Is Novellus Systems Ready To Breakout?

Apr.19.07 | About: Novellus Systems, (NVLS-OLD)

Novellus Systems' (NASDAQ:NVLS-OLD) approach to business is hardly novel: high-end products, built to last, sold to the largest possible customers. The company is a top maker of semiconductor production equipment, including chemical vapor deposition systems that layer dielectric (insulating) material on semiconductor wafers, physical vapor deposition systems that layer conductive metals, and electrofill systems that deposit copper layers. It also makes surface preparation systems that clean wafers before each round of deposition. Among its customers are chip giants Samsung Electronics (16% of sales), Intel (NASDAQ:INTC) (11%), and Hynix Semiconductor (10%); Novellus has sold its wares to all of the world's top chip manufacturers.

This stock has been somewhat range bound over the last four years, trading between $22 and $35. It may be ready to move out of that band to the upside as earnings are picking up.

Earnings have been erratic over the last several years. $1.06 in 2004, then down to 86 cents a share the next year, bounding upward to $1.86 in 2006. Analysts are forecasting $1.75 this year with $2.00 expected in 2008. That still shows a decrease for this year from last, but going forward, analysts are expecting sustained growth, to the tune of 19.5% a year, on average, over the next 5 years. Revenues are expected to grow by 12% a year, on average, in the same time.

Revenues surged in 2006, up 26%, thanks to healthy semiconductor capital expenditures. Don't expect the same growth this year. The industry is cyclical so there will most likely be a decrease in revenues for 2007. Of course, that will mean lower earnings as well, about 6% or so according to analysts.

The book to bill ratio, one of the most closely watched ratios because it forecasts future revenues, for the fourth quarter was 1.01 as compared to 1.06 in the third quarter and 1.12 in the second. That's a trend you can't ignore. But not all sectors are slowing.

The wafer fabrication equipment group is expected to see increased demand in 2008. Foundry customers and memory producers will most likely be adding to capacity.

What makes this stock worth digging into is its valuation, based on the P/E ratio. It's near the low end of its historical range. Most years the stock carries a P/E close to 30, sometimes a little less, sometimes a little more. Based on earnings of $2.00 for next year, it's trading on a forward P/E of 16 at the moment. Of course, that's using earnings that haven't come in yet. And we've already seen how volatile these earnings can be. But if Novellus delivers on analysts' expectations, the stock could go higher as it goes toward its "normal" P/E valuation.

Remember that those earnings will have to come after the current slowdown. No one can predict how long or how deep this particular cycle will run. If it lasts longer than usual, investors will be waiting a long time to see earnings at $2.00 a share. But if the cycle corrects sooner, the earnings will be ahead of schedule.

NVLS 1-yr chart

Disclosure: none