Photronics: Steady Improvement Ahead
Salomon Smith Barney
Friday, December 10, 1999




 --SUMMARY:--Photronics--Semiconductor Equipment
 Photronics reported an inline 4Q99, with EPS of $0.20 vs. our est. of $0.19
 (consensus). The $0.01 upside was due to a lower tax rate.
 The high-end is continuing to ramp, with sales of 0.25 micron and below
 masks up 25% sequentially. High-end sales accounted for 21% of revenues vs.
 18% in 3Q99. 
 Leaving our estimate of $0.97 in FY00 unchanged. 
 We expect steady improvement ahead as high-end design releases are
 beginning to accelerate. Maintain 1H (Buy, High Risk) and target of $29.

 --EARNINGS PER SHARE--------------------------------------------------------
                FYE    1 Qtr      2 Qtr      3 Qtr      4 Qtr      Year
 Actual   10/99 EPS    $0.03A     $0.09A     $0.14A     $0.20A     $0.45A
 
 Previous 10/00 EPS    $0.14E     $0.21E     $0.30E     $0.32E     $0.97E
 Current  10/00 EPS    $0.14E     $0.21E     $0.30E     $0.32E     $0.97E
 
 Previous 10/01 EPS    $N/A       $N/A       $N/A       $N/A       $N/A
 Current  10/01 EPS    $N/A       $N/A       $N/A       $N/A       $N/A
 
 Previous 10/02 EPS    $N/A       $N/A       $N/A       $N/A       $N/A
 Current  10/02 EPS    $N/A       $N/A       $N/A       $N/A       $N/A
   Footnotes: 
   

 --FUNDAMENTALS--------------------------------------------------------------
 Current Rank........:1H Prior:No Change Price (12/8/99).....:$25.18
 P/E Ratio 10/00.....:26.0x              Target Price..:$29.00 Prior:No Change
 P/E Ratio 10/01.....:N/Ax               Proj.5yr EPS Grth...:20.0%
 Return on Eqty 99...:11.4%              Book Value/Shr(99)..:7.02
 LT Debt-to-Capital(a)34.2%              Dividend............:$N/A
 Revenue (00)........:244500.00thous     Yield...............:N/A%
 Shares Outstanding..:28.6mil            Convertible.........:Yes
 Mkt. Capitalization.:720.1mil           Hedge Clause(s).....:#
 Comments............:(a) Data as of the most recently reported quarter.
 Comments............:

 --OPINION:------------------------------------------------------------------
 Photronics reported 4Q99 results which were inline with expectations, 
 with EPS of $0.20 versus our estimate of $0.19 (consensus). The $0.01 in 
 upside was due to a lower tax rate in the fourth quarter as the company 
 overestimated its tax rate in the first three quarters of the year.  We 
 believe Photronics is well positioned to see steady sequential sales 
 increases over the course of next year. We remain optimistic on 
 Photronics' outlook for next year due to the following reasons: 1) 
 high-end design releases are beginning to accelerate as the Tier 2 and 
 Tier 3 semiconductor companies move to 0.25 micron and below linewidths. 
 2) pricing in the low and mid-end has stabilized as overcapacity is being 
 absorbed by the strong pickup in semiconductor sales, and 3) capacity 
 utilization rates continue to improve, and 4) the company is well 
 positioned for the ramp in the high-end with an installed base of 5 Alta 
 3500's. We continue to believe the photomask sector is on a path towards 
 a steady secular recovery and reiterate our 1H, Buy rating and price 
 target of $29 (3x our calendar 2000 sales per share estimate of $9.6). We 
 believe the stock will trade towards our price target as the market 
 begins discounting the recovery over the next 3-6 months. 
 
 Inline 4Q99
 
 Photronics reported 4Q99 EPS of $0.20, inline with our estimate of $0.19 
 (consensus). The $0.01 was due to a lower than expected tax rate as the 
 company underestimated the R&D and tax credits it would receive. Sales 
 increased 7% sequentially to $63 million, inline with our estimate of 
 $63.5 million.  Of the 7% sequential sales increase, 60-65% was due to 
 better pricing while the remaining 35-40% was attributable to higher unit 
 volume. The company experienced improved sales trends as the quarter 
 progressed, with sequentially higher sales in each month. Sales in all 
 regions improved steadily, with Europe reaching another sales record. 
 Gross margins improved 220 basis points sequentially as the sales mix 
 shifted towards higher margin 0.25 micron and below masks and overhead 
 absorption improved. Capacity utilization improved to 77-78% from around 
 75% in 3Q99. Operating expenses of 19.7% were almost identical to our 
 estimate of 19.8%. 
 
