Intel, TSMC And Samsung Are Driving Semiconductor Capital Spending In 2013

by: Morningstar

By Andy Ng

The semiconductor equipment industry is showing signs of recovering from the cyclical slowdown in the second half of 2012. Although the business environment remains somewhat soft, Intel, Taiwan Semiconductor Manufacturing Corporation, and Samsung have announced solid capital spending plans for 2013 that should help jump-start the demand environment for chip equipment. We expect the equipment market to gradually pick up in 2013, particularly if the economy can improve. We view most of the chip equipment stocks we cover as fairly valued, even though capital intensity remains low. However, we believe two-- Applied Materials (NASDAQ:AMAT) and ATMI (NASDAQ:ATMI)--are attractively valued and provide opportunities to benefit from the improving business conditions we expect later in the year.

Industry Conditions Soft, but Showing Signs of Improvement

Chip equipment orders were $927 million in December, up slightly from $913 million in September, according to SEMI (numbers are based on a three-month average). The three-month moving average bookings numbers have since risen slightly, with total orders coming in at $1.08 billion in January, whereas the preliminary bookings total for February was $1.07 billion.

Macroeconomic uncertainty and a near-term softening in global semiconductor demand toward the end of 2012 caused chip makers in general to ratchet down capital spending and take a wait-and-see approach with their plans. But for 2013, the world's biggest chip manufacturers--Intel (NASDAQ:INTC), TSMC (NYSE:TSM), and Samsung (OTC:SSNLF) -- have all announced strong capital investment plans for the year, in an attempt to expand cutting-edge chip fabrication capabilities and push Moore's Law for strategic purposes. While these three heavyweights have significant spending plans, other chip makers so far are remaining more conservative with their investment outlooks. As a result, chip equipment industry conditions are currently somewhat mixed.

One of the industry metrics we track is capital intensity, which we calculate by dividing chip equipment orders by worldwide wafer starts. During cyclical upturns, capital intensity rises and has peaked at about 0.9 or higher in recent years. Semiconductor industry capital intensity came in at 0.46 in the fourth quarter of 2012, similar to the depressed 0.44 level seen in the third quarter. We estimate that it came in at 0.53 in the first quarter of 2013 and will be 0.56 in the second quarter. The recent improvement in semiconductor equipment orders should result in higher capital intensity, though we would characterize the chip equipment industry conditions as recovering from the cyclical slowdown seen in recent quarters.

Another metric, semiconductor industry capacity utilization, was relatively weak in the fourth quarter, falling to 79.2% from 81.2% in the third quarter, according to market research firm Gartner. In the fourth quarter, chip makers reduced manufacturing output because of continued soft global chip demand caused by an uncertain macroeconomic environment as well as seasonality, as mobile device and consumer electronics manufacturing activity wound down following the holiday rush. The global semiconductor market as a whole remains somewhat soft, though there are signs that global chip demand is beginning to recover. Nonetheless, the proliferation of smartphones and tablets continues to drive strong demand for mobility chips, which remains a pocket of strength in the semiconductor industry.

We currently estimate that chip industry utilization rose to 80.5% in the first quarter, and we expect it to increase to 82.5% in the second quarter, as semiconductor market conditions gradually improve. These utilization rates would be somewhat low in absolute terms and would be well below the 90% that typically spurs chip makers to ramp up capital investments to add production capacity.

We Expect the Chip Equipment Market to Strengthen Throughout 2013

Though overall industry conditions remain soft, the signs of recovery from the semiconductor equipment slowdown in the second half of 2012 have materialized more quickly than we originally anticipated, jump-started by solid 2013 capital spending plans from Intel, TSMC and Samsung. These three firms, which are the biggest purchasers of chip equipment in the world and account for roughly half of total capital spending, are making significant investments this year for strategic purposes, aiming to expand capabilities in the most advanced semiconductor fabrication technologies. The rest of the semiconductor industry remains more cautious on spending, but we think chip equipment demand will strengthen throughout the year as the economy shows improvement. In particular, we believe we could see a significant pickup in flash memory-related spending toward the end of the year or in early 2014 if demand for flash memory continues to grow.

