Advanced Micro Devices Inc (AMD)

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Chip Correction Nearing a Bottom
http://www.thestreet.com/p/rmoney/antitechrm/10166707.html $ub$cription required

By Thomas Kurlak
Special to RealMoney.com
6/18/2004 12:31 PM EDT

Semiconductors
The order slowdown is not a harbinger of bad things to come.
Economic growth will bring the industry through.
A new buying opportunity is developing.



I have to hand it to the analysts who ferreted out the inventory mini-correction now apparent in the semiconductor sector. But I must also say that they may be getting carried away with a good piece of micro analysis while ignoring the bigger picture.

The motivation for analysts being quick on the trigger is the vivid memory of the inventory debacle in 2000 and the subsequent stock price collapse. But despite fears that another bust is in the offing, this is not 2000 all over again.

First of all, the economy is too strong for semiconductors to have a real problem with end demand. The positive correlation with the GDP has been too strong for too long to worry that a disconnect is happening. Second, we are entering the seasonally stronger second half for tech products for both consumers and businesses.

The inventory numbers coming out now on Wall Street have been affecting semiconductor stocks for the past six months. And using these data points to act now is a little late with the stocks already down 25% to 40%. Remember, the market always looks ahead.

Catalysts
Let's look at two current data points about inventory that have recently hurt these stocks. Jabil Circuit (JBL:NYSE - commentary - research) reported strong earnings Wednesday but indicated that some of its telecom-equipment customers were correcting inventory and its next quarter would be affected slightly.

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This immediately hit Cisco's (CSCO:Nasdaq - commentary - research) stock and most of the semis. But what I have recently learned is that Cisco may be moving some of its assembly business to a large Asian contract manufacturer that is undercutting Jabil and other contract assemblers on price. Meanwhile, Cisco is having a strong quarter.

The other inventory data point was National Semiconductor's (NSM:NYSE - commentary - research) fourth-quarter release, which revealed a domestic distribution order decline. Management told investors that this was due to shorter order lead times on deliveries causing distributors to reduce inventory. But if that was the reason, bookings would have slowed everywhere instead of growing as they did by 45% overall. I am hearing that National Semi's distributors overbooked earlier in response to price discounts NSM was offering to promote more volume purchase deals where the distributor does not get return privileges. A large volume of these deals were booked under the program and then distributors cut back to work through the incoming inventory.

Faked Out
Both of these situations show that there can be different interpretations of events with different implications for stocks when additional information is uncovered. In these two cases, I think Wall Street is getting a head fake. While they have resulted in damage to portfolios in the short term and have made several analysts turn negative on the group, I do not think they are a harbinger. While inventory correction is never good, it may not be that widespread either.

I understand that electronics OEMs in Asia and the U.S. are talking up the second half with their suppliers while keeping near-term inventories lean. It is likely that the third quarter will be up from the second quarter, and of course the fourth quarter will be seasonally stronger. Every year at this time the Street breaks into a cold sweat over whether the second half for semiconductors will improve over the first half, and soft orders now make many observers decide not to wait around for the answer.

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While I don't want to dismiss all bad news and I know I've raised concerns about what might be ailing the stocks, the main thing to focus on is that we are not having the stop-and-go economy that I feared we might.

Inflation is not too rapid so the Federal Reserve doesn't have to slow the economy much. Industrial production and the leading economic indicators both strengthened last month. Consumer confidence is on a plateau but it's not falling despite the bad news in Iraq. And jobs are up. Also, profit margin guidance so far remains up. Longer-term issues like the aging of the "Wintel" monopoly and maturing of the personal computer market are not as much of a factor with the stocks depressed. And DRAM spot prices have stopped declining while contract prices have held up during the seasonally weakest period of the year.

So after a six-month correction in semiconductor stocks, we may be at another major buying opportunity, the best since the lows of late 2002. The micro analysis that correctly called this mini-glitch should be applauded, but it does not signal the end of the cycle.

Looking into 2005, it seems a consensus has formed that the semi cycle will certainly end by then as too much new capacity being ordered now swamps the market in parts. While a lot of new equipment orders are on the books, very little was ordered for the past three years. Indeed, the $40 billion to $45 billion of equipment expected to be ordered this year is about in line with the "normal" level of about 20% of semiconductor revenue. If it were 40% as in the last peak, I would be worried.

Also, customers are reportedly buying new equipment in smaller batches as they phase in increments of new capacity rather than big chunks, which typifies a top. Finally, I really haven't heard of many new factories going up and I still hear about factory closings as companies move more production to foundries. So let's worry about capacity when it's really going to be excessive, and not discount the future before it's here.

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dh