    SSB  Actual
 Sales   $63.5M  $63M
 Gross Margins  33.0%  33.2%
 Operating Exp.  19.8%  19.7%
 Operating Mgn.  13.2%  13.5%   
 EPS   $0.19  $0.20
 
 Continued Growth in Europe, Captive Divestitures in Japan Opens Up 
 Opportunities
 
 Photronics continues to expand its efforts overseas. International 
 revenues accounted for 23% of revenues (same as in 3Q99), with sales in 
 Europe reaching another record. Photronics has been helped in Europe by 
 the success of the semiconductor companies in this region and is 
 continuing to grow its market share.  Photronics' strategic decision to 
 enter the European market with high-end capability is allowing the 
 company to gain market share as a second source supplier. From a market 
 share of 15-18% currently, we expect the company to reach a mid 20% 
 market share in FY00. Japan is another region which has potential for 
 appreciable growth. Following the trend of captive mask shops in the US 
 and Europe, the Japanese semiconductor companies are increasingly 
 divesting their captive mask operations.  Toshiba recently announced that 
 it will set up a joint venture mask operation with Dai Nippon and not too 
 long ago Hitachi sold its mask operations to Dai Nippon. We believe the 
 move by captives in Japan to an outsourcing model will create 
 opportunities for Photronics to enter the Japanese market. However, given 
 the traditional difficulty with cracking the Japanese market, it may take 
 time. Japan currently accounts for 2-3% of revenues (Photronics supplies 
 US companies with operations in Japan). With 7 mask shops, Taiwan is 
 still suffering from overcapacity in the low-end and given this less than 
 favorable environment, Photronics is abstaining from entering this 
 market. We believe the overcapacity issues in Taiwan are likely to linger 
 for some time until consolidation occurs.      
 
 High-End Ramp Is Encouraging 
 
 The continued steady ramp in the high-end is encouraging. High-end mask 
 sales increased 25% sequentially and accounted for 21% of sales versus 
 18% in 3Q99. We believe that 0.25 micron and below masks will account for 
 1/3 of sales in FY00 versus 16% in FY99.  PSM/OPC masks accounted for 10% 
 of business. Photronics plans to handle all of its PSM volume out of 
 Texas and does not plan to install PSM capability on its 5 high-end tools 
 until demand increases significantly. High-end design releases at Tier 1 
 and Tier 2 semiconductor companies are accelerating and Tier 3 
 semiconductor companies are overcoming difficulties in the move to 0.25 
 micron and below linewidths. Photronics is seeing good activity with 0.18 
 micron and expects the Tier 1 companies will begin to releasing more 0.18 
 micron designs in January.  These trends bode well for Photronics given 
 that higher end masks carry higher ASPs and gross margins. However, the 
 move to 0.18 micron is being driven primarily by DRAM/microprocessor 
 companies which are less mask sensitive than the ASIC industry. We 
 estimate that DRAM/microprocessor companies can get 10,000 to 20,000 
 wafers per mask set versus 1,000 to 2,000 wafers per mask set for ASICs. 
 We believe that the transition to 0.18 micron by the 
 non-DRAM/microprocessor industry will not occur until March-June 2000. 
 Given that Photronics' customer base is dominated by logic/ASIC 
 companies, we believe the company will not see appreciable revenues from 
 0.18 micron masks until late 2000 (we look for a ramp to 10% of sales in 
 4Q00). 
 
 Improvement in Gross Margins Reflect High-end Ramp and Better Capacity 
 Utilization 
 
 Gross margins continue to improve with the increased sales volumes and 
 mix shift toward high-end masks. In 4Q99, gross margins increased 220 
 basis points sequentially to 33.2% and were 20 basis points above our 
 estimate of 33.0%. The stable pricing the low/mid-end and improved 
 capacity utilization also favorable affected gross margins. Capacity 
 utilization improved as the quarter progressed and averaged 77-78% for 
 the quarter versus around 75% in 3Q99. We are forecasting gross margins 
 to improve from the low 30% range to the high 30% range in 3Q99/4Q99. We 
 believe there could be upsides to our forecast if high-end mask sales 
 ramp faster than expected. 
 
