Where the Winners in Chips Are


If you want to put your chips on chips, the place to look now is among the companies making analog semiconductors and those for such markets as wireless communications. That's the recommendation of Thomas Smith, senior investment officer and group head for technology stocks at Standard & Poor's.

The recovery in tech may take several more quarters, Smith observes. And S&P suggests that investors underweight their exposure to the tech sector, he adds, because of a danger that it might see some retracement before the market rally gets going strongly.

Among the stocks of semiconductor and semiconductor-equipment companies, the area Smith personally covers, S&P has buys on Analog Devices (ADI) and Microchip Technology (MCHP). In addition, in the tech group generally, S&P lists as buys Microsoft (MSFT), Cisco (CSCO), Flextronics (FLEX), Fair Isaac (FIC), and Overture Services (OVER). Other buys are Affiliated Computer Services (ACS), Symantec (SYMC), and Electronic Arts (ERTS), the video-game maker. A recent small-cap addition to the info-tech buy list is WebEx Communications (WEBX).

These were among the comments Smith made in an investing chat presented Dec. 3 on America Online by BusinessWeek Online and Standard & Poor's. He was responding to questions from the audience and from BW Online's Jack Dierdorff. Following are edited excerpts. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Note: Tom Smith is an equity analyst with Standard & Poor's Investment Advisory Services. He has no affiliation with or ownership interest in any company under discussion. S&P's other affiliates may provide services to the companies under discussion today.

Q: Before we dig into the tech sector, Tom, is the market rally just pausing for breath, or do you at S&P think it has run out of steam?

A: I think the market is pausing for breath. From my seat here in the tech group, the fact that the Nasdaq composite average has been piercing its 200-day moving average in recent days is a bullish sign. Although it backed off some today, we think the Nasdaq will tend to move higher over the next quarter.

Of course, a retracement after the very fast upward movement since October would not be extraordinary. Overall, S&P is bullish on the markets. We have an underweight ranking on the tech sector out of caution that there might be a brief retracing of part of the rally since October.

Q: What do you think of Intel (INTC)?

A: Intel is a 2-STAR (avoid) with us [in S&P's Stock Appreciation Ranking System, known as STARS], although the shares have come back lately and recent fundamental indications are that Intel may be able to report in line with expectations. We see Intel heading into a seasonally weak period into the first half of next year, with some question about how strong PC sales will be in the second half of '03.

Intel maintains a substantial amount of production capacity, which will help it if sales turn up but expose it to some risk if sales should disappoint in 2003. We prefer chipmakers with less exposure to commodity-pricing situations, including the analog chipmakers. That said, Intel is expected to be able to raise prices on flash memory in January. However, we think this news is largely in the stock already.

Q: I've owned 8,500 shares of VTSS

(Vitesse Semiconductor) since '94 -- what's its future?

A: Vitesse is no longer in coverage. It is a communications-semiconductor maker. The wireline communications equipment markets remain quite weak and are apt to stay weak throughout 2003. Although we don't have a STARS ranking on Vitesse, peer companies active in that same part of the chip industry include PMC-Sierra (PMCS), which is a 2-STAR (avoid), and Applied Micro Circuits (AMCC) is also a 2-STAR (avoid). The story in this part of the chip world is that you have low-priced stocks, many of which will come back, or may come back someday. However, the time frame for recovery is beyond our 6- to 12-month time frame.

Q: Backing up a sec, you said re: Intel that you preferred other chipmakers. Such as?

A: Such as analog chipmakers, including ADI

(Analog Devices), which is a 5-STAR (buy). ADI's sales come 80% from high-end analog chips and 20% from DSP [digital signal processing] chips, which are used mainly in communications applications but really cover a wide range of end markets, including computers, wireless handsets, wireless base stations, digital consumer electronics, hospital instruments, and process-control instruments for industry and other end markets. ADI has some debt, but we believe it's generally a well-managed company and is one of the best ways to play the DSP chip area.

Texas Instruments (TXN) similarly makes high-end analog and DSP chips. However, it also makes a lot of low-end chips and educational calculators, and overall to us is less attractive. TXN is a 2-STAR (avoid) with us, despite its raising its guidance for fourth-quarter [earnings per share] by 1 cent today. Other chipmakers we like include Microchip Technology (MCHP), which is a 5-STAR (buy). MCHP makes embedded control systems used in a very wide range of end products, including automobile electronics and household appliances, where sales have been steady and where increasing penetration of microcontrollers has been a favorable trend.

Additionally, we like Linear Tech (LLTC) as a 4-STAR (accumulate) and Maxim Integrated Products (MXIM) as a 3-STAR hold. These two are pure plays in high-end analog chips. Their attraction is very wide margins by industry standards and relatively steady pricing for their chips. However, they typically trade at premium valuations. So in summation, we prefer analog, DSP, and microcontroller categories of chips rather than a commodity-oriented kinds of chips such as microprocessors and processors and DRAMs.

Q: What do you think of Kemet (KEM)?

A: Kemet is a maker of capacitors, which are a passive electronic component widely used in all kinds of electronics. Kemet is presently a 3-STAR (hold). Business conditions have stabilized at a low level for Kemet.... The capacitor industry saw a large buildup of production capacity during the boom in 2000. We think it will be a while before demand catches up with that capacity and leads to strong enough pricing to create strong earnings for Kemet.

