Technology

Should You Be in the Chips?


By Amrit Tewary We have a neutral fundamental outlook on the semiconductor industry. Year to date through Sept. 9, the S&P Semiconductors index rose 12.2%, vs. a 3.2% increase for the S&P 1500 index. Because the index is market capitalization-weighted, its return is greatly skewed by Intel (INTC

: Hold; $25), the world's largest chip company. Despite the year-to-date increase in the semiconductor index, most chip stocks we follow are still down from early 2004 levels.

However, we think that current chip valuation multiples are warranted in most cases, based on our expectation of decelerating growth for the industry in 2005 and 2006.

Also, we believe valuations are justified given elevated near-term macro risks, including high energy prices and the possibility of steeper interest rates. Gasoline pump prices have increased rapidly in recent months, and home heating costs are expected to rise sharply this winter. In addition, we believe consumers in the past few years have cut down on savings and increased debt levels, including adjustable-rate and interest-only mortgages that we believe are especially susceptible to higher rates.

SEASONAL JUMP. These factors lead us to believe that many consumers, especially those in the low-income and middle-income brackets, may cut down on electronics spending during the holiday season. One would still expect a seasonal jump, but we think its strength will not be as robust as in previous years.

According to industry data gathered by research outfit Semiconductor Industry Assn. (SIA), worldwide chip sales growth hit a healthy 18% in 2003 and a strong 28% in 2004. We estimate that worldwide semiconductor revenues totaled $216.4 billion in 2004, surpassing the 2000 cycle-high level of $204.4 billion.

However, we expect growth to moderate over the near term. We see a 5% sales increase in 2005, followed by a 2% increase in 2006. We think the industry will avoid a year of declining sales during the current cycle, thanks to disciplined supply-chain management and increased end-market diversification. But we do not expect a reacceleration in growth until 2007 at the earliest.

STRONG EXECUTION. We believe a recent accounting change requiring the expensing of stock options will bring a decline in reported earnings for many chipmakers we follow. Although we don't expect an immediate change in most chipmakers' compensation policy as a result of the new rule, we expect these companies to reduce their reliance on stock-based compensation over the next few years.

We anticipate that most chip stocks will perform in line with the S&P 1500 over the next 12 months. During that time, we believe chipmakers exposed to the high-end analog, power management, and other chip categories that serve a broad range of end markets have the best prospects.

Our strong buy-ranked stocks include Marvell Technology (MRVL

: $45) and International Rectifier (IRF

: $49). Marvell is a Bermuda-based, fabless chipmaker that provides broadband communications devices for the data communications and data storage markets. We see Marvell's sales growing 33% in fiscal 2006 (ending January) and 32% in fiscal 2007, following 49% growth in fiscal 2005.

We believe Marvell's technology expertise and strong management execution, as evidenced by 31 consecutive quarters of revenue growth in a highly cyclical industry, will enable continued share gains in its markets. Near term, we see the company benefiting its chips use in new digital consumer gadgets.

PRICING PRESSURE. Medium and longer term, we project end-market demand to benefit from a push toward wireless and broadband data transmission, as well as from a need for better data storage. Specifically, we expect to see accelerating demand for laptop computers and digital cameras, and increasing broadband usage in the home, to generate demand for Marvell's storage and data transmission products, both on the high and low ends.

Also, we think the stock is attractively valued based on our p-e and price-to-sales analyses, and we see above-average share price appreciation potential, to our 12-month target price of $57. We believe Marvell merits a premium valuation vs. its peers, given the superior growth we project for the company for the next several years.

Risks to our recommendation and target price include an unexpected decline in sales to a major customer, aggressive pricing pressure, and softer than expected demand for consumer and enterprise applications containing Marvell chips.

International Rectifier, founded in 1947, makes power semiconductors that refine electricity from wall outlets or batteries into a more usable form. We see strong growth prospects for the company, as the overall market for power management chips is projected to post a compound annual growth rate (CAGR) of 20% over the next 10 years.

TOO CONSERVATIVE? We think IRF will be a primary beneficiary of sustained high energy prices and the recent passage of the Energy Bill. Also, we project robust sequential revenue growth for the computing and communications business for the back half of calendar 2005. In addition, we see improvement in the company's gross margin in fiscal 2006 (ending June), as it increases its focus on faster-growing, proprietary products.

We believe IRF's near-term management guidance and current Street consensus estimates are overly conservative, and we expect better-than-consensus numbers in future quarters to drive share price increases.