 Operating Expenses Well Controlled
 
 Photronics has done a superb job of managing operating expenses. 
 Operating expenses only increased 3% sequentially versus the 7% rise in 
 sales. SG&A expenses increased 2% to $8.2 million (vs. our $8.4M est.) 
 from $8.0 million due to increased payroll costs and infrastructure 
 investments. R&D expenses increased 5% to $4.3 million (vs. our $4.1M 
 est) primarily due to costs associated with the Mask Center of 
 Competency, a joint effort with IBM. Photronics is obligated to fund 
 approximately $300K during each quarter. While Photronics is unlikely to 
 see NGL mask revenues for at least 2 years, we believe the investment is 
 a prudent one as it allows the company an early jump on future photomask 
 technologies. As a percentage of sales, operating expenses of 19.7% were 
 10 basis points below our estimate of 19.8%, with SG&A expenses at 13.0% 
 (vs. our estimate of 13.3%) and R&D at 6.8% (vs. our estimate of 6.5%). 
 
 Cash Position Improves
 
 Due to the improved financial results, Photronics was able to improve its 
 cash position from just $8 million in 3Q99 to $16 million. Capital 
 expenditures amounted to $12 million during the quarter ($72 million for 
 the entire year), with depreciation at $11 million. The company expects 
 capital expenditures to total $65-70 million in FY00 before the merger 
 with Align-Rite. Photronics ended the quarter with book value of $8.68 
 and long-term debt of $117 million ($103 due to the convertible note 
 outstanding).  Accounts receivable increased 11% to $41 million with DSOs 
 increasing slightly to 59 days from 57 days. Inventories remained 
 essentially flat at $14 million. 
 
 Look For A Steady Ramp in Sales During FY00, Maintain Estimates.
 
 Following a seasonally slow quarter in 1Q00, we believe Photronics is 
 well positioned to report steady sequential sales increases. The move to 
 finer geometries will necessitate new design releases, which will allow 
 high-end mask sales to continue increasing as a proportion of total 
 sales. In addition, the strength of the semiconductor recovery is 
 allowing for overcapacity in the low-end to be absorbed, which alleviates 
 the pricing pressures in this segment of the market. While the slower 
 than expected ramp in the high-end and the overcapacity at the low-end 
 had previously constrained the company to reporting sales/earnings at the 
 low-end of Street estimates, we believe the positive trends in both the 
 high-end and the low-end should allow Photronics to comfortably meet 
 estimates going forward. While visibility is still low due to the virtual 
 absence of backlog in the mask business, the strong sales trends upstream 
 provide us with some comfort.  
 
 We are maintaining our estimates in FY00 for sales to increase 18% 
 year-over-year to $264 million, gross margins to improve 550 basis points 
 to 35.6%, and operating expenses to decline 150 basis points to 19.3% - 
 which leads to EPS of $0.97 (consensus - $0.98).  Photronics typically 
 experiences a sequential decline in sales during the January quarter 
 since design releases are slow during the end of the year. In 1Q98, the 
 company recorded a 8% sequential decline in sales and in 1Q99, the 
 company had a 9% sequential decline in sales. For 1Q00, we are modeling 
 an 8% decline in sales to $58 million, consistent with the sales declines 
 in the previous two years. However, we believe that the company could 
 report a smaller sequential decline this time around, on the order of 
 4-5% (which implies sales of around $60 million) due to fewer shutdowns 
 (given the strength of semiconductor sales). Assuming the company 
 reported sales of $60 million, we believe EPS could be as high as $0.15 
 (consensus). Following 1Q00, we are looking for quarterly sequential 
 sales increases of 12% in 2Q00 and 5% in both 3Q00 and 4Q00. The timing 
 of the ramp in the high-end will determine whether we see any upsides to 
 our sales/earnings estimate in FY00.  Photronics is expected to close the 
 Align-Rite merger in late January 2000. We will adjust our model for the 
 combined company at that time.