A similar company, AVX (AVX), is a 2-STAR (avoid), and we have some of the same concerns -- that a lot of capacity is out there and that demand is coming back slowly. Again, these companies should cycle up with the electronics industry. However, the time frame for recovery is long enough so that these are not among our favorite companies right now.

Q: What about FLEX

(Flextronics)?

A: Flextronics is one of the stronger contract-manufacturing companies. Flextronics was upgraded today from 4-STAR (accumulate) to 5-STAR (buy). Analyst Richard Stice believes that Flextronics is the best-positioned electronics manufacturing-services company and should benefit from the growing trend of outsourcing manufacturing activities.

Q: Do you cover RFMD

(RF Micro Devices)?

A: Yes, I do. RFMD is presently a 3-STAR (hold). It's a strong player in radio-frequency chips for wireless communications and should see sales and earnings improve as companies such as Nokia (NOK) begin to sell more units of phones and to sell next-generation phones that are packed more densely with high-powered electronics. In the near term, RFMD's earnings are just beginning to come back into profitability.... Overall trends within the semiconductor industry seem to be favoring wireless chips compared to other kinds of chips.

Q: What about ORCL

(Oracle) and SUNW

(Sun Microsystems) -- are they worth holding?

A: Oracle is a 4-STAR (accumulate) as covered by analyst Jon Rudy. We estimate that it will have earnings of 39 cents in the fiscal year ending in May, 2003, and EPS of 42 cents in the '04 fiscal year. Oracle, of course, has a large franchise in computer software for businesses. It should do better as patterns for information-technology spending by business become stronger.

We should see a little of this in the second half of '03 and expect to see more decisive recovery in 2004. So, yes, we would hold Oracle for this recovery and advise accumulating a larger position.

Sun Microsystems, as followed by Megan Graham-Hackett, is a 3-STAR (hold). We estimate that Sun will lose 2 cents per share in the June '03 fiscal year. Sun, of course, is an innovative player in the network-computing markets. The share price has been driven under $5 for some time now, and its book-to-bill ratio is near 1, implying that business is stable -- and for this company, the lack of deterioration may be viewed as good news. On the other hand, an acceleration to robust earnings still seems somewhat distant.

Q: Can we please get your viewpoint on KLAC

(KLA-Tencor)?

A: KLAC is the premier maker of semiconductor equipment used for yield management and process monitoring during the making of semiconductors. It's presently ranked as 2-STAR (avoid), as covered by analyst Richard Tortoriello.... Although KLA is one of the larger companies in the semiconductor-equipment group and has strong market position, as judged by market share, in certain niches, it's suffering along with other semiconductor-equipment makers from a very slow pattern of orders this fall.

Q: AMAT

(Applied Materials) is another name that several people have brought up. Do you like it?

A: Most of the same arguments just stated for KLA also apply for AMAT. It's a large company in the group with strong R&D and the potential to sell equipment to the leading-edge chip plants. However, earnings visibility is low, and the time to strong earnings recovery could be long.

Therefore, at the moment, Applied is a 1-STAR (sell) with us. This is based mostly on valuation and low earnings visibility for the group. We carry an underweight ranking on the semiconductor-equipment group.

Q: What about EMC (EMC)?

A: EMC Corp. is one of the larger players in the storage hardware and software markets. It's covered by analyst Richard Stice. It's a 3-STAR (hold). We estimate a loss of 9 cents per share in 2002 and a loss of 5 cents in 2003, indicating that the time to recovery may be a little longer than we would like to see in a bullish call. So while we expect EMC to come back when IT spending picks up, for now we are neutral on the shares.

Q: How about Rambus (RMBS) and ATML

(Atmel)?

A: We don't cover Rambus. However, we do cover Atmel Corp. -- it's presently a 3-STAR (hold). The shares showed some life in recent days on the concept that wireless chips might be doing better and that flash-memory pricing might be rising, as based on comments by Intel.

Atmel is a broad-line chipmaker that makes various kinds of logic chips, memory chips, and microcontrollers, It's active in wireless areas, including handsets, but also including things like smart cards, identity-security chips, and chips for more humble wireless functions such as remote controls for garage doors.... We expect Atmel to recover with the chipmakers as the industry cycles up more strongly in 2004. But we would prefer other chipmakers here and are neutral on Atmel.

Q: You have buys on Analog Devices and Microchip, Tom. Any other positive readings for us as we wind this up? The revival in corporate IT spending -- and with it the revival of many of the tech names -- seems to have become a moving target.

A: With the recovery in tech seeming to be closer, yet still a process that's apt to take several more quarters -- or perhaps up to two years for some parts of the IT sector -- we are choosing as 5-STARS names that have strong market position in their franchise and solid balance sheets.

The recent additions to the 5-STAR list have included Microsoft (MSFT), Cisco (CSCO), Flextronics, Analog Devices, Fair Isaac (FIC), and Overture Services (OVER). We're still positive on Affiliated Computer Services (ACS), Symantec (SYMC), and Electronic Arts (ERTS), the maker of video-game software. A recent small-cap addition to our IT buy list is WebEx Communications (WEBX).


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