Chips: Ready to Bounce Back
By Tom Smith
We at Standard & Poor's Equity Research Services are positive on the outlook for semiconductor stocks during the next 12 months, despite some stormy share-price action in recent weeks. A common proxy for shares of semiconductor makers, the Philadelphia Semiconductor Index (which also contains some semiconductor equipment makers), dipped as far down as 471.74 on Mar. 15, from 560.65 on Jan. 12, and has recovered a bit to 485.30 as of Mar. 25. This leaves the SOX down 13% in about 10 weeks -- and observers wondering if the downtrend will continue or whether the drop since mid-January is just a brief, but vigorous, shakeout before prices move higher.
Our bullish view of the group is based on strong fundamentals for the industry. One factor is rising earnings. Chipmakers' reported orders and earnings have accelerated since August. Most chipmakers that we follow have given midquarter guidance for revenue and earnings at the upper half of original projected ranges for the March quarter. We think most chipmakers will meet or beat consensus numbers when earnings are released in April.
Other bullish fundamental factors we see include: constructive economic growth stories in key global economies such as the U.S., China, and Japan; an absence of excess inventories in distribution channels; some stretching of order lead times, but not close to lengths near 20 weeks seen at industry cycle peaks; and generally tight production capacity across the industry which is conducive to strong average selling prices for chips. Indeed, market researcher Gartner/Dataquest Inc. said on Mar. 18 that semiconductor capacity is not increasing as fast as demand, which will likely lead to high utilization rates at wafer fabrication plants through 2005. Market analyst VSLI Research forecasts 91.3% fab utilization in 2004, up from 87.7% in 2003 -- another indication that capacity is apt to be tight in 2004.
We are forecasting 25% growth in worldwide semiconductor sales (in dollars) for 2004 and 20%-plus in 2005. A batch of industry researchers views 2004 in that same ball park, with more divergence of opinion on the pace of growth in 2005, a year which might see substantial additions of production capacity in China. We think the new Chinese plant is not apt to cause an oversupply problem affecting chip pricing until late 2005 or 2006, depending on the pace of the build-out and success in executing production plans.
As examples of market-research thinking, Semico Research expects 2004 semiconductor-industry growth of 27.5% -- with 32.5% and 20.6% as the high and low ends of its forecast range. Wide ranges are common in chip-sales forecasts, given that chip pricing tends to fluctuate a lot. Another researcher, IC Insights, forecasts 27% growth for 2004. The chip-sales growth forecast for 2004 from VSLI Research is 24.8%.
Recent chip-sales numbers lend some support to the researchers' contention of a 27% pace in 2004. As tracked by the Semiconductor Industry Assn. (SIA), chip sales in January, 2004 were up 27% from the prior year, on a three-month moving-average basis. Also, on Mar. 24, memory maker Micron Technology (MU , 3 STARS, or hold, recent price: $16) reported that sales for its February quarter were up 26% year-over-year. Sales at Analog Devices (ADI ; 5 STARS, or buy; $48) were up almost 30% year-over-year in its January quarter, and we think that this company should typically be running a few points ahead of industry growth, given its exposure to digital signal processors (DSP), which are a fast growth category according to SIA forecasts.
In short, we believe the semiconductor industry has entered the fat part of a cyclical upswing, and that the expansion is apt to last through 2005. We think this leaves ample time for revenue, earnings, and share prices to move higher. We think that if there's a really big year for chip sales, say 30%-plus, stocks should respond bullishly, since that's not being factored in to the Street's estimates. If growth in 2004 is more like the 25% we forecast, then we think that the rush to build new plant will be seen as less urgent and the whole cycle will take longer to play out, which we think improves the chances for a bullish chip pricing environment to last well into 2005.
What could go wrong? Even the best scenarios are subject to change with economic conditions and knocks to the overall stock market, such as terrorist attacks, bank failures, or election shocks. Semiconductor stocks are volatile and respond readily to changing stock-market situations, so chip stock investors should be nimble.
Another caveat is valuation levels. Valuations might be considered high, but the SOX is selling at over 10% discount to levels seen in January. Another knock is that greater recognition of stock options expenses might produce headwinds for semiconductors shares, along with other information-technology stocks.
Among S&P's top picks in the semiconductor area are a few where we believe the Street's estimates for 2004 revenue growth are a little behind where the market researchers suggest the industry is headed, that being 27% give or take about 5%. For instance, Street estimates for Intel (INTC , 5 STARS, $28) indicate expected growth near 15% in 2004, vs. our estimate of 19%. While PC-oriented chips might lag the industry as a chip category, we think a 15% estimate for Intel is too far behind the industry pace described by market researchers. We expect American corporate purchases of computers to pick up in the second half of 2004 and think the Street may have to raise its revenue estimates for Intel.
Street estimates for Xilinx (XLNX , 5 STARS, $38) are for growth of about 27% in fiscal year 2005 (ending March), vs. our estimate of 30%. We think that the largest maker of programmable logic devices (PLD chips) will grow a bit faster than the industry pace, as PLD chips are selling into new markets, particularly in consumer and industrial areas. Granted, the fiscal year for Xilinx is one quarter different from the calendar year used by market researchers.
Street estimates for Microchip Technology (MCHP , 5 STARS, $27) are for 20% growth for fiscal 2005 (March), vs. our estimate of 24%. We believe this maker of microcontrollers and associated analog and specialty memory products should grow approximately in line with the industry pace. So a 20% revenue estimate seems too conservative to us.
We agree more with the Street on the revenue growth outlook for Analog Devices (ADI , 5 STARS, $47). The Street is at 31% growth for fiscal 2004 October (again, not a perfect fit with the calendar year), and we see 32%. We agree with the Street that this maker of digital signal processor and analog chips is apt to grow faster than the industry, given historical patterns and SIA forecasts for DSP growth. Our 26% forecast is above the Street's 22% estimate for fiscal 2005, which fits with our more bullish outlook for an industry expansion to endure deeper into 2005.
Note: Tom Smith has no stock ownership or financial interest in any of the companies in his coverage area. He's a registered representative of Standard & Poor's Securities, Inc. Other S&P affiliates may provide services to the companies under discussion.
Analyst Smith follows semiconductor stocks for Standard & Poor's Equity Research Services
Edited by Karyn McCormack