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The Semiconductor Capital Equipment Industry manufactures and markets machines used in the production of electronic devices. Equipment is classified as either front-end or back-end. Front-end involves silicon wafer fabrication and other various functions, such as photolithography, deposition, etching, cleaning, ion implantation, and chemical & mechanical polishing. Back-end encompasses the assembly, packaging and testing of integrated circuits. The front-end segment accounts for roughly 70% of industry sales, with the back-end making up the balance. Volatile Semiconductor Capital Equipment stocks are well suited to aggressive investors looking to gain on industry upswings.

Cyclicality

The semi equipment industry is best characterized as highly cyclical, reflecting the nature of its primary end market, the chip sector. While the long-term sales outlook may appear positive, based on broad demand trends, short-term business influences can render equipment makers' quarterly results erratic. Chip companies order equipment in line with their projections for future demand. If planned production capacity seems too high, relative to current chip orders, they will likely reduce equipment bookings. Should chip demand outpace expectations, they may order more equipment.

Technology Trends

Advancement in circuit-board technology is the key driver of the semiconductor equipment industry. Device manufacturers need leading-edge tools to make increasingly complex chip designs and better compete. The most important trends for the intermediate term are: the continuing shift to larger wafers, the development of smaller geometry chip designs, and the transition from aluminum to copper interconnections.

By shifting to larger diameter silicon wafers, device producers can fit more chips on each surface, thereby lowering manufacturing costs. The use of factory automation can maximize output and decrease defects. The newest wafer facilities have higher rates of productivity. The tradeoff, one that is reasonable, is they require expensive production lines. This is a positive, however, for equipment makers.

By using smaller and smaller geometries, i.e., putting a greater number of transistors in each integrated circuit, semiconductor companies can design chips with higher performance and lower power consumption. Some high-end processors contain over one billion transistors on a single chip. As geometry gets increasingly smaller, equipment companies must keep up, developing advanced offerings to fabricate and test new chips.

Chipmakers are using more copper, as opposed to aluminum, for the interconnections between transistors. Copper's best attribute is its high electrical conductivity, which yields better device performance, increased processor speeds, and reduced power needs. Since copper is more difficult to work with, compared to aluminum, semiconductor companies have had to upgrade production - another benefit to capital equipment producers.

Industry Metrics

The two main indicators of short-term prospects for semiconductor equipment producers are: order trends and the relationship between current orders and sales, commonly known as the book-to-bill ratio. If overall equipment bookings rise for one to three months, this may be signaling increased demand in the coming quarter. Alternatively, lower orders suggest a coming decrease in sales. The book-to-bill ratio is simply the value of equipment orders divided by sales during a particular period. A ratio above 1.00 indicates expansion, and one below that level reflects a slowdown.

Another important measure of potential capital equipment business is the global chip plant usage rate. There is a high correlation between the factory utilization rates of chip producers and bookings of equipment. At rates above 90%, semiconductor manufacturers usually add capacity. During periods of weak demand, usage rates can approach 80% to 85%, which suggests excess capacity. In such times, customers will delay orders until chip supply and demand fall into proper balance.

Investment Considerations

When considering a specific equipment company for investment, an investor should ask certain questions. Is the company's historical operating track record a strong one? What was the sales growth rate over the past five to ten years? How well did profitability stand up to previous downturns? Has management maintained healthy gross and operating margins throughout each business cycle? Is research & development spending adequate and effective?

Other salient questions involve the company's market share and equipment offerings. Has the manufacturer gained or lost share? Loss of share could mean that competitors have developed products with more attractive technology. This leads one to ask: How well is the product line positioned? High-tech offerings usually result in faster growth and fatter margins. Investors should also inquire: Is the equipment line-up diversified enough according to end markets to soften the impact of downturns? Lastly: Has management taken advantage of outsourcing opportunities? Such action lowers the breakeven point, providing an operating cushion when sales turns south and optimal profitability in good times.

Valuation

In addition, investors should determine whether the stock's valuation is reasonable. Key measures include price-to-earnings, price-to-sales, and price-to-book value ratios. These ratios should be compared against the company's historical averages and those of industry peers to find if the stock offers good value.