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Sorting Through the Chip-Stock Mess

Chip stocks have seen better days. The Philadelphia Semiconductor Index (SOXX), which began 2000 at 704.56, closed the year at 576.61, a drop of 18.1%. Although the index has bounced back to around 640 currently, many experts say it'll be some time before the sector's fundamentals begin to improve again as chip demand continues to sputter.

Investors shouldn't despair, however. Just about all the chipmakers' shares have been clobbered with the general rout in tech stocks. But amid the rubble of this beaten-down sector, some issues are poised to outperform the rest of the industry.

WEAK SPOT. Clearly, the chip market mainly continues to drag along. Valuations for semiconductor stocks peaked in March, 2000, and then began cooling off in June, when demand estimates for mobile-phone sales were cut about 20%, to between 400 million and 410 million units for the year. Matters worsened with a decline in demand for DRAMs, which are considered commodity memory, during a time when it usually starts to pick up steam.

Chip demand has remained lackluster over the last two quarters, causing inventories to rise. This excess is gradually working its way through the system. But it still hit some companies' reported earnings in January, while a host of chipmakers -- Intel (INTC), Texas Instruments (TXN), LSI Logic (LSI) -- are lowering earnings expectations quite aggressively into the first quarter of 2001. Plus, growth prospects for the overall industry aren't that positive. Tim Mahon, semiconductor analyst at CS First Boston, projects industry growth at just 5.8% this year.

Nonetheless, some companies still look promising. Vincent Benedetti, vice-president for semiconductors and electronics at Gruntal & Co., is mostly positive on telecom chipmakers. "I think the communications market will be one of the first to come back and start seeing more sustainable growth," he says.

BRIGHT PROSPECTS. More specifically, Thomas Smith, semiconductor-equipment analyst at Standard & Poor's, favors companies serving the optical-switch markets, such as PMC-Sierra (PMC), Broadcom (BRCM), and Vitesse Semiconductor (VTSS). "Companies like that will still able to show double-digit growth sequentially every quarter this year," Smith says. Their longer-term prospects also look good. Although growth rates are currently slowing down, the companies' customers often have five-year plans to build out the Internet that are likely to continue regardless of current consumer demand, Smith says.

Mahon sees other hot areas within the communications market. His favorites include Applied Micro Circuits (AMCC) and TranSwitch Corp. (TXCC). Both companies design and develop highly integrated digital mixed-signal semiconductors for telecommunications and data communications markets -- both solid growth sectors. "They're probably going to be in a little bit of a safer situation than the rest of the industry," he explains. "Plus, they're highly proprietary devices, so they should not come under significant pricing pressure."

Fundamentals for wireless handset manufacturers also should improve, says Eric Rothdeutsch, Robertson Stephens' semiconductor/computer hardware analyst. "I think we'll see an acceleration for handset demand in the second half," he says, adding that wireless penetration rates are relatively low worldwide. "There are a lot of upsides, a lot of new features that phones are going to be offering like integrated personal digital assistants." S&P's Smith also notes that plenty of new markets are opening up for wireless handheld devices.

BURGERS AND CHIPS. Furthermore, a market is growing for low-end chips -- like the ones in refrigerators and other appliances, Smith says. Companies capitalizing on this include Microchip Technology (MCHP) and Vishay Intertechnology (VSH), he says. Smith compares these low-end specialists to fast-food giant McDonald's. "Both concentrate on low-end products," he says "Anyone can make them, but if you build out the system and the chain better, it's a nice sturdy operation." Smith says it's a strategy where the product is so low-end that little competition exists, "and then if you spend enough time researching seemingly little things, you might come up with a system that's better than anyone else's."

Programmable logic vendors also deserve consideration, Mahon contends. Specifically, he likes Xilinx (XLNX) and Integrated Circuit Systems (ICST), which lease their chip-fabrication capacity from Taiwanese companies. "Because they're fabless, they're going to probably weather the storm a little better than some of the companies that have large wafer-fabrication facilities." Mahon explains that when demand slows and inventory builds up, the margins of large semiconductor companies with enormous manufacturing facilities tend to get pinched.

Gruntal's Benedetti isn't positive on the prospects of chipmakers for personal computers. That's because he expects PC makers to aggressively cut prices through February in an attempt to stimulate demand and pare down inventories. Rothdeutsch, however, remains "reasonably optimistic" on PC-component suppliers. "I think what's clear is that investors have a huge appetite for negative news, and we've seen an incredible amount of negative news be digested in these stock prices," he says. "Short of a full-blown global recession, I think the incremental news [will] improve from here."

What will it take for the chip sector as a whole to bounce back? "The current inventory really needs to dissipate," Benedetti says. "If [the Fed] can continue to cut interest rates at a precipitous could provide a good stimulus for the consumer, which could actually promote stronger end-user demand, especially towards the second half of the year." But whatever happens, most analysts agree that investors willing to be selective can find rewards among the chip stocks. By Alan Hughes in New York

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