From SmartMoney:
The Year Ahead: Break Out the Chips
By Monica Rivituso
December 18, 2001
FOR SEMICONDUCTOR MAKERS, New Year's Eve can't come soon enough. After all, who wouldn't want to see the end of the industry's annus horribilis, its worst year on record?
It's been a nasty 12 months, to be sure. Chip makers struggled with inventory levels that were much too fat amid a lack of demand for the PCs, cell phones and telecom equipment their chips go into. A fierce price war broke out in microprocessors, memory-chip prices plummeted, and companies like Cisco Systems (CSCO) found themselves sitting on massive stockpiles of communications chips. All of this pushed semiconductor sales down more than 30% this year — a far more severe drop than the 16.4% decline in 1985, the industry's previous worst year. Earnings skidded 89% (after rising 88% last year), according to Thomson Financial/First Call. Meanwhile, stock prices fell a staggering 75% from last March, when the Philadelphia Semiconductor Index hit an all-time high. Roll it all together, and you can see why few in the semiconductor industry are shedding any tears that 2001 is coming to a close.
Question is, will next year be any better? Most analysts agree that it will. In fact, there are already whiffs of a rebound in the chip market, which tends to show signs of cyclical recovery ahead of other industries. In October, world-wide chip sales grew sequentially for the first time since last November, rising 2.5% to $10.43 billion. While that's still 44.1% below year-ago levels, the month-to-month improvement is a sign that the steep slide in chip sales has started to abate.
Still, as we've explained before, investors who are expecting a quick bounce back will be sorely disappointed. The industry should lay the foundations for real recovery next year, but good year-over-year sales growth won't come until 2003. Like other market watchers, Brian Matas, vice president for market research at IC Insights, a semiconductor market research firm, expects sales to greatly improve in the second half of next year — but not by enough to offset the weakness still to come in the next few months. He figures that world-wide sales will decline 2% sequentially in the first quarter (a seasonally soft quarter for chip makers), then increase 5% in the second quarter and 13% in both the third and fourth quarters. That would leave 2002 sales approximately flat with 2001's. (The industry's trade group, the Semiconductor Industry Association, or SIA, has a rosier forecast, calling for a 6% sales increase.) Earnings should also rebound nicely, rising 51%, according to First Call.
This wouldn't be the first time the industry dragged itself up off its knees, nor will it be the last. Chip makers are notoriously cyclical, and the bottom has fallen out before, explains Doug Andrey, the SIA's director of finance and principal industry analyst. In 1969 and 1970, a huge run-up in mini- and mainframe computers proved to be a bonanza for chip sales, but that later gave way to a downturn. Likewise, chips prospered in the first venture-capital boom in 1984, but the industry fell sharply in 1985.
A number of factors should help the industry embark on the road to recovery sometime next year. For one thing, all that inventory sitting out there is growing older by the day. After 18 months or so, much of it is likely to become obsolete as a new crop of smaller, more powerful chips that generate less heat hit the market. SIA's Andrey thinks that much of the $2 billion in chip inventory now sitting on customers' shelves will be liquidated in the first quarter of next year. And it will have to be replaced with new products.
An improvement in the global economy, especially in the U.S., should also help spark sales of all manner of gadgets, says IC Insights' Matas. While analysts say the real drivers for the chip industry will increasingly be small, mobile devices that offer wireless Web browsing and emailing capabilities, they also expect a modest recovery in a couple of traditional, yet important, end markets for chips: PCs and cell phones. The computers that companies purchased ahead of Y2K are starting to show their age and will need to be replaced, Matas says. That would be a welcome development. Just in the third quarter, world-wide PC shipments fell 12%, according to Gartner Dataquest. Likewise, sales of cell phones should perk up somewhat next year, as an inventory overhang is worked down and newer, zippier models hit the market. Gartner expects world-wide cell-phone sales, which remained roughly flat this year, to increase about 10% next year. All of this should set the stage for the next big leg of the upcycle in 2003, analysts say. IC Insights expects chip sales to increase 21% in 2003 and 29% in 2004.
The stocks in this sector are already starting to reflect a rosier outlook. The Philadelphia Semiconductor Index, or SOX, hit bottom on Oct. 2 at 354.6, which left it down 38.5% for the year. But since then, the benchmark index has steadily climbed higher and is now down only 2.2% year-to-date.
Question is, has the sector gotten ahead of itself? Stocks tend to reflect fundamentals six months to one year out. And at this level, the SOX is already pricing in the upturn in 2003, says Needham & Co. analyst Dan Scovel. "The stocks in general reflect a recovery that's not yet apparent," he says. He expects that disappointing first-quarter guidance in upcoming fourth-quarter reports next month will spark a sell-off. But that, he adds, will likely be followed by another rally in the second quarter.
While he agrees that chip stocks in general are vulnerable to a pullback from their current levels, Scott Randall, a Wall Street Journal All-Star analyst at SoundView Technology, sees some opportunity for investors in communications-chip stocks. The key to this subsector is the draw down of inventories. Stockpiles of communications chips are becoming lean enough that even without growth in end markets next year, inventories will have to be rebuilt. Of course, he adds, that rebuilding process will eventually have to be followed by a second step — an increase in demand — if inventories aren't to become excessive again.
Randall favors large-cap names like Texas Instruments (TXN) and Applied Micro Circuits (AMCC). TI has the best exposure to wireless markets — especially cell phones — and the company's core business is finally finding some stability, he says. Applied Micro has seen some tough times lately, as carrier infrastructure spending has dried up. While that spending probably won't show broad-based gains for some time to come, carriers are likely to make more modest, strategic investments that let them offer selected new services to customers. And Applied's portfolio of chips is particularly well-suited to meet such needs, Randall says. So while the chip sector could very well see a few bumps in the near term, investors might want to watch for pullbacks in these stocks. |