The stock recently traded at 17 times our forward 12-month earnings-per-share estimate. That amounts to a large discount relative to its peers and to its historical average multiple. Our 12-month target price of $63 suggests major upside potential.

NEED FOR SCRUTINY. Risks to our opinion and target price for IRF include semiconductor industry cyclicality; competitive pricing pressure in the commodity business (about 15% of revenues); and above-average share price volatility.

Investors should also keep in mind that 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 the SIA. As the industry matures, we believe cyclicality will continue but expect the long-term growth rate to decline to roughly 10%.

Still, if investors choose carefully and stick with chipmakers with a special niche, we think rewards could be in store.

Required Disclosures

In the U.S.

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services U.S. have recommended 30.2% of issuers with buy recommendations, 57.5% with hold recommendations and 12.3% with sell recommendations.

In Europe

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Europe have recommended 34.4% of issuers with buy recommendations, 46.8% with hold recommendations and 18.8% with sell recommendations.

In Asia

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services Asia have recommended 33.3% of issuers with buy recommendations, 47.2% with hold recommendations and 19.5% with sell recommendations.

Globally

As of June 30, 2005, research analysts at Standard & Poor's Equity Research Services globally have recommended 31.0% of issuers with buy recommendations, 55.4% with hold recommendations and 13.6% with sell recommendations.

5-STARS (Strong Buy): Total return is expected to outperform the total return of a relevant benchmark, by a wide margin over the coming 12 months, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of a relevant benchmark over the coming 12 months, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of a relevant benchmark over the coming 12 months, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of a relevant benchmark over the coming 12 months, and the share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of a relevant benchmark by a wide margin over the coming 12 months, with shares falling in price on an absolute basis.

Relevant benchmarks: in the U.S. the relevant benchmark is the S&P 500 Index, in Europe the S&P Europe 350 Index, in Asia the S&P Asia 50 Index, and in Malaysia the KLCI or KL Emas Index.

For All Regions:

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.

Additional information is available upon request.

Other Disclosures

This report has been prepared and issued by Standard & Poor's and/or one of its affiliates. In the United States, research reports are prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). In the United States, research reports are issued by Standard & Poor's ("S&P"), in the United Kingdom by Standard & Poor's LLC ("S&P LLC"), which is authorized and regulated by the Financial Services Authority; in Hong Kong by Standard & Poor's LLC which is regulated by the Hong Kong Securities Futures Commission, in Singapore by Standard & Poor's LLC, which is regulated by the Monetary Authority of Singapore; in Japan by Standard & Poor's LLC, which is regulated by the Kanto Financial Bureau; in Sweden by Standard & Poor's AB ("S&P AB"), in Malaysia by Standard & Poor's Malaysia Sdn Bhd ("S&PM") which is regulated by the Securities Commission and in Australia by Standard & Poor's Information Services (Australia) Pty Ltd ("SPIS") which is regulated by the Australian Securities & Investments Commission.

The research and analytical services performed by SPIAS, S&P LLC, S&P AB, S&PM and SPIS are each conducted separately from any other analytical activity of Standard & Poor's.

S&P and/or one of its affiliates has performed services for and received compensation from Intel, Marvell, and International Rectifier during the past 12 months.

Disclaimers

This material is based upon information that we consider to be reliable, but neither S&P nor its affiliates warrant its completeness, accuracy or adequacy and it should not be relied upon as such. With respect to reports issued by S&P LLC-Japan and in the case of inconsistencies between the English and Japanese version of a report, the English version prevails. Neither S&P LLC nor S&P guarantees the accuracy of the translation. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Neither S&P nor its affiliates are responsible for any errors or omissions or for results obtained from the use of this information. Past performance is not necessarily indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale of any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. Any opinions expressed herein are given in good faith, are subject to change without notice, and are only correct as of the stated date of their issue. Prices, values, or income from any securities or investments mentioned in this report may fall against the interests of the investor and the investor may get back less than the amount invested. Where an investment is described as being likely to yield income, please note that the amount of income that the investor will receive from such an investment may fluctuate. Where an investment or security is denominated in a different currency to the investor's currency of reference, changes in rates of exchange may have an adverse effect on the value, price or income of or from that investment to the investor. The information contained in this report does not constitute advice on the tax consequences of making any particular investment decision. 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. Analyst Tewary follows semiconductor stocks for Standard & Poor's Equity Research


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