Hot Chips in a Cold Sector

While most semiconductor stocks missed the recent rally, S&P's Amrit Tewary finds a lot to like about Maxim and Linear Technology

Despite a neutral stance on semiconductor stocks in general, Standard & Poor's has found a few names to recommend, says S&P senior industry analyst Amrit Tewary, who rates Microchip Technology (MCHP ) a buy because of its leadership in the 8-bit microcontroller business. He also has buy rankings on Maxim Integrated Products (MXIM ) and Linear Technology (LLTC ), both high-end analog chipmakers. Tewary lists as accumulate International Rectifier (IRF ), which makes power semiconductors used to enhance performance and efficiency of electrically powered products.

Chip stocks in general did not participate in the market's post-election rally. Tewary attributes their lag to an inventory buildup among both manufacturers and distributors, due to less-than-expected demand. However, 2004 should end with industry sales growth of 25%, "followed by moderation to 10% growth in 2005," he predicts.

These were a few of the points Tewary made in an investing chat presented Nov. 9 by BusinessWeek Online and Standard & Poor's on America Online, in response to questions from the audience and from Jack Dierdorff , consulting editor of BW Online. Edited excerpts from this chat follow. AOL subscribers can find a complete transcript from BusinessWeek Online on AOL at keyword: BW Talk.

(Amrit Tewary is a Standard & Poor's Equity Research Services analyst. He has no ownership interest in or affiliation with any of the companies under discussion in this chat. All of the views expressed in this chat accurately reflect the analysts' personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat. For required disclosure information and price charts for all S&P STARS-ranked companies, go to A HREF="http://www.spsecurities.com" target="_new">spsecurities.com and click on "Investment Research," then on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts." Standard & Poor's affiliates may provide services to the companies that are the subject of this discussion.)

Q: Amrit, have the semiconductor stocks you cover shared in the rally that followed last week's election?

A:

The SOXX Index, which is the Philadelphia Semiconductor Index (SOXX ), is up only slightly less than 1% since the elections, whereas the S&P 500-stock index is up more significantly. So I would say that most chip stocks have not participated in the rally following the election.

Q: In your view, why are chip stocks lagging?

A:

Chip stocks have been down substantially from the start of the year. Until early September, they were down about 35% or so. Since that period, they have rebounded about 15% to 20%, in some cases, from levels in September. However, they are still down year-to-date, underperforming the S&P 500 index. I would say that the reasons for this underperformance are twofold. First, demand so far during the back half of calendar year 2004 in end markets has been less robust than expected, leading to a buildup of inventory within the distribution channel. Secondly, many chipmakers themselves have had a buildup of inventory, anticipating a pickup in orders from their customers during the back half of the year. We believe the chip stocks have been pressured as a result of these two disappointments.

Q: I wanted to ask your opinion about Intel (INTC ) and what you see for the semiconductor industry in 2005.

A:

Our expectation for the chip industry in 2005 is that sales growth will moderate from robust levels seen in 2004. We expect that the current industry inventory correction will continue in the short term, but that decent demand during the fourth quarter will exceed most chip customers' very modest expectations. This should lead to improved order rates from these customers during the first half of 2005. This will lead to a decent, but less robust, growth year.

However, we have a neutral stance on the industry as a whole.... Chip stocks typically trade within the lower half of their historical range during the latter stages of industry upcycles. Since we believe we are entering the latter stage of the current upcycle, we think most chip stocks merit their current discount to historical average multiples.

We have a 3-STAR (hold) opinion on shares of Intel. We believe Intel's scale-based strengths in R&D, manufacturing, and marketing should help it prosper during the current industry expansion that we expect to endure through 2005. Ironically, strength in production execution during the first half of 2004 has led to high die yields and an inventory buildup that we think will take a quarter or two to clear up. We believe shares are fairly valued at current levels, based on our historical price-earnings multiple analysis, as well as our price-sales ratio analysis.

Q: Any opinion on Fairchild Semiconductor (FCS )?

A:

I maintain a hold on the stock. We see the shares performing roughly in line with chipmaker peers over the next 12 months. Despite a significant drop in the share price year-to-date in 2004, we think current valuation levels are warranted, based on what we see as above-average near-term industry inventory and macroeconomic risks. Our 12-month price target of $16 is based on our price-sales analysis.

Q: Amrit, any buys? What are your favorite chip stocks?

