The current psychology of buying semiconductor stock
Wednesday June 16, 2004 - [ 05:39 PM GMT ]
Topics: Investment , Management
By: Melanie Hollands
management.itmanagersjournal.com
The "buy" psychology has been -- and continues to be -- negative in the semiconductor stock trade, largely due to fears of a 2005 slowdown. On balance, the sell side is baking in minimal growth for 2005 in the low single-digit area. So, the Street is fearful that year-over-year growth rates will turn ugly in 2005.
I still think we'll get good trade opportunities within the group, but it's hard at this stage to get a sense for timing a trade. I'd wait until we get a 5 percent to 10 percent up move from the recent lows before I decide a real upward trend is starting.
My sense is that PC units and handsets will grow 10 percent-plus in 2005, and currently the Street is at low single-digit growth rates. So I think numbers will move up again. I think wireless local area network (WLAN) sales will drive
PC units, especially notebooks, which should be higher than people currently expect. In addition, the replacement cycle in handsets with color and camera phones is just beginning. Corporate profits are still strong outside of technology, and that should drive better-than-expected IT spending as we exit 2004 and enter 2005.
Melanie Hollands
Good move may happen in second half
I just ran a screen of tech-trading under market multiple, possible earnings revisions. I think the psychology is negative now, too, for semi cap equipment, which makes me happy that order growth expectations for next two quarters is minimal.
Looking at some of the small cap semi equipment names, I think we'll get a good move in them the second half of this year. I ran a screen recently, and there are a number of names trading at under 16x forward (2005) earnings. In addition, utilization rates should remain above 85 percent for next three quarters – and that, in my mind, should drive upside to orders, which most on the Street seem to think will be flattish over next two quarters.
I think we'll see a number of the larger cap names also look to fill in product areas, as many of their balance sheets are cash rich. Applied Materials just did a small deal, and I'd not be surprised to see a lot of M&A in semi cap equipment over next six months.
So while many semiconductor fundamentals are smoking, sentiment remains poor. Also, a lot of money has been invested in software stocks lately, rather than semiconductors. I might take a long position in the Merrill Lynch Semiconductor Holders Trust (SMH) at some point, but it's a bit early -- and it depends what happens over the next month or so in the broader market. But within the next few weeks I'd not be long SMH, because the market psychology still is awful. But come late June/early July I think we could see the semiconductor companies talking about delivering substantial third-quarter numbers (revenue growth and EPS), and I expect the fears over inventory builds will be gone.
Some background: The Semiconductor Holders Trust was created by Merrill Lynch in cooperation with the American Stock Exchange (AMEX) and is traded under the ticker symbol SMH on the NYSE. The SMH is comprised of 20 semiconductor and equipment stocks. Among the group's more heavily weighted members are Intel (INTC), Texas Instruments (TXN), Applied Materials (AMAT) and Analog Devices (ADI).
Advantages of investing in the semi group
An advantage of SMH is that an investor taking a longer-term (positive) view of semiconductor stocks can thus buy a composite semi stock in the SMH compared with the SOX, however, which can only be bought in the form of an option. Options also exist for the SMH.
I tend to take positions that are not longer than six months in the semi and equipment names, but not without exceptions; I mostly take shorter-term trades (a few days to a couple of weeks) or intermediate-term positions (three to six months). I'd rarely want to take a one-to-two year position in almost any name within the semiconductor stocks (or the semic cap names, for that matter) -- long or short. Product cycles, market share, and design-win momentum fluctuate too much over a six-month time frame that what you thought would occur often changes quickly. The key is where Street expectations and market sentiment are at a point in time, and then determining if an edge is present to exploit.
I mostly take positions in semiconductor stocks based on product cycles, end-market exposure, and DRAM prices (some industry dynamics of DRAM were discussed in detail in this column in May 2003).
For semi cap equipment stocks (such as large cap names AMAT, KLAC, NVLS, LRCX), I look at the directional bias of utilization rates, DRAM pricing, and the overall profitability of semiconductor companies.
Although the market has firmed up a little, I'd wait till the Philadelphia Semiconductor Index (aka the SOX, and discussed in detail tomorrow) can base for a while at 5 percent to 10 percent above the May lows, before I'd think about taking a position in many of the semiconductor names.
