Hanging Semi-Tough on the Internet

SAN FRANCISCO -- Among semiconductor investors, the end is dear.

There is no other aspect of technology investing so focused on calling the end of a trend, be it boom or bust. And fundamental to this endless analysis of historical semiconductor sales is the notion of the cycle. The end of these cycles can be brutal, so the Wall Street fantasy is to get in on the bottom and bail at the top.

But semiconductor sales have boomed far longer than expected this time around, confounding investors who bailed early. This game of chicken intensified on July 5 when Jonathan Joseph, Salomon Smith Barney's San Francisco-based semiconductor analyst, issued a bearish call. This smacked the Philadelphia Semiconductor Index (SOX) down 9.3% in a day. It has been wobbling punch-drunk ever since but has yet to take the full count. (The SOX is now almost back to the level where it was when Joseph landed that hard right and is close to breaking through its 50-day moving average.)

Why the comeback? Simple. The bullish argument for semiconductors has an entirely different element to it this time. To paraphrase James Carville , it's the Internet, stupid.

Internet Demand Propels Worldwide Semiconductor Bookings

Source: Semiconductor Industry Association

"People are watching these analysts, and they're watching Wall Street," says Nick Moore, a money manager with Oakland, Calif.-based fund family Jurika and Voyles. "But what they're not watching is the sources of demand. That has fundamentally changed. Last time, the semiconductor boom was overwhelmingly dominated by demand for PCs. This time, the demand is much more diversified."

And chief among those new demands is the Internet. It is creating a broad demand: digital cameras, Internet-equipped mobile phones, personal digital assistants like Palm's Palm Pilot. But no demand is greater than the massive rebuilding of the telecommunications system necessitated by the Internet. In just five years, according to the Semiconductor Industry Association, telecommunications chips have grown from 15% to 21% of total semi sales, eclipsing consumer products as the second-largest market for semiconductors. And this comes amid dramatic growth in the industry, which went from $101.9 billion in 1994 sales, to $149.4 billion in 1999.

Substantially, the new cycle is being driven by growth in markets other than personal computers, and some say that's only just begun. "Traditionally it's a four-year cycle," says Doug Andry, director of information systems and finance for the SIA. "And this thing only really started in earnest in the second half of 1999. So, even if it only follows to course of the last two or three cycles, it has a few years to go. But this one could be different."

Veteran technology investor Bruce Lupatkin, who once headed the research team at Hambrecht and Quist and now is a portfolio manager at North Bay Technology Partners, thinks the paradigm has been broken. "Five years ago, you started to see the effect of the Internet and the infrastructure build-out associated with that," he says. "So it's quite different than it was when we had, really, one end market. That's why we're seeing this long boom. It tends to spook investors who look at it historically, but to understand the semiconductor market now, you have to look at all these new end markets. And I don't care if you're talking about MP3 players, digital cameras or regional phone companies building fiber-optic networks -- really, the Internet touches everything."

For Lupatkin, that means digging a little deeper into the semiconductor sector, buying what he sees as Internet-driven, less cyclical semi stocks. "I tend to avoid the more commodity-like semi companies, like Micron (MU:NYSE - news - boards)," he says. "That stock is about market psychology. I try to find companies that have some kind of special technology with a broad customer base. So I like Applied Micro Circuits (AMCC:Nasdaq - news - boards), NewPort -- which was just bought by Broadcom (BRCM:Nasdaq - news - boards), PMC-Sierra (PMCS:Nasdaq - news - boards), which is absolutely a leader, Altera (ALTR:Nasdaq - news - boards), Xilinx (XLNX:Nasdaq - news - boards) ... these are all seeing demand coming from the Internet, have fairly defensible technologies and strong end markets that aren't subject to that cyclicality."

Moore concurs. "I would argue that this is a supercycle," he says. "Look at end markets and tell me if these are healthy -- the Internet backbone, consumer wideband, upgrades from VCRs to DVD players, digital cameras -- these are incredibly healthy markets."

The notion that It's Different Now has surely been sounded before. But for a growing group of technology investors, there's a belief that the Internet has changed everything -- even the notorious semiconductor cycle. Surely, semiconductor supply will eventually catch up with the Internet's demands. But the bigger picture is, well, bigger. And that suggests the swings won't be as vicious as they once were. "The cycle still exists," says Andry. "But I think the amplitude will be less because of the diversity of the demand."

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Cory Johnson files weekly from TheStreet.com's San Francisco Bureau. In keeping with TSC's editorial policy, he neither owns nor shorts individual stocks, although he owns shares of TheStreet.com. Johnson also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send it to Cory Johnson.