From Red Herring - Chip stocks walk a fine line
In the tech world, the semiconductor industry is the granddaddy of all technology. So why are the semiconductor stocks acting like spoiled little brats?
Despite reams of positive data surrounding the semiconductor market, chip stocks continue to be among the most petulant on the market, falling on even the most insignificant data. Most semiconductor stocks are well off their 52-week highs due to a sell-off in the past two months, but it looks like investors are heading for the exits even as the industry's future remains strong.
After shaking off the Asian flu two years ago, the market has enjoyed a downright boom period to date. The Semiconductor Industry Association (SIA) released numbers early in August showing that year-over-year growth for the month of June was at 58.6 percent. Flash memory and dynamic random access memory (DRAM) chips, both considered to be commodity items and subject to the supply-and-demand whims of the overall market, led the charge with 165.5 percent and 112.5 percent growth respectively.
SUPPLY DEFICIT IS GOOD?
In addition, the semiconductor industry is severely supply-constrained at the moment, which counterintuitively is positive for this cyclical market. Chip companies tend to run into trouble when they build excess manufacturing capacity -- fabrication plants that cost billions -- for the moving demand targets. Right now, pent-up demand is working in the favor of chip makers and will continue to do so for at least the next year before they catch up.
Meanwhile, earnings season could not have been much stronger. Intel (Nasdaq: INTC)'s earnings of 50 cents a share were a 92 percent increase over the second quarter last year. And semiconductor equipment giant Applied Materials (Nasdaq: AMAT) demolished estimates this week, posting earnings of 70 cents a share, two cents above the analyst consensus.
Careers have been built on trying to understand and predict the supply-driven, two- or three-year cycles of the semiconductor market, and as the market matures, analysts are starting to believe they have it figured out. Because of the massive capital outlay behind building extra manufacturing capacity, semiconductor cycles tend to be purely supply-driven, dipping when supply catches up and surging when supply is constrained. Last month, Jonathan Joseph and Clark Westmont, analysts at Salomon Smith Barney, thought they saw signs that the end of the latest boom is right around the corner and lowered their rating on the industry.
Upon hearing the news, investors who were anxiously awaiting the end of the boom period went scrambling to take their profits and get out before things got really ugly. Combined with bad news from Nokia regarding a slowdown in sales of cell phones -- a major consumer of flash memory -- suddenly whether Mr. Joseph and Mr. Westmont were actually correct in predicting the beginning of the end ceased to matter. It became a self-fulfilling prophecy, driven by sentiment.
PHOBIA FOOD
The slower adoption of newer wireless application protocol (WAP) phones and concerns over PC sales also are contributing to investor fears, given that both can drive demand for chips. But some analysts say that demand's demise does not necessarily signal the end of a long and profitable run for semiconductor companies, since there still seems to be a relatively low supply of chips to meet current demand.
The SIA predicts that the boom could continue for as many as three years. While that may be a bit optimistic, there is evidence for a continuation despite the recent dips. According to Dave Bujnowski, a research analyst at UBS Warburg Dillon Read, this may not be the same type of cycle we've seen in the past.
"Every cycle is different. It is possible that this cycle's best days are behind it, but people are worrying that it's going to fall off a cliff, and that's where we disagree," says Mr. Bujnowski. "The last cycle had a very clearly defined peak, but we feel that this cycle will trade sideways for a while, presenting short-term opportunities."
Mr. Bujnowski says that even in the worst case scenario -- one in which cell phone and PC sales drop off dramatically -- chips will continue to be in short supply at least for the next year. And in a market he characterizes as "trigger-happy," news like that from Nokia tends to be far overblown in the effect it has on stocks.
SAFE HARBORS
In the meantime, there are still some safe opportunities in the sector, particularly with companies that make proprietary technology. A stock like PMC Sierra (Nasdaq: PMCS) may certainly seem expensive, trading at about 141 times 2001 earnings estimates, but it has a safe demand in supplying chips for broadband infrastructure suppliers like Cisco Systems (Nasdaq: CSCO) and Nortel Networks (NYSE: NT). Analysts are expecting the company to post a 40 percent annual gain in earnings over the next three to five years.
Analog chip makers Linear Technology (Nasdaq: LLTC) and Maxim (Nasdaq: MXIM) have been particularly resilient during extended troughs in the overall market. And as for bottom-feeding, Atmel (Nasdaq: ATML) and Cypress Semiconductor (NYSE: CY) in the flash memory and static random access memory (SRAM) markets, respectively, have been abused in recent months, despite being relatively diversified. Atmel is now trading at just 16.5 times 2001 earnings estimates, well below its expected 25 percent growth rate. And Cypress is trading at a multiple of 14 times its 2001 earnings estimate, even though analysts are predicting annual earnings growth of 20 percent over the next few years.
Eventually, of course, the cycle will end. Supply will far outstrip demand, and the boom will go bust in a big way, making the past two months look like a minor correction. But Mr. Bujnowski doesn't see that happening until 2002 because of solid fundamentals in the sector and pent-up demand.
But even though chip stocks have had their ups and downs over the last few years, Intel, Applied Materials, and Maxim have all vastly outperformed the Nasdaq and the overall market over the last five years. So rather than worrying about timing the peak of the chip cycle, it makes sense to hold on to top semiconductor stocks over the long haul.
You can find this article at: redherring.com
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