On Jan. 14, 2004, this column discussed that the market was due for a correction. The correction was led down by the SOX, and the broader market indexes (including the S&P 500 and the Dow Jones Industrial Average) followed around three weeks later. At that time, the SOX – a benchmark index for the semiconductor sector – had reached what was, in hindsight, a roughly 21-month high of 560.65 on Jan. 12, 2004. Starting on Jan. 13, 2004, the SOX started to correct and ultimately pulled back around 10 percent to a low of 440.87 on May 3, 2004. It has since firmed up a little so close June 10 at 476.28.
The SOX has been making lower highs and lower lows for about the past three months now. Our March 10 column provided an update of the correction, but at that time I did not believe the correction was over. We have since reached what I believe are the lows for the SOX on May 3, and I now think we'll move sideways for a while. I'd wait to see a base of between 5 percent to 10 percent above the May lows before scaling into long positions in many of the semi names.
Looking at analog and semi cap stock names
Some semiconductor and related stocks I have been looking lately at include analog stocks (ADI, MXIM and LSI), semi cap equipment names, Cymer, ASML, and Cypress Semi.
Analog stocks. Analog Devices and Maxim. Both Analog Devices and Maxim Integrated posted great recent quarters, but getting the bigger macro call on tech and the semiconductors is more important right now. I still think semiconductor stocks can work on the long side during the second half of 2004, but I'd rather own names with greater consumer exposure in semiconductors. I'd be careful owning analog names like ADI and MXIM up here, because if the market cracks, they will all get clobbered. LSI Logic. LSI Logic's storage spin could unlock some value. Many people did not understand all of the moving parts of the company's business before. And 1+ 1 = a higher valuation, potentially. In addition, the MPEG decoder business is actually doing well now, after two or three down years.
Semi cap equipment names. I thought the semi cap stocks would make a great long trade after the Applied Materials' (AMAT) report on May 18, and I still hold that view. But in my mind, the risk/reward is probably greater in the small caps now. I'd rather own names at 14x than at 24x, and the needle will move more in small cap semi caps. I'd be very careful shorting any of the semiconductor capital equipment stocks over the next few months. They have all managed down expectations to quite low levels in my mind (-5 percent to +15 percent), while utilization rates are still increasing. I think we'll see most of them maintain guidance here, then beat guidance when they report in July, and then guide up for September.
Large cap AMAT has just needed a little digestion period during March/April, during which it looked like dead money. Expectations are tempered now to 5-15 percent order growth in June. I feel that order growth could be around 25 percent + in the third quarter this year, in which case these stocks can run up again. Legs of growth come from tight utilization rates at foundries and increased order from DRAM companies.
Cymer and ASML. In the semi cap space, I like the stocks of Cymer and ASML the most for "buys." Both stocks are leveraged to capacity buys and technology buys with a shift to 193-nanometer steppers. In addition, both companies have fairly solid product cycles, especially Cymer, and should see ASPs and margins ramp in the second half of 2004.
Cypress Semi. I still like CY long. The Cisco business is fine, and a better sales mix this quarter should deliver gross margin upside. After the company reported earnings a few weeks ago, CY stock recently got hit far worse that I'd thought. Previously, I saw $15-ish as a support zone, but since dipping into the mis-$13s, it started to come back nicely into the mid-teens. I still think it's hard to find a semi company with such strong fundamentals and pricing advantage. If I were a buyer of CY at current levels, I'd be prepared to hold it for a few weeks/months. Cypress should see a pickup in orders in late May/early June during Cisco's strong July quarter. I think the Street will need to boost Cypress' June numbers sometime, but I had originally thought this would happen sooner (sometime after the conference call), and it's taking longer.
Melanie Hollands may hold a personal or professional position in the stocks she discusses. This article does not constitute a recommendation to buy or sell any security and is intended as "food for thought" only. For 14 years she has covered the technology and telecommunications sectors, from positions held in business strategy (McKinsey & Co., Bain & Co.), corporate finance (Salomon Smith Barney) and fundamental equity research (Merrill Lynch). She follows PC/server/storage hardware, enterprise and application software, wireless hardware/software/middleware, data networking and telecom equipment, optics, semiconductors, semi capital equipment, and various niche technologies (RFID, WiMax, VOIP and others). Hollands is president of Koala Capital (located in Aspen, Colo., and New York City), which focuses on trading/investing in technology stocks. She is also a senior advisory board member for a start-up financial services venture, the Semiconductor Futures Exchange Inc., and an advisory board member for a start-up Linux-HPC venture, Tadpole Ventures, LLC. She has been a guest lecturer and adjunct professor at Columbia Business School, where she earned her MBA, and also holds joint bachelor's degrees in Architecture and Structural Engineering. Ms. Hollands is unable to provide personalized investment advice.
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