Gartner expects the front-end wafer fab equipment market to shrink about 8% year over year, to $27.4 billion in 2013 from $29.7 billion in 2012. Major chip equipment suppliers Applied Materials and Lam Research (NASDAQ:LRCX) expect a similar range of outcomes, with Applied forecasting the WFE market to be flat to down 10% from 2012, while Lam expects WFE spending to be roughly $30 billion (flat or up nominally). We now project the 2013 WFE market to be $28.4 billion, down 5% year over year but up slightly from our prior forecast of $27.9 billion. We believe spending should strengthen as we go through the year, particularly as the global economy improves.

Robust demand for chips used in smartphones and tablets continues to be the key theme for the foundry segment, at least for the biggest player, TSMC. The firm has been the major beneficiary of the trend, as TSMC's semiconductor fabrication technology leadership has created significant demand for its outsourced manufacturing services from key mobile chipmakers, including Qualcomm. In fact, communications chips have accounted for roughly half of TSMC's sales in recent quarters. Over the past few years, TSMC has been spending heavily to push its technological capabilities, with capital expenditures of $8.3 billion in 2012. The firm plans to raise spending further in 2013 to a record $9.5 billion-$10 billion, as it aims to expand its cutting-edge production capacity at the 28-nanometer (circuit size) node to meet heavy demand and to prepare for next-generation technologies, with the intention of ramping up the 20-nanometer process later in the year. There has been plenty of noise that TSMC may be adding Apple as a customer, as Apple may shift at least some of the outsourced manufacturing of its A-series processors used in iPhones and iPads to TSMC from Samsung. If the switch were to occur with significant volume, we believe TSMC might have to boost its 2013 capital investments by another billion or two.

There had been rumors that Samsung, which is currently Apple's sole foundry supplier, may have to reduce its capital spending substantially in 2013 owing to the threat of losing some of the Apple business, but the firm appears to have defied expectations and is probably planning significant investments for the year. Currently, Gartner forecasts that Samsung's semiconductor capital spending will be $9.5 billion in 2013, down from $12.1 billion in 2012. That number includes capital expenditures for both Samsung's foundry and memory businesses, as the firm is the world's largest foundry supplier, and the anticipated reduction in 2013 spending is likely to affect both businesses.

However, the capital investment gap between TSMC and Samsung and the smaller foundries is likely to widen in 2013. Outside TSMC and Samsung, other foundry players are expected to be more cautious about their capital investments, which will amplify the divide between the haves and have-nots. United Microelectronics intends to lower its 2013 investment to $1.5 billion from $1.7 billion in 2012. GlobalFoundries will maintain its budget flat at $3 billion, according to Gartner, though this will be well below the $4.9 billion it spent in 2011. While TSMC noted that its spending will occur more in the first half of 2013, we believe capital expenditures from the rest of the foundry segment will be loaded more toward the second half of the year.

Top chip maker Intel continues to go full throttle with its capital expenditures as it invests for the longer term. The firm recently lowered its 2013 capital expenditure outlook by $1 billion, but continues to plan on spending $11.5 billion-$12.5 billion for the year, which would be a record and an increase from $11 billion in 2012. We had previously projected 2013 spending of $10.5 billion, as we thought the firm would respond to softening PC demand but would continue investing for the next-generation 14-nanometer manufacturing process, which will ramp up later this year. However, Intel plans to elevate its investments for two initiatives. First, the firm will spend $2 billion on a 450-millimeter wafer development facility to prepare for the transition from 300-millimeter to 450-millimeter wafers in a few years. Second, Intel is spending strategically as it attempts to outfit its 14-nanometer fab and begin building out future 10-nanometer fabs. While the move will boost future production capacity, management believes that it's necessary to invest in order to maintain its chip manufacturing technology lead, which allows Intel to lower per-unit chip costs, push performance, and boost power efficiency. Intel believes that its competitive advantage in manufacturing will come into play in server processors, as the cloud infrastructure is built out, and in smartphone and tablet chips, where the firm is trying to gain a foothold. This outlook could be subject to change if the PC market continues to weaken.

