Chipmakers Feel an Unseasonable Chill


By Amrit Tewary The nearly 7.5% drop in shares of No. 1 chipmaker Intel (INTC) on Sept. 3 after it lowered sales and profit guidance was only the most recent example of the significant decline recently in semiconductor share prices. Despite the pullback, we at Standard & Poor's Equity Research think current valuation multiples on chip stocks are warranted in most cases, given what we see as elevated near-term risks. We believe that concerns about the broader economy, including high oil prices, a lack of meaningful job growth, and the possibility of higher interest rates, will likely continue to have an impact on end-user demand and weigh on chip stocks in the near term.

Those factors are behind our neutral outlook on the semiconductor industry. Year-to-date through Aug. 27, the S&P Semiconductor Index fell 28.5%, vs. a 0.2% drop for the S&P 1500. Because the return is market-capitalization weighted, it's greatly skewed by Intel (S&P investment rank, 3

STARS, hold; recent price, $21.63), the world's largest chipmaker.

INVENTORY GLUT? These macro concerns suggest to us that end-user demand in the second half of 2004 may not be as robust as many analysts and investors expect. Our perception is also supported by other recent developments, including cautious comments by hardware manufacturers such as Cisco (CSCO

; 4 STARS, accumulate; $19.30) and Hewlett-Packard (HPQ

; 3 STARS; $18.01), chip-equipment outfit Kulicke & Soffa (KLIC

; 2 STARS, avoid; $5.63), and numerous semiconductor producers such as Intel.

We believe weaker-than-expected demand will mainly result from a more cautious consumer, whose discretionary spending this year on PCs, cell phones, and other electronic gadgets may be more constrained by relatively high gasoline prices, the prospect of higher payments on mortgages and other debt, and less confidence in the job market.

Excess inventories at some chipmakers and within their distribution channels also worry us. We believe that customer-order rates during the initial part of the current upcycle were boosted not only by strong end-user demand, but also by distributors' normal inventory restocking that normally follows a downturn. However, we think this replenishment has largely been completed and an inventory glut likely exists in some segments.

WEAKER UPSWING. The upshot: Future order rates are expected to be largely driven by distributors' and original equipment manufacturers' (OEMs) perceptions of what end-user demand will be like a few months ahead. We think distributors and OEMs are especially fearful of building up inventory in this cycle and will thus be cautious in their ordering.

Given the heightened macroeconomic and inventory risks that we foresee, the seasonal upswing during the upcoming back-to-school season likely won't be as strong as we previously anticipated. Prior to Aug. 13, we expected worldwide semiconductor sales growth to be 30% in 2004 and 20% in 2005. However, on that date, we moderated our growth estimates to 25% for 2004 and to 10% for 2005.

We also now believe 2006 will be a flat-to-down year for most chip concerns. Our forecast compares with the Semiconductor Industry Assn.'s (SIA) June, 2004, projection of 28.6% total chip sales growth in 2004, followed by a 4.2% increase in 2005 and a 0.8% decline in 2006.

The chip industry has historically been subject to intense boom-and-bust cycles. From 1975 through 2000, annual sales growth averaged 16.1%, according to SIA data. As the industry matures, we think cyclicality will continue, but we see the long-term growth rate likely to decline toward about 10%. For 2004, we expect worldwide semiconductor revenues to surpass the 2000 cycle-high level of $204.4 billion.

A FEW OUTPERFORMERS. Although we have a neutral outlook on the industry as a whole, we do think a few companies should outperform their chipmaking peers. What are our top picks? We like Microchip Technology (MCHP

; 5 STARS, buy; $27.36), a business that has built a strong market leadership position in the relatively steady 8-bit microcontroller business. We think Microchip should gain market share from smaller competitors in this fragmented segment of the industry.

We also like Maxim Integrated Products (MXIM

; 4 STARS; $43.83) and Linear Technology (LLTC

; 4 STARS; $36.76), two high-end analog chip outfits that have similar businesses. We think the high-end analog business has more attractive long-term growth prospects than most other segments of the industry. Also, we believe Maxim and Linear are both well-run companies that have diversified market exposure, no long-term debt, and wide margins -- all attributes we at S&P favor. Furthermore, we think both stocks are attractively priced at current levels.

On the flip side, we have a 1-STARS, or sell, opinion on Micron Technology (MU

; $11.65). We believe risk is increasing that a supply-demand imbalance for its chips will lead to pricing pressure. We're also concerned about competitive pressure, Micron's significant exposure to the PC end-market, and what we view as low earnings quality, as reflected by the relatively large divergence between our operating EPS projections and our Standard & Poor's Core EPS estimates. We don't think these risks are reflected in the stock price, and we would sell the shares.

Finally, we have a 2-STARS opinion on National Semiconductor (NSM

; $13.84). We believe our concerns about a broad-based weakening in demand trends for the company, which we expect to continue, are not fully reflected in the stock price. We would avoid the shares.

Required Disclosures

As of June 30, 2004 SPIAS/SPSI and their research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings.

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

All of the views expressed in this research report accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com.

Affiliates of SPSI received non-investment banking compensation from INTC, CSCO, MCHP, MOT, and LLTC during the past 12 months.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS") and is distributed in the U.S. by Standard & Poor's Securities, Inc. ("SPSI"), a registered broker-dealer, and a member of the New York Stock Exchange, Inc. and National Association of Securities Dealers, Inc. The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Additional information is available on request to Standard & Poor's, 55 Water St., New York, NY 10041 (212-438-2000)

Analyst Tewary follows shares of semiconductor companies for Standard & Poor's Equity Research Services


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