08:47am EDT 17-Sep-98 Merrill Lynch (J.Osha (1) 212 449-0930) BRCM PMCS VTSS TX
ELEC-SEMICONDUCTOR:Communication is the Key
ML++ML++ML Merrill Lynch Global Securities Research ML++ML++ML
ELECTRONICS - SEMICONDUCTOR
Communication is the Key
Joseph Osha (1) 212 449-0930
17 September 1998
Reason for Report: Industry Comment
Investment Highlights:
o The semiconductor industry is seeing a reduction in the aggregate value of
ICs sold into the PC market as PC prices move downward. We think that the
industry is shifting away from the personal computer market to the
communications equipment market as the key driver of growth.
o We expect the semiconductor industry to see an increasing degree of
fragmentation as it enters this new phase - the emergence of another dominant
company like Intel seems unlikely, while Intel's dominance is expected to
gradually decline.
o Over the intermediate term, the current downturn will eventually give way
to a new recovery once supply is absorbed and markets improve. The PC
producers have been the most visible customer base that is sharply reducing
chip inventories, and they are now showing some snap back from the inventory
depletion of Q2. The most recent attempt to rally was concentrated in PC-
centric chip producers.
o For the long term, slowing growth in sales of semiconductors to the
personal computer industry, due to less unit growth and lower prices, could
hold overall industry growth below its 17% trend line until the next century.
New market such as communications will eventually become large enough to drive
overall industry growth once again.
o We are currently recommending the stocks of newer companies such as
Broadcom (BRCM $74 7/8 C-1-1-9), PMC Sierra (PMCS $29 13/16 C-1-1-9) and
Vitesse Semiconductor (VTSS $28 1/4 C-2-1-9)on the basis of their exposure to
the communications equipment industry.
o Companies such as Texas Instruments (TXN $53 13/16 B-3-2-7)and Analog
Devices (ADI $14 7/8 C-3-1-9)will benefit from communications exposure as well,
although both companies have intermediate-term problems that prevent us from
recommending them at this time.
Overcapacity and a transition in end markets
The semiconductor industry is in the midst of two significant reckonings at the
moment - an intermediate-term overcapacity problem and a change in end markets
that is longer term and more fundamental in nature. The intermediate-term
problem, overcapacity and the pricing weakness that has come with it, was
brought about by several years of industry overspending that is now in the
process of being corrected. We are drawing closer to a cyclical recovery,
although we think that another extended period of negative developments remain
in front of us, aggravated by the global economic slowdown.
Capacity reduction will eventually yield a PC-led recovery
The current downturn will eventually give way to a new recovery once excess
supply is reduced and end markets start growing faster. As order lead times
return to normal, due to reduced production levels, customer inventory levels
will need to be increased causing higher booked to billed ratios. The PC
producers have been the most visible customer base that is sharply reducing
chip inventories so they should be the customers most likely to display a snap
back in ordering now that a seasonal upturn has begun.
Outlook for 1998 still bleak
We believe the industry has entered the steepest part of the slowdown, which
has now become a downturn, at least on a YoY basis. Demand is slow and pricing
remains weak across a broad range of industries and geographies. We estimate
that industry revenues will decline in 1998 by perhaps 12% - 13% instead of
being flat as earlier expected. In July, worldwide sales fell 16%. 1998 is
the third year of lackluster results for the semiconductor industry and sets up
the potential for an above trend growth year in either 1999 or 2000 as long as
the macroeconomic environment remains stable.
Shift in end markets is more fundamental
The more important and fundamental development is the move that the
semiconductor industry is seeing away from the personal computer, and towards
communications equipment, as the most important driver of high-end
semiconductor shipment growth. We expect the communications equipment market
to create significant new opportunities for communications-geared companies
including Broadcom, PMC Sierra and Vitesse Semiconductor. Older companies with
the potential to benefit include Texas Instruments and Analog Devices over the
longer term. In contrast, the shift towards less expensive personal computers
is expected to continue, limiting the potential future revenue growth of
semiconductor makers supplying the PC market. The internet has changed the PC
from a computer to a consumer electronics appliance. We expect the most
substantial unit growth rates to occur in the consumer space, where low prices
are the most important factor.
The need for bandwidth translates directly into a need for improving
semiconductor performance
Driving the transition from one end market to another is the need for
communications bandwidth, which is affecting both the communications equipment
and computer markets. In communications equipment, regardless of whether we
are thinking about a PC-based modem or a router costing hundreds of thousands
of dollars, the need for performance is increasing relentlessly.
Semiconductors handle the process of turning incoming signals into digital
data, and processing and forwarding the information as needed. Increasing data
transmission rates translate directly into the need for increased semiconductor
performance.
Growth opportunities in the market for communications-use semiconductors are
attractive. We expect portions of that market to grow at 25% to 30% for the
next four years.
We expect the industry to be more fragmented going forward
The shift in end markets, combined with the increasing success of the fabless
semiconductor model, is expected to result in growing fragmentation in the
semiconductor industry. We believe that the companies we've identified have
the potential to become successful suppliers to the communications equipment
industry. However, we do not believe that another company will emerge in this
next phase of the semiconductor industry that will dominate to the extent that
Intel has.
(BRCM, PMCS, VTSS) The securities of the company are not listed but trade over-
the-counter in the United States. In the US, retail sales and/or distribution
of this report may be made only in states where these securities are exempt
from registration or have been qualified for sale. MLPF&S or its affiliates
usually make a market in the securities of this company.
Opinion Key (X-a-b-c): Investment Risk Rating(X): A - Low, B - Average, C -
Above Average, D - High. Appreciation Potential Rating (a: Int. Term - 0-12
mo.; b: Long Term - >1 yr.): 1 - Buy, 2 - Accumulate, 3 - Neutral, 4 - Reduce,
5 - Sell, 6 - No Rating. Income Rating(c): 7 - Same/Higher, 8 - Same/Lower, 9
- No Cash Dividend.
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