Sector Investing

[ReturntoSender]

Is the Chip Dip a Buying Opportunity?
By Monica Rivituso
April 27, 2004

http://www.smartmoney.com/sectorpatrol/index.cfm?story=20040427

AFTER SEVERAL disappointing years, semiconductor stocks served up a stellar performance in 2003. The Philadelphia Semiconductor Index soared more than 75%, far outpacing the 26% rise in the Standard & Poor's 500 and even the Nasdaq's 50% gain. And some stocks were positively white-hot: Shares of Broadcom (BRCM) rallied 126%, while Atmel (ATML) surged 170%.

But the group has taken a bit of a breather in 2004. The SOX has fallen more than 6% this year, while Intel (INTC), STMicroelectronics (STM) and Linear Technology (LLTC) have slumped 15%, 16% and 11%, respectively.

Does the dip represent a buying opportunity — or a hint of more pain to come?

Recent earnings reports paint a rosy picture for the rest of the year. Broadcom, Microchip Technology (MCHP) and Xilinx (XLNX) all recently topped consensus expectations, while STMicroelectronics, California Micro Devices (CAMD) and On Semiconductor (ONNN) have ratcheted up sales and earnings guidance in recent weeks. Scottsdale, Ariz.-based market research firm In-Stat/MDR forecasts that sales will rise another 29% this year to $214.7 billion.

The question on many investors' minds is, will rising interest rates choke off economic growth in general and chip sales in particular? Perhaps not. Semiconductor makers' earnings — and stocks — generally continue their upward trajectory during the early stages of a tightening cycle, say analysts at Merrill Lynch. And this time around, with rates still hovering near 40-year lows and inflation low, rising rates might have less of a dampening effect than usual — meaning chip stocks could make another leg up.

And chip cycles don't necessarily coincide with the broader economy. Chip booms and busts, generally lasting between five and seven years, are almost purely functions of supply and demand. During the booms, demand for chips increases and capacity to manufacture them tightens, boosting prices and sales in the process. During the busts, slack demand and overcapacity lead to plunging prices. In the current boom cycle, most industry watchers expect growth to peak sometime in 2005.

But Walden Rhines, chief executive of Mentor Graphics (MENT), sees this cycle playing out a little differently. Back in 1999, he says, chip companies devoted gobs of money to building fabrication plants. But after the bust began in 2000, those plants weren't filled with equipment. Companies are just now outfitting some of those empty shells with new machines and putting some of that unused manufacturing space to use. That means additional capacity will be brought on line in a much more orderly fashion than usual, which could lengthen the current boom cycle to 2007, according to Rhines.

Other observers disagree. Brian Matas, vice president of market research of Scottsdale, Ariz.-based IC Insights, says chip industry upturns have grown shorter over the years, not longer. During the last boom, there were only six quarters of positive sales growth before the bottom fell out in 2000. And six upbeat quarters is what he figures the cycle will amount to this time as well. That means growth should continue this year, but in the first or second quarter of next year, he expects things to slow. "We're not feeling too good about how things are panning out for 2005," says Matas.

The ramp-up in chip-equipment purchases is only adding to his concern. IC Insights' capital-spending forecast for this year calls for chip makers to spend 53% more than last year, or $44.4 billion. "We have the potential now to have this excess capacity available, and that puts pressure on pricing for these parts," says Matas.

The current cycle isn't likely to be very different from past ones, says Matas. Historical patterns, the ramp-up in capital spending and robust chip sales all argue for a downturn to begin next year.

Regardless of which camp you belong to — the giddy optimists or the gritty realists — there's no denying that, despite last year's stunning rally, chip stocks appear relatively cheap right now. As a group, they trade at a price/earnings-growth, or PEG, ratio of 2.11, lower than the S&P's PEG of 2.28. Chip stocks generally trade at a premium to the broader market.

Some might argue that the discount is a result of investors betting that chip earnings growth will begin to decelerate next year. Perhaps they'll be proven correct. But investors who just can't overlook a low PEG might consider two exchange-traded funds based on the chip sector. Merrill Lynch's Semiconductor HOLDRS (SMH) track 20 chip-related stocks. (HOLDRS are similar to ETFs in that they follow a basket of stocks, but they can also be unbundled, allowing investors to trade the underlying components separately.) The fund is heavily weighted in three stocks: Intel, Applied Materials (AMAT) and Texas Instruments (TXN), which respectively account for 30%, 26% and 22% of the holdings.

A more diversified play is the iShares Goldman Sachs Semiconductor Index Fund (IGW). The fund tracks chip-related companies as well as some multimedia companies, but the top 10 holdings, including Motorola (MOT), Texas Instruments and Applied Materials, comprise a little more than 61% of the fund.

Chips may have dipped, but that doesn't mean they've crumbled — yet.