A:

Despite our neutral outlook for the industry overall, we do think a few companies should outperform their chipmaking peers. First, we like Microchip Technology (MCHP ) -- it's a 5-STARS (buy). It's a company that has built a strong market leadership position in the relatively steady 8-bit microcontroller business. We are attracted by what we see as a superior business model vs. peers, a below-average risk profile, given the company's diverse end markets and low cost structure, and above-average financial flexibility. Given our view of these competitive strengths, we expect the company to continue to gain share from smaller competitors in this fragmented segment of the industry. Our 12-month target price of $37 implies well-above-average appreciation potential. We also like Maxim Integrated Products (MXIM ), which also has a 5-STARS (buy) recommendation. Linear Technology (LLTC ) is also a 5-STAR buy. MXIM and LLTC are two high-end analog chip outfits that have similar businesses. We think the high-end analog business has more attractive long-term growth prospects than most other segments of the industry.

Also, we believe Maxim and Linear, like Microchip, are both well-run companies that have a diverse customer base in a number of end markets. We believe this diversity results in a lower risk profile for these companies, as it limits exposure to weakness at any one customer or end market.

Also, we note that both of these companies are highly profitable, with well-above-average gross and net margins. In addition, with no long-term debt and plenty of cash and equivalents on hand, both companies have healthy balance sheets. Furthermore, we think both stocks are attractively priced at current levels, based on p-e and price-sales analyses. Our 12-month target price for Maxim is $60, and (it's) $50 for Linear Technologies.

Lastly, we have a favorable opinion on International Rectifier (IRF ), which has a 4-STAR or accumulate ranking. IRF is a manufacturer of power semiconductors that are used to enhance performance and efficiency of electrically powered products. We see robust sales growth for IRF for the year ending in fiscal 2005 (June), driven by increased power-management content in personal computers and other electronic devices, market-share gains, and demand for new proprietary products. Our 12-month target price of $52 implies above-average appreciation potential.

Q: How has earnings season been overall for the stocks you cover?

A:

During the third quarter of calendar 2004, the majority of companies I cover lowered their sales guidance for the quarter. We believe this was due to the inventory correction we discussed earlier and also less robust than expected end demand in the electronics markets.

Q: Altera (ALTR ) -- opinion?

A:

We have a hold (3-STARS) opinion on the stock. We believe current valuation multiples are warranted, in light of what we see as elevated near-term macro uncertainty. Also, we believe multiple expansion is unlikely over the next 12 months for most chip stocks, as we enter what we believe will be the latter stage of the current industry upcycle.

In addition, based on our view that inventory levels in the distribution channel are at or above optimal levels, we expect distributors and OEMs to be more cautious in ordering. We believe shares are fairly valued at current levels based on our historical p-e and price-sales analyses.

Q: How about valuations in the semiconductor sector now?

A:

In general, stocks that we cover are trading below historical average multiples on p-e and price-sales. We believe that this is warranted, given our expectation that we will see a moderation in industry sales growth during 2005 and a flat-to-down sales year in 2006.

Q: Given that you believe we are in the latter stages of an upcycle, do you believe that most of 2005 will be flat?

A:

We believe industry sales growth in 2005 will be a moderation from the robust levels experienced so far in 2004. Currently, we expect industry sales growth of 25% in 2004, followed by moderation to 10% growth in 2005. We believe this is still a decent growth year for the industry and expect that the downcycle we see in 2006 will be a shallow one.

Q: What are the latest technological advances to watch in chips, and which companies are on the leading edge?

A:

Chipmakers constantly strive to improve their manufacturing technology. Also they generally devote a large proportion of their budget to product R&D. We expect that those chipmakers that are on the cutting edge with these technologies will have a competitive advantage in their respective fields. A couple of the companies that we expect to benefit from cutting-edge technology include Intel because of its R&D and manufacturing might, and high-end analog chipmakers including Linear and Maxim.

Q: One chipmaker we haven't talked about is Texas Instruments (TXN ) -- how do you see that one?

A:

We have a hold (3-STARS) opinion on TXN. Although the shares are down year-to-date in 2004, we think current valuation multiples are warranted. We believe chip order rates will continue to be sluggish in the short term as some distributor and OEM customers will likely require a quarter or two to clear out excess channel inventory. We also believe that macro concerns may dampen demand during the near term. We believe the shares are fairly valued at current levels, based on our historical p-e analysis.

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