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Semiconductor Market Rally May Be Over

Nearly every company building a chip factory or expanding a production line has to go through Applied Materials. The Santa Clara, California-based company has been filling order after order for chip manufacturing equipment as the semiconductor market has soared to more than $400 billion annually. Business has been booming as customers race to meet the global demand for electronics.

But Applied Materials is also one of the first companies to lose business when customers ranging from Micron Technology to Texas Instruments cut back on capital expenditures. Even though the semiconductor equipment market is growing—an estimated 14 percent to $62.8 billion in 2018, according to industry organization SEMI—Applied Materials and its rivals are entering stormy waters.

One of the industry’s bellwethers, Applied Materials said that it would have revenues between $3.56 and $3.86 billion in the current quarter, down from $4.20 billion in the same quarter last year. Equipment sales for the company—the single largest supplier of chip manufacturing equipment—are projected to decline more than 20 percent year-over-year in the first quarter of the 2019 fiscal year.

The company’s rivals are also increasingly feeling the pain. Last month, Lam Research said that it would report between $2.35 billion to $2.65 billion in revenue for the current quarter with gross margins of 45.1 percent. In the same quarter last year, the Silicon Valley company—the second largest supplier of fab equipment behind Applied Materials—reported $2.63 billion in revenue with gross margins of 46.7 percent.

KLA-Tencor’s forecast for the current quarter is $985 million to $1.065 billion, slightly higher than its $976 million of revenue in the same quarter last year. The company, which is attempting to close its $3.4 billion deal for Orbotech, is the fifth largest supplier of fab equipment in the world, according to The Information Network. The company sells process control tools that can spot defects in displays and chips.

The announcements came as Samsung and other major memory players started reigning in capital expenditures to avoid adding more manufacturing capacity than customers need, driving down DRAM and NAND prices. The effect started to show in the third quarter, when the global semiconductor industry’s annual growth rate slowed to 13.8 percent, down from 15.7 percent in the second quarter, according to World Semiconductor Trade Statistics.

The global semiconductor industry reported revenues of $429.1 billion last year, an increase of 21.7 percent over the previous year. But without the memory market, where shortages allowed companies to start charging more for the components, the growth rate was less than 10 percent, according to market researcher IHS Markit. The prolonged shortages have started giving way to oversupply conditions, feeding concerns that the semiconductor boom is over.

“Overall demand in the server, personal computer and smartphone markets is weaker than it was earlier in the year and memory prices are softening in the near term,” Gary Dickerson, chief executive of Applied Materials, said on a conference call with financial analysts earlier in the month. “Our customers tell us they expect demand to pick up and pricing to stabilize in the second half of 2019,” he added.

The mounting trade conflict between the United States and China is weighing on the semiconductor industry. Over the last year, the Trump administration has imposed tariffs on hundreds of billions of dollars of Chinese products to punish forced technology transfers and other tactics Chinese firms are allegedly using to pilfer intellectual property. American chip companies worry that tariffs could threaten demand for a broad range of electronic devices.

The United States has also started limiting the supply of semiconductor manufacturing tools in an attempt to preserve its technology lead over China. Last month, Fujian Jinhua Integrated Circuit Corporation was restricted from importing equipment used in DRAM production. The state-owned enterprise funded by the Chinese government has also been charged with stealing intellectual property from Micron to pry into the $122 billion memory chip market.

The sanctions have whipped up both Silicon Valley, where the world’s largest suppliers of chipmaking equipment are based, and Beijing, which is trying to become more self-sufficient in chips. Lam Research, Applied Materials and other companies are expanding into China as the more chip manufacturing moves into the region. China has long struggled to muscle into the markets for semiconductor and display equipment.

Companies operating in China are forced to import billions of dollars of critical chemicals and equipment every year. The country is projected to spend $12 billion before the end of the year building new factories and more than $20 billion in both 2019 and 2020, according to industry organization SEMI. Semiconductor equipment sales in China are forecast to grow more than 45 percent to $17.3 billion in 2019.

In 2016, Santa Clara, California-based Applied Materials announced plans to invest $615 million to bolster its position in the growing Chinese market. Last month, Lam Research said that one-fourth of the company’s revenue in the third quarter was from businesses operating in China, including major multinationals like Intel and Globalfoundries. Nearly two-thirds of that number were homegrown Chinese customers, the company said.

“Memory and foundry manufacturing in the region are investing at a high level to accelerate process development and yield,” said Richard Wallace, KLA-Tencor’s chief executive, on an October conference call. Chief financial officer Bren Higgins added that the controls on Fujian’s ability to import manufacturing tools would not cause major damage unless the restrictions are broadened to other customers in China.

“I don’t think it changes in a material way how we are really thinking about the business going forward,” Higgins said.

“While near-term market headwinds remain, overall industry spending remains robust, and we are focused on positioning ourselves for the long term,” Dickerson said on the conference call this month. “We're not seeing the large fluctuations that characterized the semiconductor and display equipment industries in the past,” Dickerson said, adding that the changes “are due to increasingly diverse market drivers.”

Dickerson also sees Applied Materials tapping into the development of artificial intelligence and the movement to install chips in everything from cars to factory equipment. The company could also profit from the use of advanced packaging, novel architectures and the integration of new materials to improve power, performance, area and cost as the semiconductor industry outgrows Moore’s Law.

For Applied Materials, fourth-quarter revenues only increased slightly over the last year to $4.01 billion. The results topped off $17.3 billion in annual revenue, an increase of around 19 percent over the last year. The company’s annual operating profit was $4.80 billion. The company reported operating income of $1.02 billion and earnings of $0.89 per share in the fourth quarter with gross margins of 44.3 percent.

Applied’s equipment business in the fiscal fourth quarter was $2.31 billion, down from $2.43 billion in the same quarter last year. Contract chip suppliers accounted for 23 percent of the company’s revenue, down from 36 percent over last year. DRAM manufacturers accounted for 12 percent of revenue, dropping from 26 percent over the last year. Flash memory suppliers moved from 38 percent to 34 percent.

Other companies are taking advantage of the end of the Moore’s Law, the semiconductor industry’s playbook for the last half century. ASML plans to increase revenues by 10 percent next year as Samsung, TSMC and Intel upgrade manufacturing lines with its latest lithography technology—more commonly called extreme ultraviolet or EUV. Customers are adding it to 10-nanometer and 7-nanometer processes.

While Applied Materials is grappling with the slowing market for memory chips it has long depended on, the Veldhoven, Netherlands-based ASML is tapping into additional capacity being added for chips based on the 7-nanometer technology node. Contract chip manufacturers are projected to boost capital expenditures by 26 percent to $22 billion over the next year, according to SEMI.

Capital expenditures related to DRAM production will grow 16 percent to $16 billion in 2018 before declining 14 percent to $12 billion next year. The growth rate for flash memory investment, including NAND and NOR, will increase 3 percent in 2018 and another 3 percent to $17 billion in 2019, according to SEMI. Applied Materials admitted it would lose market share as customers upgrade to ASML’s EUV systems, which only it sells.

The company expects to ship 18 systems before the end of the year and another 30 systems next year as customers boost production using the technology, which is aimed at lowering the cost of manufacturing chips with smaller and smaller transistors. ASML reported revenues of $4.2 billion in the third quarter, with operating profit of more than $1 billion. It projected sales of $3.47 billion in the current quarter.

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