Chip Stocks: Rolling with the Punches

After pulling back from big gains earlier in the year, Intel and Cypress Semiconductor shares look attractive, says S&P's Clyde Montevirgen

Semiconductor stocks have been dragged through the mud along with many other stocks in this stormy November marked by troubles in the financial sector, the weak U.S. dollar, and near-$100 oil. The good news is, the group is still ahead for the year, after falling behind in 2006. Year-to-date through Nov. 16, the Standard & Poor's Semiconductor index has risen 8.9%, outpacing the 2.9% increase for the S&P's 500-stock index. (Just a month ago, though, the semiconductor index's year-to-date gain was 17.3%.)

Amid the worries about where the economy is headed, the strong earnings and outlook from Hewlett-Packard (BusinessWeek, 11/19/07) (HPQ) were certainly welcome news and helped boost many tech stocks on Nov. 20. "HP's earnings report bodes well for chip companies," says St&P equity analyst Clyde Montevirgen, who has been woefully watching many semiconductor stocks that he follows falter in the last few weeks.

Montevirgen has a positive fundamental outlook on semiconductor stocks overall, and favors companies that make chips for PCs and wireless handsets, given the strong demand for those products. His buy recommendations include Intel (INTC), Cypress Semiconductor (CY), Broadcom (BRCM), Volterra (VLTR), and ON Semiconductor (ONNN).'s Karyn McCormack spoke with Montevirgen on Nov. 19 about his outlook for chip stocks. Edited excerpts of their conversation follow:

Why have chip stocks pulled back lately? Are there worries specifically about chip demand, or are investors just worried about an overall economic slowdown?

I believe that semiconductor stocks have pulled back recently for a few different reasons. First, considering that the second half of the year is usually stronger than the first half, third-quarter results were somewhat weaker than our expectation, and fourth-quarter guidance indicates that results could also be below the seasonal average. On top of that, we see an uncertain economic environment, so the chances of a steeper-than-expected economic downturn could hurt industry sales, especially considering that there's a very high correlation between gross domestic product and semiconductor sales.

Third, a lot of industry forecasters are seeing 2008 as the peak growth year for the semiconductor industry. If you look at the different end markets, handset growth will likely decelerate and consumer electronics growth could slow as well, based on unit sales. Lastly, there's a lot of speculation about double ordering by chip customers—that could slow down results. All of these factors have contributed to the pricing of risk and profit taking, in our view.

What's your outlook for chip sales for 2008?

We have industry sales growth forecasts in the mid- to high-single digits for 2008—that's following our forecast for 4% growth for 2007.

What are the growth areas?

We like chip companies that are highly exposed to the computer space. This includes microprocessor makers, especially Intel. We think that consumer PC sales are robust and almost every industry forecaster that covers vcomputers sees strong growth for the next couple of years. So we believe companies exposed to the PC market will benefit the most.

We also like certain companies that are exposed to the wireless handset space. Even though we believe that lower-end, handset unit growth will slow modestly, we believe that higher-end handset (this includes Apple's (AAPL) iPhone) growth will accelerate, supporting greater revenue growth for the semiconductor industry. That's because higher-end phones generally carry more chip content. We believe that trend will play out over the next couple of years. Those are our two favorite spots right now.

Do you think average selling prices (ASPs) for chips will improve any time soon?

I think that prices will continue to fall next year, however they will fall at a more reasonable pace. Prices, in my opinion, will always fall as companies find ways to produce chips more cheaply.

With microprocessors, we think that recent product releases by Intel and Advanced Micro Devices (AMD) will help blended ASPs. We think enterprise spending will eventually chip in, meaning we think large corporations will eventually buy PCs in what's referred to as the refresh cycle. We do not believe that Microsoft (MSFT) will support older operating systems forever, and see corporations upgrading hardware to support new software applications. That will help ASPs because enterprises tend to buy more higher-end laptops, desktops, and servers. We see those as positives for pricing ahead.

Regarding memory chips, we see more rational price declines for DRAM. With slower equipment orders from memory chip makers, we see a more favorable supply-demand balance next year, which should support a recovery in DRAM prices. Also, considering low prices for DRAM, and more favorable prices for NAND flash memory, we expect memory makers to focus more on NAND flash production ahead, which should indirectly support higher DRAM prices. We expect NAND prices to hold up fairly well in 2008 as memory content in consumer electronic products increases and as demand for consumer electronics remains healthy.

Which stocks do you like?

We have a buy recommendation on Intel. We believe that Intel will continue to gain market share in the high-end market. We think Intel will have the ability to reduce per-unit costs, which will help gross margin expansion. And we believe Intel is one of the more reasonably priced companies in our universe as far as relative valuations are concerned.

We also like Cypress Semiconductor, which we recommend as a buy. We believe that their subsidiary, Sun Power, that produces solar products, will continue to grow exponentially. And we also believe that Cypress' core semiconductor business is grossly undervalued.

We also have buy opinions on Broadcom, Volterra, and ON Semiconductor.

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