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Chip Stocks: Brace for "Dismal Earnings"

Just when chip stocks will take a turn for the better remains open to debate, but for long-term investors some companies are worth a shot now, says Thomas W. Smith, analyst for Standard & Poor's, who covers semiconductor and semiconductor-equipment companies.

Smith thinks the market for personal computers, crucial to chipmakers, could turn up by the Christmas selling season. But for makers of communications chips, improvement may have to wait until 2002, he predicts. These were among Smith's comments in a June 26 chat presented by BusinessWeek Online and S&P on America Online. He was responding to questions from the audience and from BW Online's Jack Dierdorff. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

Q: What's your take on the overall market?

A: The overall market is sandwiched between an increasingly accommodative Fed and weak earnings. Earnings for the tech group generally will be exceptionally dismal this June quarter, and many companies will be fortunate if they can report flat earnings in the September quarter. Thereafter, tech companies might be able to start climbing out of a deep hole.

Q: Cutting right to the chip chase, is Intel (INTC) finally in position to start its return to better days?

A: First of all, Intel is formally covered by my colleague Megan Graham-Hackett. And she ranks Intel a with most chip companies, 2000 was a great year, 2001 is a bust, and 2002 should look like a modest recovery year. Intel seems to be among the fortunate ones that are delivering earnings instead of losses in 2001. Generally speaking, the personal-computer markets have been softer in 2001 than in many recent years. However, there are hopes for some improvement in demand by the Christmas selling season.

Q: How about the semiconductor sector generally and the companies you cover? I see you just downgraded Applied Micro Circuits (AMCC) to avoid.

A: As I was saying with Intel, the chipmakers have all suffered from the weak economy, but some end markets went down earlier than others. For instance, the PC markets and then wireless handset markets showed weakness in autumn of 2000, but many of the wireline-equipment companies didn't show weakness until February, 2001....Markets for chips for wireless communications may take until the first quarter of 2002, and chips for wireline markets might not come back until the middle of 2002.

Now, AMCC is stuck with this wireline group, along with Vitesse Semiconductor (VTSS) and other chipmakers that sell to big communications equipment companies such as Lucent (LU), Nortel (NT), Cisco (CSCO), and Tellabs (TLAB). That customer base has been severely weakened, and the AMCC warning confirms that inventories will be slow to clear in that group.

Q: Thoughts on Texas Instruments (TXN) and Vishay Intertechnology (VSH)?

A: Texas Instruments is a player in analog chips and digital signal processor chips that are at the heart of many communications processes. They should come back with the group and do pretty well over the next decade.... I rank Texas Instruments a hold, but at prices below 30, it begins to look attractive as time goes by.

Vishay is a company we like. It's a leader in passive components and capacitors that are used in cell phones and other products. And it does very well with making low-cost acquisitions that give it either complementary product lines or a richer product mix.... So for TXN and VSH, there's still downward pressure on revenue and earnings, which gives the investor the option of trying to be early in getting back in for the next cycle, or waiting until later in 2001. Both these stocks should do well as the group cycles up -- but the timing of the next cycle is open to debate.

Q: What is your outlook on LSI Logic (LSI)?

A: LSI Logic is a hold.... LSI makes application-specific integrated circuits. They specialize in logic chips for big contracts such as the Sony PlayStation 2. They have a broad customer base, and through recent acquisitions, they have about 15% of revenues from data-storage products. And with this breadth of product lines, the share price has gone down with the group -- and the company should come back with the group.... However, it's reasonably valued and has a lot of chip-making expertise.

Q: PRI Automation has been a most volatile chip-equipment manufacturer, but with the hoped-for pickup of other chip-using areas, do you see PRIA as a good buy at $15 or so?

A: I used to follow PRIA until a couple of months ago, when my colleague Richard Tortoriello took over coverage. And today, following PRIA's revenue warning, Richard took the company down to hold from accumulate. He sees PRIA as the second-strongest competitor in a very weak market for semiconductor factory automation equipment.

Q: Any thoughts on the future for Integrated Device Tech (IDTI)?

A: IDTI we rank a hold. It serves the Lucent, Nortel, Cisco customer base and has suffered a big hit to revenue as these customers have withdrawn orders. So the next few quarters will be very tough.... However, much of the damage is already reflected in the stock price, and we would keep an eye on this one as the customer base begins to break through its inventory overhang.

Q: What is your outlook and buy price on Analog Devices (ADI)?

A: Well, first things first -- ADI is a hold for now. We have liked ADI as a buy in the past cycle. They are a good company to have if you're interested in high-end analog and DSP chips....In the next few weeks, some of the analog chipmakers might have to warn on revenues, and if any of the peer companies warn, Analog could be knocked on that news. So I would caution investors to wait for the July earnings report to get a more accurate picture of ADI's position.

Q: Your thoughts on Nvidia (NVDA)?

A: We recently initiated coverage of Nvidia. It was initiated as an accumulate.... Nvidia is the leader in graphics-processor chips that create dynamic and stunningly animated 3-D images on desktop PCs, workstations, and video-game consoles. Nvidia is built into Microsoft's X box, which is due to be released in November.

Nvidia is an anomaly in the group right now, because it's exhibiting 40% annual growth at a time when most chip companies are suffering a downturn. One reason is that Nvidia is in a great chip category, and to some extent, 3-D graphics could be considered an enabling tool that will help propel sales of PCs. Nvidia is expanding from the mainstream PC market to offer products for mobile computing devices and the Apple computer market, so there seems to be plenty of room to expand the market. The company believes there is an $8 billion market opportunity out there, and Nvidia should cross the $1 billion sales level in the next few quarters.

Q: Atmel (ATML)?

A: Atmel is buy with us. It has a nice, steady business combining high-end flash memory with logic chips to create a broad line of chips and chip sets that should do well in an era of mobile computing. They make chips for smart cards, which may evolve first in Europe and therefore not be as well known to Americans as PDAs and other mobile computing products.

Atmel's earnings model has seemed very smooth and steady to me in comparison to most other chip companies that I follow.... All that said, Atmel has been reducing its revenue estimates through 2001 as the general economy weakens both here in America and in Europe, and it's possible that Atmel -- as well as many other chip companies -- may have to warn again on earnings.

Q: It's a difficult year, but you've used the words "buy" and "accumulate" at least a couple of times. What names on your coverage list merit those rankings?

A: For buys, we include Atmel, which I mentioned; Xilinx (XLNX), a maker of programmable logic chips, which we think is a good category to be in long-term, and Linear Technology (LLTC).

Linear will show a big sequential drop in revenue for the June quarter, however, Linear is perhaps the most profitable business model that I cover and would be a good one to buy at some point in this downturn to hold for the longer haul....Also, we think the semiconductor-equipment companies may turn around a little before the chipmakers, so I have chosen two of the larger wafer-fabrication equipment suppliers as 5-STARS. They are Applied Materials (AMAT) and KLA-Tencor (KLAC)...these stocks have already seen their lows for the cycle, I think.

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