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Wafer Fab Equipment Dragging Down Semiconductor Investors


Insistence to maintain high inventory levels is creating a depression in this sector.

As noted earlier this week in my article "Inventory in Semiconductors Looking Lean", most of it has improved with the exception of hardware OEMs. Within that classification, one of the sub-sectors that has done little to improve its inventory position over the last year has been the wafer fab equipment (WFE) companies -- KLA-Tencor (KLAC), Applied Materials (AMAT), and Novellus Systems (NVLS) for example.

For a number of years, the rapid expansion of memory-production capacity had been a major catalyst for growth for WFE companies, frequently driving more than 50% of the topline. However, with the recognition of over capacity in the DRAM and NAND flash markets in 2008, the various players in these markets slowed their capital spending at first, then slammed on the brakes as the depth of the problem became obvious.

What started as a recession quickly became a depression for anyone supplying WFE. However, unlike what we saw among many others in the technology supply chain, the WFE companies did little to scale back their building inventories.

I noticed the expanding inventory levels on various conference calls over the last year or so but only recently decided to look at the entire group. Using data from 23 WFE companies, I looked at the changes that have taken place over the last two years. As you can see in the graph below, these companies have seen their revenue decline 54% from September 2007 to September 2009. That's quite a drop but keep in mind that the results from the third quarter of this year actually started to show some improvement.

While revenue was plummeting it appears little was being done about inventory. On an absolute dollar basis, it was down only 9% from the third-quarter-2007 levels. Just how much of that may actually be the result of write-downs is anyone's guess. On a days-of-inventory basis, it has exploded 52% to 158 days.

WFE companies always argue that it's necessary to maintain high levels of parts for their customer maintenance programs. While that's true to some degree, it's also true that spare parts have a shelf life like most non-commodities. Is it reasonable to assume that the volume and value of these parts have remained unchanged over the last two years?

There are those who will suggest that this inventory "problem" will disburse quickly as capital spending picks up. That may be more wishful thinking than anything because it assumes that we're going to see a significant ramp in new capacity. The only market large enough to generate that level of capital spending is memory and, after the bloodbath these companies have experienced, it's highly unlikely we'll see dramatic increases in capacity.

This issue leaves investors with prospects of inventory write-downs in the near future or the margin compression if they continue to attempt a work-down. Either solution may be painful from an earnings perspective.
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