Commentary: Look Out, Chipmakers: This Upturn May Be a Mirage

By Andy Reinhardt

At first glance, chipmakers seem to be getting their groove back. After the worst year ever in the semiconductor business, many companies turned in modestly better results for the first three months of 2002. Preliminary figures from the industry's trade group show first-quarter sales advanced from the final three months of 2001--a break from the usual slump at the start of the year. Chip stocks, although flat since Jan. 2, have handily outperformed the Nasdaq's 14% drop. "We're convinced that revenue bottomed out in the first quarter," says Pasquale Pistorio, CEO of STMicroelectronics (STM ) in Geneva, the world's No. 3 chipmaker. "We're into the new cycle."

Others offer similar hope. Texas Instruments Inc. (TXN ) in Dallas, as well as STMicro, predict second-quarter sales gains of 10% over the first quarter. No. 1 Intel Corp. (INTC ) retains a cautious outlook, with expected second-quarter growth of less than 6%, but said on Apr. 25 it would restart construction of a delayed $2 billion plant in Ireland. And Fairchild Semiconductor International Inc. (FCS ) in South Portland, Me., is hiring workers to boost output.

No wonder analysts in the past three months have raised their predictions for 2002 semiconductor profit growth from 45% to 76%. And chips historically represent the leading edge of demand for all electronic products.

But there's something troubling about this picture. Although chipmakers see bluer skies ahead, their customers--makers of PCs, communications gear, and consumer electronics--aren't ready to declare the storm over. Many of these manufacturers, which account for the bulk of chip demand, announced rocky first quarters and gloomy outlooks. Mobile-phone giant Nokia Corp. (NOK ) just cut its 2002 industry projection by 20 million handsets, for net growth of only 5% to 10%. Researcher Gartner Group Inc. pegs PC growth this year at just 4%, and even red-hot categories such as digital cameras and DVD players show signs of slowing. Worst of all is telecom gear: Analysts say sales could plunge as much as 35% this year.

The mismatch in forecasts raises a troubling question: If consumers and corporations aren't buying, where are these chips going, anyway? Right now, they're replenishing depleted stocks throughout the electronics supply chain, where inventories are near historic lows. In other words, chipmakers may be confusing reorders from electronics distributors with a genuine uptick in demand. Yet for the industry to see a sustained upturn, parts have to flow out the other end of the pipe within two quarters, or they'll back up into another inventory bubble.

Some of the industry's more skeptical observers see the risk. Although they still think profits will grow from a sickly 2001, they worry about top-line growth once inventories are topped off. "It's Field of Dreams all over again," says analyst Ashok Kumar of brokerage U.S. Bancorp Piper Jaffray, referring to that movie's famous "If you build it, they will come" line. "Chipmakers are hoping huge demand will materialize, but so far there's no sign of it."

There are already indications that the pipeline is backing up. Intel and archrival Advanced Micro Devices Inc. (AMD ) together built 4 million to 5 million more PC microprocessors in the first quarter than the market consumed, estimates Lehman Brothers Inc. Spot market prices for dynamic memory chips, which tripled between November and February, have since plunged 30%.

Whence all the euphoria, then? Chip buyers may bear some of the blame. Their "wishful thinking and denial" prompted them to raise orders too fast late last year, says Malcolm Penn, president of British chip researcher Future Horizons. Thus the chipmakers may be falling into an age-old trap: At the first sign of an upturn, they all jack up production, flooding the market with too many parts that end up marked down or destroyed.

So far, chipmakers are sticking to their guns. Jean-Philippe Dauvin, chief economist at STMicro, admits there could be an "air pocket" between the current inventory replenishment and an upsurge in true demand, which he figures will kick in later this year. That's what all chipmakers are counting on. But if the second half stays bearish, get ready for another agonizing year in chips.

Reinhardt covers European technology from Paris.

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