By Thomas W. Smith, CFA
The December quarter earnings reports from semiconductor companies indicate that the chip industry is stabilizing, and a mild recovery is under way. Overall, the high-end analog chip companies are in good shape: They're profitable with low debt, wide margins, and stable pricing, and they can wait out the demand doldrums better than other types of chipmakers.
PC-oriented companies are finishing up restructurings and anticipating stronger demand in the second half of 2003 after what's expected to be a seasonally weak first half. Their prospects fluctuate with the movement in chip pricing for microprocessors and memory. Chipmakers for the wireless communications companies have also been reorganizing and are getting hints that demand is improving for chips used in handsets and wireless local area network (WLAN) systems. The wireline-communications chip companies, however, remain less stable as demand keeps fading and layoffs continue.
In the high-end analog category, Linear Technology (LLTC ; ranked 4 STARS, accumulate) earned 14 cents per share in the December quarter, a penny above the consensus estimate, and paid a quarterly dividend of 5 cents per share. Net margin was healthy at 39%. Standard & Poor's gives Linear Technology an Earnings/Dividend Rank of A, indicating a strong record of earnings growth and stability over the past 10 years relative to other companies.
It's unusual to find "A" rankings among technology companies, because many don't pay dividends and tend to demonstrate cyclical, rather than stable, earnings. Steadiness in analog chipmakers' results stems from exposure to a wide range of electronics markets and the high degree of proprietary design that goes into the chips. Plus, prices for these chips don't fluctuate as much as the prices for commodity processors and memory.
Another analog player, Texas Instruments (TXN ; ranked 4 STARS, accumulate), reported strong growth in its analog and digital-signal processing (DSP) lines. Before charges, TI beat earnings expectations and raised its outlook for the March quarter following some disappointments in its October report.
So far, the big stories in the PC chip arena have been Intel (INTC ; ranked 3 STARS, hold), which beat the consensus estimate by 2 cents, and Advanced Micro Devices (AMD ; ranked 3 STARS, hold), which reported a greater than expected loss of 68 cents per share (before $1.81 charges). Intel's orders rose more than expected in December, and fourth-quarter revenues lifted 10% from the September quarter and 3% from a year ago. Intel increased market share in several chip lines and increased its outlook for the March quarter.
One red flag, however, was Intel's cut in capital spending for 2003, from $4.7 billion in 2002 to a range of $3.5 billion to $3.9 billion. The decrease implies that demand isn't picking up enough to build or expand plants and suggests a protracted recovery. Semiconductor equipment companies were also hurt by the cut.
A more optimistic interpretation, though, is that Intel already did such a good job building its 300-mm wafer plants over the last three years that it has ample production capacity and should enjoy some savings now. Capital-spending budget projections are moving targets and subject to adjustment. Overall, S&P believes Intel's good December results, brighter outlook for March, and cost savings on capital outlays improve its outlook. We have raised our ranking for Intel shares to hold from avoid.
LOTS OF RISK.
AMD's story is more complex. This chipmaker has been clearing unneeded inventory, cut staff by 2,000, added $400 million in convertible debt, and is preparing to launch its Hammer line of chips in the spring. AMD claims good progress on their plans, but the restructuring effort is very ambitious, and we at S&P think a lot of factors -- such as a poor product launch, competition from Intel, and chip pricing -- could throw off its plans.
Also, AMD's shareholder equity has shrunk 31%, from $3.56 billion at yearend 2001 to $2.47 billion at yearend 2002, reflecting the severity of the industry downturn. AMD shares -- currently around $5.50 -- are trading near cycle lows on a price-to-book basis, suggesting that a lot of risk is reflected in the price. S&P has a hold ranking on the shares.
Wireless chipmaker RF Micro Devices ( RFMD ; ranked 3 STARS, hold) reported strong December-quarter revenue growth of 45% from a year ago and 22% from the previous quarter. Revenues were driven by acquisitions, modestly improving end-market growth in wireless handsets, and market-share gains in power-amplifier chips for handsets. RF Micro reported earning per share of 8 cents (excluding charges) and beat the EPS consensus forecast handily, but its outlook was disappointing. Despite improving order trends, RF Micro expects to break even or lose a penny per share in the March quarter.
Wireline chipmakers, such as PMC-Sierra (PMCS ; ranked 2 STARS, avoid), continue to face stalled end markets as telecom service providers hesitate to spend much on equipment. On Jan. 16, PMC-Sierra announced a round of facilities closures and job cuts, along with a writedown of $20 million to $25 million for investments and inventory. Its outlook for orders is quite low. The company says it sees flat revenue growth in the March quarter vs. the December quarter.
Given the tough climate, the industry's wireline segment may continue to consolidate. Agere (AGR.B ; ranked 3 STARS, hold) has sold some operations and Conexant (CNXT ) split itself into three parts.
Overall, S&P has a neutral outlook for semiconductor stocks over the next 6 to 12 months. Judging from past industry cycles, the pace of the recovery should pick up over the next few years. Our favorite companies are those already expanding -- such as Linear Technology, Texas Instruments, Analog Devices (ADI ; ranked 5 STARS, buy) and Microchip Technologies (MCHP ; ranked 5 STARS, buy) -- even though their valuations might be higher than those companies that are taking longer to come back.
Analyst Smith follows semiconductor stocks for Standard & Poor's
Edited by Karyn McCormack