Silibubble
forbes.com
Chipmakers are looking at one of their best years in 2004. That's why you should avoid them--with certain exceptions
Christmas came early for chipmakers. Personal computers, cell phones, DVD players and other silicon-powered gadgets have been sailing off the shelves. Intel, Texas Instruments and National Semiconductor raised sales and profit estimates in the past two months. Flash memory buyers are scrambling to find what they need, and capacity utilization is revving up to around 90%, from 82% at the beginning of 2003. That might not sound like much, but 90% is where price increases start to take hold. Those few percentage points can mean the difference between a profit and a loss.
"We're making more chips than ever," says Fred G. Ramberg, a former chip equipment executive who now advises hedge funds about the industry. Worldwide semiconductor production, 23 billion integrated circuits last quarter, now exceeds its rate in the previous peak, in third-quarter 2000.
All this, paradoxically, makes for a bad time to buy chip stocks. They anticipated the volume upturn and have had their run. In early December the Philadelphia Semiconductor Index was twice its February low. The biggest surges have come from companies making low-end chips used in consumer machines ranging from TVs to autos: National Semiconductor, for instance, has nearly tripled since last winter. Price/earnings multiples, where they are not meaningless by dint of losses, are dizzying. National Semi goes for 141 times trailing earnings. Try to make some sense of these prices by looking at enterprise multiples (equity market value plus debt minus cash, all divided by earnings before interest, taxes and depreciation) and you still have to conclude that the business valuations are quite steep (see table). Bear in mind that enterprise multiples deserve to be lower in this field than in, say, publishing, because capital expenditures are a real cash drain. Semiconductor manufacturing gear wears out or becomes obsolete in the space of a few years.
Semiconductors are a binge-and-purge business. As soon as sales pick up, so do orders for new equipment--and oversupply inevitably follows. In the new year Semiconductor Equipment and Materials Institute, an industry association, forecasts that sales to chip companies will expand 39%.
Most integrated semiconductor companies, the ones that both design and manufacture chips, are just now beginning to invest in new equipment. By 2005 Asia will outfit as many as ten new fabrication plants, according to Isuppli, a market research firm. Who is going to buy all those chips that spew out? The growth rates for new cell phones (20%) and personal computers (14%) may be dwarfed by the amount of new supply the semiconductor industry has in store for 2004 and beyond.
At $2 billion to $3 billion each, it's not just the cash outlay for the next generation of fabs that is scary. It's that the new plants will increase output volumes by scaling up from 8-inch to 12-inch slices of silicon at the start of the assembly line. Using a new manufacturing technology and a 12-inch wafer, Intel says it can get up to four times as many chips as it can from an 8-inch. But to cover the staggering depreciation on the equipment, the chipmaker must keep the factory humming at 80% of capacity. Factories are meeting that test now. They will be hard-pressed to meet it in the years ahead.
China is more of a competitive threat than it was during the last boom. When U.S. chipmakers saw their prices fall as much as 90% post-2000, they did the smart thing: They closed down plants and laid off workers. The old equipment didn't disappear; it resurfaced in China. At the moment the technology at most Chinese plants is two generations, or three to five years, behind that of the newest U.S. plants. That means the lines etched in the chips are 500 nanometers wide in much of China, 90 nanometers in the most advanced U.S. factories. But the Beijing government has great plans to leap forward. More than 400 semiconductor design centers have sprung up across China, according to Isuppli, and the technology gap will close significantly by next year. As it has done in other businesses, China has shown it can expand despite worries over profitability or intellectual property rights. Digital circuits are in fact easier to reverse-engineer than analog circuits, which are part art and part science.
If U.S. chipmakers aren't quaking yet, that's because it can take two years to reverse-engineer a technology with a six-month life span. Perhaps they should be more worried, especially if they have big overseas sales, as many do. One prescient exception is Intel, which already sees China as a threat, says Howard High, the company's strategic communications manager. Reason: 72% of Intel's sales come from overseas. Most of the growth is coming from Asia, particularly China.
Even with old technology, a huge new entrant in the chipmaking sector can wreak havoc with prices. Until 2000 most of the chips produced in China went into domestically produced goods, and China was relatively isolated from the international market. But by 2002 Chinese foundries (plants that take in outside work) started competing for international business. And not all of their capacity is old. China has 7 plants under construction that can accommodate equipment capable of handling 12-inch wafers (the plants must be built a certain way to do this). By next year it will have 11. Right now China has 4% of the world's manufacturing capacity in chips. By 2007 it will have 9%, says Isuppli, while the U.S. share shrinks by five percentage points to 13%.
Morris Chang, the founder and chief executive of Taiwan Semiconductor Manufacturing Co., or TSMC, the leader in chip foundry work, told a Silicon Valley conference this fall that the good times for chipmakers will slow in 2005--and China will be the main reason. Especially hurt will be makers of second-tier chips Rohm and Episil Technologies, and memory makers such as Infineon Technologies of Germany, Micron Technology of the U.S. and Elpida Memory of Japan. The Semiconductor Industry Association tempered its usually bullish forecasts with a prediction that revenues for memory chips next year could fall by as much as 10%, after leaping 35% this year.
You can find U.S. chip firms that are likely to survive the coming bloodbath. Intel, master of microprocessors, is one. At 45 times trailing 12-month earnings, Intel isn't cheap. And it hasn't triumphed across the board. The shares fell in early December after the company announced a writeoff in its fledgling telecom business. But Intel enjoys a Microsoft-like near-monopoly in its core market; it sells 83% of microprocessors used in PCs and 86% of those in laptops.
Despite challenges to its overseas market from China and price-cutting in the domestic market from Advanced Micro Devices, Intel boasts an operating margin of 29%. With $9.4 billion of cash on hand and next to no debt, it can afford to construct the efficient factories that will help it stay a step ahead of price erosion and develop premium products that command high prices. Most other chipmakers have slid into the red in recent years; Intel hasn't had a loss year since 1986.
Among gearmakers the leader is Applied Materials, with an expected $7.3 billion in sales for 2004. The new Asian factories alone will keep the company busy for awhile. Applied--a solid company but no great bargain--also sells equipment to make liquid crystal displays, an industry growing far faster than its silicon cousins. At 45 times the earnings expectation for 2004, Applied's shares already incorporate the good news.
A third survivor is TSMC. Its orders are record-breaking and its operating margin in the third quarter jumped from 21% in 2002 to 30% in 2003. Up just 35% over the past 52 weeks to $10, these American Depositary Receipts are somewhat overlooked--in comparison with U.S. chipmakers. At this price TSMC goes for 44 times trailing earnings and 19 times estimated.
If you want to speculate, buy a put option on the semiconductor HOLDRs trust, a derivative that mimics the benchmark Philadelphia Semiconductor Index. The HOLDRs (ticker: SMH) recently closed at $40. A May put with a strike of $37.50, near the spot price, will cost you $255, or 6.4% of the value of the underlying HOLDR. The put (SMHQU) trades on the Amex and four other exchanges. |
