Sat, Aug 04, 2001 page18

• Merrill's Heyler says fabs have hit bottom

  Daniel Heyler, head of Asia Pacific semiconductor research at Merrill Lynch & Co, explains in an interview with Bloomberg that the company upgraded its ratings on three chipmakers based on a slowdown in supply growth and on the belief that the rate of decline in their shares is leveling and a trough is beginning to form

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  Bloomberg: Dan, you put a note out on your views of Taiwan Semi-conductor Manufacturing Co [TSMC, 台積電], and United Microelectronics Corp [UMC, 聯電], two of the world's biggest made-to-order chipmakers.

  In it, you make some assumptions about semiconductor demand.

  Can you tell us about your note?

  Daniel Heyler: OK, now there's also Chartered Semiconductor as well. What we've done with this sector is we've upgraded our recommendations from the neutral at Chartered to accumulate and from accumulate to buys by TSMC and UMC. The basis of the call is a macro-call in that we think that the rate of decline is leveling and we're approaching a bottom to their business processes and the business flow. The thinking there is that -- a couple things: the rate of supply growth globally in semiconductors, wafers and our supply based analysis indicates that we're in the leveling period by the fourth quarter. Supply growth of foundries has gone from 8 percent growth in the first quarter, likely to go to 2 percent to 3 percent only and then it hovers around that level for the first half of next year.

  We're also encouraged on the capital spending front in that we've seen cuts in capital spending globally, which is translating into slower supply growth. But on top of that, although the foundry number is still declining by 40 percent in capex [capital expenditures], a lot of that is technology-related spending, so that's fairly non-productive technology which kind of leads back into the slower supply growth that we're seeing.

  On top of that, what we're looking for is, although the third quarter will be worse, we think the level of wafer loading by Com IC companies is very low. So given that low level of orders, we don't see downside to Com ICs, but we would expect some level of reordering coming through in Com ICs at a very low level in the fourth quarter. But as things start to work down, we've seen the Com IC inventory decline by 20 percent in the second quarter, that means we're on track for a first or second normalization in Com ICs, which represents a third of foundry demand.

  So we'd say that here we are at the bottom. This is an opportunity for people to buy the growth. And we're really focusing on the quality companies as we think the outsourcing trend will accelerate, particularly as the industry moves to 0.13 and 300mm.

  Bloomberg: Right. You've upgraded your recommendation on UMC and TSMC to "buy" from "accumulate." Why is that?

  Heyler: Yeah, as I said, we think that the valuation levels at this point are 15 percent to 20 percent below 1998's trough, and we really don't have any situation of such quality companies being below trough evaluation in the US, on the US listings. So I think that that represents -- and I think that the ADR premium represents a quality in which markets are valuing these stocks, so we think they're fairly undervalued, for one, given we're very late in the cycle here.

  You know, three, four months ago, we would have suggested there's still more downside to fundamentals in which we would say there's downside to share prices. We don't see the level of downside. We see minimum downside of fundamentals, and we think we're really at a trough level and these stocks could start to trade up on a 12-month basis. So we think now is the time and opportunity to pick up these quality names.

  Bloomberg: Indeed, that's what the stocks are doing.

  They've been rising over the last three or four days, despite disappointing earnings reports. UMC said it made a second quarter loss; it will probably make a third quarter loss. And TSMC barely made a second quarter profit.

  Are you confident, given that other analysts have called a bottom in the semiconductor cycle that we're really at the bottom now?

  Heyler: Well, the important thing is the bottoming of the a couple data points in terms of bottoming, third quarter is definitely going to be worse. Now, I think you also need to look at the rate at which inventories have worked down in the Com IC space. And I think that's where we're definitely see a bottoming in the level of orders.

  The broader areas where we're seeing is kind of somewhat of a seasonal uptick in the fourth quarter. But we're really looking for a very mild recovery coming out of this. We're not saying that demand is strong.

  The last data point that we were really focusing on was the overall economic growth, so in terms of the leading economic indicators, we've seen a couple months in which that has started to move and then APM numbers have also been turning upwards.

  In fact, we get more positive economic data that there would still be upside to our scenario in demand, and we may see the current rallying share prices continue to transport based on likelihood of stronger demand in the first quarter of 2002 based on the economy bottoming on top of the inventory work down that I talked about.

  Bloomberg: Where do you see the share prices of TSMC and UMC going on a 12-month basis?

  Heyler: What we've done is we've kind of looked at a trough-to-peak valuations and normalized those earnings estimates. And I think on an initial basis, we'd look for 30 percent to 35 percent upside. However, on the ADR, we see less upside, given the steep premium there, so we expect a 15 percent to 20 percent upside based on, you know, our current assumptions.

  Now, again, the pull through in end demand will be the key uncertainty. And to the extent that we see average selling price pressure, also the key uncertainty, if we in fact we start get more comfortable then we've suggested, raising our objectives further.
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