Our Outlook for Tech Stocks

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The semiconductor equipment sector is a difficult one to invest in, given the alternating boom and bust cycles. However, for the slightly more nimble-footed, it is a great industry to trade because stock prices will tend to overshoot on both the upside and downside. Your goal is to simply go against the crowd, or as Warren Buffett so eloquently puts its, "Be fearful when others are greedy, and greedy when others are fearful."

The past year has been a difficult one for the industry with stalwarts such as  Applied Materials (AMAT) and  KLA-Tencor (KLAC) down 28% and 46%, respectively, from their yearly highs. The story this cycle is the same as previous cycles: overinvestment by manufacturers to support an emerging technology. In both 2006 and 2007, semiconductor manufacturers rushed to invest in flash memory capacity, and if you've purchased a flash memory card recently, you know there is massive manufacturing overcapacity. The same amount of flash memory that sold for over $100 a year ago at retail now sells for about $10. The shares of  SanDisk , a leading flash memory maker, have declined by more than 60% from their high. This excess capacity in the memory market must be worked off before this current downcycle can bottom.

In addition to the flash overcapacity, the semiconductor foundries such as  Taiwan Semiconductor Manufacturing (TSM) and  United Microelectronics (UMC) have cut back their capital spending substantially. This is understandable given the slowdown in demand. TSM's year-over-year sales growth slowed from a robust 45% in January to a pedestrian 7% in August. However, at some point, this underinvestment must reverse itself as technology marches forward. One of the main drivers of the technology revolution that puts gadgets like  Apple's (AAPL) iPhone in your hand is the continual push toward "faster, smaller, cheaper" chips. This push requires new manufacturing equipment at each successive stage, so as technology progresses, the foundries must eventually invest to meet the needs of their customers.

Although stocks in the sector have come down significantly, there is little evidence to suggest a bottom for the industry or, going one step further, a catalyst to propel the next upcycle. In the last downcycle, one could point toward the transition to 300-millimeter wafer manufacturing, the increase in capital intensity at  Intel (INTC), and the coming of flash memory as reasons to look past the pessimism. Potential catalysts are more difficult to discern this time around, especially as the global economy suffers the effects of deleveraging. The growing use of flash memory in solid state drives to replace traditional hard disk drives may put a dent in the excess capacity, but there is a countervailing force as multilevel cell technologies increase the number of flash chips that can made on a silicon wafer, effectively increasing capacity without the addition of new equipment.

A bottom may not be in sight for the industry yet, so we expect that pessimism may drive share prices even lower. However, each day that passes brings us one day closer to the catalysts that will help the industry bottom and eventually recover. The growth in silicon consumption has risen unabated for many decades and that trend is unlikely to reverse in a sustained manner. It is this long-term growth trend that will help the industry recover, and when the next upcycle comes you can be sure we will let you know about it. In addition, we have chosen the best five stocks for you to play the semiconductor equipment cycle.

Valuations by Industry
During the quarter, valuations came down dramatically across the board as the bear market showed its teeth. Earlier this year, some investors thought the technology industry--with its rather pristine balance sheets--could be a safe haven from the troubles in the financial system. However, as the real economy begins to slow as a result of the credit contraction, technology spending will also take a hit. Investors are starting to price in this risk.

Looking ahead, we expect the bear market to turn up more bargains to join current 5-star stocks such as Apple,  Autodesk (ADSK), Intel, and  Microsoft (MSFT). Let's turn back to semiconductor equipment and our favorite five stocks in the industry.

Tech Stocks for Your Radar
These five stocks are our favorite semiconductor equipment picks. Applied Materials and KLA-Tencor are the only two wide-moat businesses in the industry, while  ATMI ,  Cymer , and  FormFactor (FORM) have carved out attractive niches.

Stocks to Watch--Tech
Company	Star Rating	Fair Value Estimate	Economic Moat	Fair Value Uncertainty	Price/ Fair Value
Applied Materials		$25	Wide	Medium	0.62
KLA-Tencor		$49	Wide	Medium	0.65
ATMI		$29	Narrow	Medium	0.66
Cymer		$32	Narrow	Medium	0.84
FormFactor		$24	None	High	0.81
Data as of 09-18-2008.

 Applied Materials (AMAT)
Applied Materials is the behemoth of the semiconductor equipment industry, with its unmatched scale and broad product portfolio. The firm has steadily been establishing its solar equipment business, which we think could turn into a key growth driver for Applied. Applied has a wide moat for several reasons. Its installed base has expanded to more than 22,000 tools, and the firm has engineers in nearly every chip-manufacturing facility in the world. Applied's scale and trusted name have allowed it to develop close relationships with customers, giving the firm insight into current and future customer technology needs.

 KLA-Tencor (KLAC)
Despite a near-term business slowdown in the cyclical semiconductor equipment industry, we are excited about KLA's long-term growth prospects. Each successive generation of semiconductor fabrication technologies involves smaller circuit sizes, new materials, and more process steps. This all amounts to a greater number of increasingly complex defects, which drives the growing need for ever more advanced PDC tools. For example, KLA estimates that its market opportunity at the next-generation 45-nanometer (circuit size) technology node will jump 30% from that of the 65-nanometer node. Given KLA's wide moat and appealing exposure to technology advances by chipmakers, we think the firm has a bright future.

 ATMI 
ATMI is a leading provider of materials used in chip fabrication. Demand is driven by the number of wafer starts (the number of silicon wafers placed into production) in the semiconductor industry, as ATMI's materials (such as gases, liquids, and various chemicals) are consumed during manufacturing. Therefore, ATMI's business is much steadier than those of chip equipment suppliers, which depend on chipmakers' volatile capital spending. Since the firm disposed of the last of its noncore chip equipment business in 2004 and focused solely on consumables, its gross margins have risen to about 50%. Moreover, because the materials business is not particularly capital-intensive and operating margins of 20%-plus are achievable, we think ATMI's returns on invested capital will continue to increase from their current 13%.

 Cymer 
The continued drive toward ever smaller and faster chip devices requires more-advanced light sources. Cymer's technological leadership in lithography lighting creates a competitive barrier to entry and has allowed the firm to dominate the market. Cymer spends large sums on research and development (totaling more than $200 million over the past three years), which smaller rivals don't have the scale to match. Also, the substantial time and resources that would be required to develop a competing light source deter potential entrants and allow Cymer to widen its technology lead.

 FormFactor (FORM)
FormFactor's growth has been impressive, as well. The firm's sales have more than quintupled since 2002, and the long-term prospects for additional growth look bright. The chip industry's transition to larger wafer sizes, new memory architectures, and smaller transistor sizes will continue to drive demand for probe cards. The firm has also been adding capabilities to its probe cards to run test processes that have traditionally occurred at other stages of the manufacturing process, thereby providing customers with more cost savings and opening FormFactor up to a wider market. FormFactor holds only minor share in the logic and flash probe card segments and views expansion in these markets as growth opportunities, too.

If you'd like to track and analyze the stocks mentioned above, click here to create a watch list. Then simply click "continue," name your watch list, and click "done." (If this link does not work, please register with Morningstar.com--registration is free--or sign in if you're already a member, and try again.) This will allow you to save and monitor these holdings within our Portfolio Manager.

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