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Hot Plays in the Chip Rebound

As world economies improve and companies resume spending on information technology, the semiconductor sector is looking better, believes Manoj Nadkarni, founder and president of the newsletter He sees some interesting investment possibilities among makers of chips and chip equipment, especially "small or midsize companies that have shown the ability to have good margins at a relatively low revenue base," as he puts it.

Nadkarni names Semtech (SMTC), ICOS Vision Systems (IVIS), and Keithley Instruments (KEI) as examples. As for areas with potential for the future, Nadkarni points to wireless applications and to 64-bit processors, such as the Opteron from Advanced Micro Devices (AMD), as well as to experiments with new materials in chipmaking.

These were a few of the points made by Nadkarni in an investing chat presented Oct. 2 by BusinessWeek Online on America Online, in the course of replying to questions from the audience and from Jack Dierdorff and Karyn McCormack of BW Online. Following are edited excerpts from this chat. A complete transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.

First, a disclaimer from Manoj Nadkarni: Different company examples in this chat are for the purpose of illustrating ideas. They are not an endorsement by Mr. Nadkarni or by, nor a recommendation or an offer to buy and sell securities. Any action any investor may take as a result of the discussion here is strictly at his or her own risk. Mr. Nadkarni or shall not be liable for any gains or losses resulting from such actions. You

should be aware that Mr. Nadkarni has positions in some of the stocks discussed.

Q: What has been driving semiconductor shares higher? Do you think more gains are to come?

A: We're seeing a broad-based recovery in the semiconductor sector. The global economies are faring better, and there's higher demand now for a variety of new consumer-electronic products. The PC sector is also recovering, thanks to resumption of IT spending. Two major world events, the [Iraq] war and the SARS outbreak, are mostly behind us now. So we should see a good continued recovery of semiconductor business.

Q: How would you compare the relative risk/return potential of Texas Instruments (TXN), STMicroelectronics (STM), and National Semiconductor (NSM)?

A: Let's take TXN first. Texas Instruments has guided for sequentially higher revenues, and, in fact, in the mid-quarter update, they narrowed the guidance to the upper half of their range. They're ramping 300mm capacity up rapidly, so we expect the margins to improve. Growth is returning to the wireless sector, after SARS-related weakness in the second quarter. TI has a strong portfolio of DSP [digital signal processing] and analog chips, and they should stand to benefit.

Now, National Semiconductor has also been one of the outperformers in the index.They are focusing on the analog business again, and they're guiding 4% to 7% sequential growth in the November quarter. Their backlog is the highest it has been in 10 quarters, thanks to portable product management and wireless products. We have not followed STMicro as closely.

Q: What are your top five recommendations in the semi space?

A: Well, we can talk about a few of our recommendations. Among chipmakers, one company we've recommended is Semtech (SMTC). They're a midsize fabless [having no chipmaking facilities of its own] company supplying analog chips for PC, communications, and industrial markets. Semtech is seeing good acceptance of power-management chips for notebooks and cell phones. Its bookings were up 7% sequentially. The company is solidly profitable, like other leading analog chipmakers, and its valuation is reasonable compared with peers'. Its operating margins are improving again. We have an accumulate rating on Semtech.

The back-end equipment sector looks attractive, and there are some less-followed small companies in this space. One is ICOS Vision Systems (IVISX) -- it's a leading provider of inspection equipment for chip packaging, based in Europe. ICOS's customer base includes all major chipmakers around the globe. We think the stock represents a good combination of valuation, growth, and profitability. We have a buy rating on ICOS.

I do have one more I'd like to mention. It's a company we've followed for some time: Keithley Instruments (KEI). It's a well-managed small-cap supplier of test equipment for semiconductor chips, wireless handsets, and other electronic components. Their valuation ratios are attractive when compared with peers'. Its bookings were up 22% in the June quarter, thanks to strong growth in the Asia-Pacific region. We think its testers for advanced chips are gaining market share. We have a buy rating on KEI, and I have a position in this stock.

Q: What do you think about Advanced Micro Devices?

A: Well, we expect AMD to do better sequentially in the September quarter, and better again in the December quarter. Clearly, the PC sector is recovering. Particularly for AMD, we expect ASP [average selling price] to rise noticeably. We think its new Athlon 64 and Opteron chips will be big successes. The company is well ahead of Intel (INTC) in launching 64-bit desktop and mobile chips. Microsoft (MSFT) has strongly supported AMD's 64-bit efforts, and someday that could translate to marke-share gains for AMD.

There are a few negatives: AMD lost some share previously in the Asian and European markets that it needs to regain. Also, the company's balance sheet isn't as strong, and the breakeven point is high.

Q: Manoj, what do you see as the next big thing in chips or chip equipment? And who might be out in front with whatever it is?

A: What seems promising near-term are the wireless applications. Intel's Centrino technology launch has increased awareness of wireless capabilities. New consumer devices like 3G cell phones and recordable DVDs will all help create new applications and expand businesses. We think the long-term potential for 64-bit processors, like Opteron from AMD, will open a whole new realm of software applications, as well as increasing memory content in servers.

In the case of chip equipment, there are always new and novel materials being put to test, like various kinds of insulators and strained silicon. There will be a demand for equipment, enabling the use of new materials.

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