quarter, AMAT reported $2.1 billion in backlog. Investors will be watching whether backlog increases again this quarter. If it doesn't, the stock may sell off. Equipment orders can be lumpy, especially in the second quarter, so I would wait until the dust has settled. In 2010, there was a short-lived equipment buying frenzy, which drove the stock over $16. But when the snapback ended, the stock slid 38%.

If fabricators are shifting large numbers of wafer start-ups to smaller dimensions, then AMAT's stock could run for many quarters. But in the semiconductor equipment sector, you have to keep one eye on this quarter and one on the future.

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