Chip Stocks: The Bad News Bulls


By Thomas W. Smith, CFA It has been a curious year for semiconductor shares. Many have risen smartly, even as leading industry forecasters are calling for slower sales growth than had been previously expected. What's going on here? How should investors react? Let me try to make some sense of it.

Let's start by taking a look at the performance of the Philadelphia Semiconductor Index (SOX). Widely regarded as a proxy for the semiconductor industry, it includes some chip-equipment outfits as well. The SOX ended 2002 at 289.24. It rose in early January, but retreated to closing at 260.92 on Feb. 7.

Since then, despite global political and military tensions, the SARS epidemic, a falling U.S. dollar, and what we at Standard & Poor's consider a generally sluggish recovery for chip sales, the SOX rose to 332.50 as of the end of April. And it's had a merry month of May, closing at 365.34 on May 27. That represents a gain of more than 100 SOX points, or 40% from the Feb. 7 closing low to May 27. Talk about spring fever! Year-to-date through May 27, the SOX was up 26%.

EARLY MOVERS. This seems oddly bullish, given that the fundamental picture for chip demand was dimming in the view of many industry observers. For instance, in early May, the Semiconductor Industry Assn. reduced its 2003 chip-sales forecast to growth of 10% to 15%, from 19.8%. On May 20, market researcher Gartner nudged its forecast for 2003 chip-sales growth down to 8.3% from 8.9%. Looking at a major end market for chips, PCs, market researcher IDC on May 19 told S&P and others it was contemplating a 1%-2% decrease in its outlook for PC unit sales growth in 2003, from 6.9%.

Many things can influence share price, but let's look at what we consider the key factors in the chip-stock revival. On the macro level, we believe the end of the hot part of the conflict in Iraq removed a lot of uncertainty as we headed into April. Also, while the economic outlook based on consumer confidence and job losses tended to be weak in March, by May those problems were provoking a possible solution via stimulus by lower interest rates and federal tax cuts.

Historically, semiconductors are a cyclical growth industry, and it makes sense that the shares should be early movers on rate cuts and economic recovery. It's possible that some investors were willing to overlook the woes of 2003 and look ahead into 2004-05 for a more decisive cyclical recovery.

WIRELESS SIGNALS. On the company level, scattered earnings warnings in late March appeared to be forgotten as industry heavyweights Intel (INTC

; S&P rank 3 STARS, or hold) and Texas Instruments (TXN

; 5 STARS, or strong buy) reported results that topped Wall Street expectations in mid-April. They both benefited from rising demand for wireless chips for portable computers, phones, PDAs, and other electronic gadgets -- the movement toward "untethered" electronics.

Broadcom (BRCM

; 3 STARS) and Cypress Semiconductor (CY

; 4 STARS, or accumulate) are other examples of chipmakers that caught some upside from the growth in wireless. The analog chipmakers and the programmable-logic outfits likewise did well through the spring. The open question for the industry is whether spring production of wireless chips will ultimately sell through to the end-consumer of laptop PCs and wireless phones. It's indeed possible that SARS or other negative factors could curtail demand, creating a chip-inventory buildup at OEMs that would, once again, make fools of chip-stock bulls.

Looking at the longer term, we believe that the semiconductor industry is in the middle of a four-to-five-year industry cycle that should see a new high point in 2005, with industry sales near the $204 billion peak seen in 2000.

Given this broad perspective, we now are likely have two full years before the cycle top. Generally speaking, we think 2003 should be a good year to invest in semiconductors and we are positive on the industry. However, picking the best quarter and month for new investment is forever challenging with such a volatile group of stocks.

PRICING STRENGTH. One key indicator of the industry's health appears to be on the upswing. From the peak for wafer-fabrication plant utilization in mid-2000 at 96.4%, according to SIA data, utilization fell to 64.2% in the third quarter of 2001 and has since been recovering.

Note the flash-in-the-pan surge in utilization in the second quarter of 2002, followed by a modest pullback. A repeat of that phenomenon in 2003 would be a victory for chip bears. Despite that risk, we're bullish, based on our projection for a cycle climax out in 2005, at which point utilization would run above 90% and chip outfits would finally regain some pricing strength.

Integrated Circuit Capacity Utilization (%)

2000

2001

2002

2003

Q1

83.9

77.3

82.8

Q2

73.2

87.0

Q3

96.4

64.2

86.3

Q4

92.8

65.9

81.5

Source: Semiconductor Industry Assn.

Based on some broad observations from the group of semiconductor companies that I follow (what we analysts call our "universe"), here are some further insights on how to approach investing in the chip industry:

1) The high marks for stability of past earnings and dividends, based on S&P's proprietary

Earnings and Dividend Rankings go to the analog and programmable logic-device chipmakers. All of those companies had S&P Earnings and Dividend Rankings of B or better. Linear Technology (LLTC

; 4 STARS) features an A ranking, unmatched in my universe except by Intel. I count Texas Instruments and Analog Devices (ADI

; 5 STARS) with the analog group, although they both make digital signal processors (DSP) chips, too.

2) The low marks for past stability goes to the communications semiconductor makers, which were all ranked C, except for one unranked stock.

3) My average STARS ranking on the analogs and programmable-logic device (PLD) makes is near 4, whereas my average STARS opinion on communication chip stocks is 2.7.

4) The communications chipmakers are all expected to post losses based on our Standard & Poor's Core Earnings estimates for 2003, compared to only one among the analog and PLD makers.

5) The year-to-date performance through May 27 has been better for the communications group and the PLD chipmakers than for the analogs on a percentage basis. Most of the communications chipmakers started the year with share prices below $10. It is possible to get a good percentage kick from beaten down, low-price cyclical shares as a recovery begins. However, we prefer to aim higher on the quality ladder just in case the recovery falters.

6) The clearest divergence between

S&P Fair Value -- our proprietary quantitative model that calculates the price at which we believe an issue should trade at current market levels, based on fundamental data -- and our STARS ranking is with the two major electronic component distributors Avnet (AVT

; 1 STAR, or sell) and Arrow Electronics (ARW

; 2 STARS, or avoid). They both have Fair Value rankings of 5, which under the S&P system means that they're considered the most undervalued.

Our concern is that debt could make these two more vulnerable than many others in my universe if a bearish scenario were to play out for the chip industry. Arrow announced 400 job cuts (3% of its global workforce) on May 28, indicating that the direction in the industry is still toward shrinkage of capacity rather than expansion. In a prolonged recovery, companies with debt face more challenges.

7) The only stock in my universe with both a Fair Value ranking of 5 and a 5-STAR ranking is Vishay Intertechnology (VSH). This company is a hybrid: It makes both passive electronic components and relatively simple semiconductors. The passive products have lower margins and tend to trail the semiconductors in recovery by a couple of quarters as an industry upturn unfolds. In April, the company reported making rapid progress on cost synergies with recent acquisitions. The product line is broader now than in the prior up cycle and should help Vishay further its strategy of offering one-stop-shopping for components. Analyst Smith follows semiconductor stocks for Standard & Poor's


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