Cyclical softness in both the DRAM and flash memory markets continues to hamper capital investments by chip makers, and even market leader Samsung has become more cautious about investing in its memory business. The DRAM market remains weak, despite some signs that conditions could be bottoming, as the severe cyclical slowdown that has hampered DRAM chip makers for about two years drags on. What began as an oversupply situation in the DRAM market, which pressured pricing and hurt profitability for DRAM chip makers, has given way to a fairly soft demand environment as global PC demand has weakened. As a result, capital spending from the segment will remain depressed for the foreseeable future. Gartner forecasts that DRAM-related capital investments will be $4.1 billion in 2013, down from $4.4 billion in 2012 and $8.5 billion in 2011. We expect the spending to focus on transitions to next-generation manufacturing technologies, and to be limited for capacity expansions.

While cyclical softness in the flash memory market has persisted, the situation is significantly better than in the DRAM market. The NAND flash memory market has rebounded from a cyclical bottom seen in mid-2012, as production cuts by key players helped alleviate the oversupply situation, but end market demand has not picked up as much as the industry had anticipated. As a result, flash memory chip makers like Toshiba and Samsung are limiting their capital spending. For 2013, Gartner projects flash memory-related investments to be $9.0 billion, down from $9.1 billion in 2012 and $10.9 billion in 2011. However, because flash memory chip makers have been limiting production capacity expansions in recent quarters, we believe there could be shortages in the market by the end of the year. The smartphone and tablet phenomenon has been driving increased flash memory bit demand, and the adoption of solid-state drives as replacements for traditional hard disk drives in computing applications will provide longer-term tailwinds. While these tailwinds have been somewhat below industry expectations in recent quarters, they are inevitable technology trends that will ultimately push flash memory consumption growth. Given the conservative approach by the flash memory segment in the past couple of years in managing production capacity, any significant pickup in flash memory demand as the economy improves would cause shortages in the market. In turn, semiconductor equipment makers would see a significant boost in orders, as the flash memory market would need to respond by making substantial investments in additional production capacity.

Wait for Better Entry Point for Most Names; AMAT and ATMI Top Picks

Industry wide chip equipment orders and capital intensity remain somewhat soft, but chip equipment stocks in general appear fairly valued. We would mostly remain on the sidelines, except for two stocks that are in 4-star territory, ATMI and Applied Materials. We believe these two are attractively valued and provide opportunities to benefit from the improving business conditions that we expect later in the year.

We think Applied is attractively valued, and the firm's substantial stock buybacks in fiscal 2012 could significantly boost earnings per share in the next chip equipment industry upturn. It has generally underperformed other chip equipment stocks during the past couple of years, which we believe is a result of the headwinds facing Applied's noncore solar and flat-panel display equipment segments following severe downturns in those industries.

Nonetheless, the firm's core chip equipment unit remains highly profitable and generates healthy cash flows. These cash flows allowed the firm to buy back $1.4 billion worth of stock in fiscal 2012, with $500 million of repurchases in the fiscal fourth quarter alone. Though Applied reduced its buybacks to $48 million in the fiscal first quarter and $100 million in the fiscal second quarter of 2013, it has made substantial buybacks in the past couple of years. We expect repurchases to provide an incremental lift to EPS, as the business environment has begun to improve, and help accelerate earnings per share over the next cyclical upturn in the firm's main semiconductor equipment business.

Management has placed a renewed focus on its main chip equipment business by shifting research and development and resources from the solar equipment segment to the core unit, in an effort to gain market share, which could be another positive for the stock.

Although ATMI has experienced a near-term cyclical slowdown due to lower semiconductor manufacturing activity, business conditions have begun to improve. The firm has better growth prospects than most other suppliers to the chip industry, as materials are playing an increasingly important role in helping drive technology advances down with Moore's Law.

The recent technology transitions by chip makers to next-generation semiconductor fabrication processes, particularly the cutting-edge 28-nanometer process at the foundries, have provided some tailwinds for ATMI, and the firm stands to benefit further as chip makers continue to expand their leading-edge capabilities in 2013. ATMI will also benefit from future technology advances, including the upcoming 20-nanometer transition, which foundries will begin to ramp up later this year.

In addition, the firm has growth opportunities outside its main semiconductor business, as it expands its life sciences segment, which provides consumables used in pharmaceuticals manufacturing. We believe that ATMI's exposure to the cutting-edge manufacturing technologies at leading chip makers and its emerging life sciences business should allow the firm to outperform other similar-size firms tied to the semiconductor industry as business conditions recover with the economy.