Chips: Nowhere to Go But Up?

The industry's short-term outlook remains grim. For patient investors, however, that may represent a buying opportunity

The past year was the worst in the $204 billion semiconductor industry's history. Chip sales have grown at a 17% average annual compounded rate since the 1950s, when transistors turned huge and bulky radios into the small devices we use today. This year, however, chip sales will fall by about one-third vs. 2000 levels -- the worst slide ever, according to communications consultants Cahners In-Stat.

However, the end of the slump may finally be drawing near. Analysts believe the industry could hit bottom in the fourth quarter of this year or the first quarter of 2002. Indeed, signs are that some manufacturers' orders may be stabilizing. On Oct. 17, Texas Instruments, which makes semiconductor components for computer electronics and wireless phones, said its third-quarter sales were about the same as in the previous quarter, though the company expects a slight dip in the fourth quarter. LSI Logic (LSI ), whose silicon products are used to store voice, video, and data, expects zero to 5% growth in the fourth quarter. That's an improvement.

What's an investor to do? "Long-term investors should buy now," says Joseph Osha, analyst with Merrill Lynch. His picks: communications semiconductor stocks, such as Analog Devices (ADI ) and Linear Technology (LLTC ), which Osha favors for their stable margins. Many other analysts recommend TI (TXN ) and Qualcomm (QCOM ), which they see as bound to benefit from wireless and cell-phone growth.


  Intel (INTC ) remains a favorite as well, bound to benefit if PC sales revive in 2002. As the worst year for the semiconductor industry comes to a close, the time to buy could be drawing near. But beware: Next year won't be a picnic (see BW Online, 11/5/01, "Singapore Sticks with Its Chip Program").

The news certainly looks grim through the end of 2001. The holiday season -- usually the industry's best period -- is wreathed in gloom. With unemployment rising, fewer people are expected to be putting pricey PCs and stereos under their Christmas trees. Consumer-electronics stores could enjoy a 2.5% bump in sales in the fourth quarter vs. the same period in 2000, says Kurt Barnard, president of Barnard's Retail Consulting Group. But that's not much of an increase -- and even less so when judged against last year's holiday season, which was unusually weak. Indeed, such an increase would barely cover inflation.

Another complication: In 2002, corporate-technology spending, which accounts for 85% of the semiconductor industry's revenues, could decline an additional 2% to 5%, according to tech consultants at META Group. Product prices also are falling -- but demand is not picking up in response. DRAM memory prices have already dipped more than 80% in the past year -- to the point where chips are selling below cost. Since this summer, all semiconductor products' prices have been in free fall and are likely to plunge even further next year, says Mario Morales, analyst with tech consultancy IDC.


  Fierce competition will likely kill off second-tier players. The ensuing reshuffling of the market will favor sector leaders, such as TI in wireless phones and networks and Intel in components for PCs, Morales says. Some of the smaller players with good financial backing could return to the limelight when the market recovers.

The September 11 terrorist attacks will boost demand for cell phones, which many consumers are now buying in case of an emergency. According to consultants Yankee Group, 2 million more people will sign up for wireless services this year than were previously expected to do so, bumping the total count to 130 million. Also, consumers now replace their mobile phones more often -- once a year, on average, instead of once every two years, says Morales. So expect single-digit growth in 2002.

Morales thinks the wireless-components sector, which accounts for 20% to 25% of the industry's revenues, will see the first rays of light in the second half of 2002. "Many manufacturers plan to launch their products in the second half of 2002," explains Ed Valdev, director of marketing for wireless and mobile systems at Motorola (MOT ). As telecom carriers start phasing in upgraded wireless networks and new phones in the summer of next year, increased demand for components will start fattening many semiconductor makers' purses. The PC recovery should come a bit after that, analysts predict.


  However, even the recent introduction of Microsoft's new Windows XP operating system likely won't give PC sales much of a boost in the near-term, say analysts (see BW Online's Special Report on Windows XP). Worldwide PC shipments fell by 13.7% in the third quarter compared with the same quarter of 2000, according to IDC.

PC demand is likely to pick up in late 2002, as the economy snaps out of its slumber. But so far, "I don't think there's been any great news," says John Geraghty, analyst with the investment bank Gerard Klauer Mattison & Co. PC-related semiconductor-component sales will remain flat or curve up slightly next year.

Not all semiconductor sectors will be so lucky. Memory chips, which now account for less than 10% of the total market, could suffer further price declines. And the telecom slump will hurt sales of chips used in routers and switches that direct phone calls traveling via ground communications lines. In 2002, telecom carrier spending in North America could fall an additional 27% compared to 2001, estimates ABN AMRO analyst Ken Leon.


  The bottom line: The industry's recovery will be gradual at best. Single-digit, quarter-to-quarter growth might resume by the middle of next year, but annual sales will likely fall an additional 7% in 2002 from the depressed level this year, estimates IDC's Morales. "It's not going to be a V-kind of recovery bounce," says Steve Cullen, director of In-Stat's semiconductor group.

Double-digit growth probably won't return before 2003, when economists predict the U.S. economy will have bounced back. So if your investing time horizon extends that long, you might find some deals in chips. If not, steer clear.

By Olga Kharif in Portland, Ore.

Edited by Thane Peterson

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