Alexei Oreskovic

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Holiday Cheer Eluding Chips

Alexei Oreskovic

While most chipmakers have wrapped up their quarterly earnings season, it's the holiday season that is already looming large for investors.

With the semiconductor industry's fortunes tied more than ever to consumer spending, the holidays will prove critical to maintaining the sector's momentum. But for many investors, what they saw in the recent spate of quarterly earnings reports didn't make for reassuring reading.

"There's certainly apprehension as we close out the year of some further slowing down within the industry," says Bill Gorman, vice president of equity research at PNC Advisors.

Although profit growth showed strength among chipmakers in the third quarter, top-line revenue was less impressive, with Intel(INTL), Texas Instruments(TXN) and LSI Logic(LSI) landing at or below expectations. More significantly, many companies guided down their forecasts for the fourth quarter.

"Clearly, the orders for a lot of the companies lightened up a little," says Douglas Whitman, the president of Whitman Capital, a tech-focused hedge fund. "I think people are very concerned about what consumer demand is for Christmas. We're still growing, but we are in the fourth quarter, which is normally a seasonably good [one]."

As of Thursday, the Philadelphia Semiconductor Index was down 7.5% from its 52-week peak, but has fought back to its level of a month ago as the tech sector began to rally in the past two weeks.

However, little of the news in the past few weeks has suggested a further move higher.

After a strong 2004, in which worldwide revenue in the chip industry grew nearly 30%, the current year is on track to produce a more moderate 6% growth rate, according to the Semiconductor Industry Association. And the sector's 800-pound gorilla, Intel, said sales for the fourth quarter would be less than expected, due in part to a $100 million surplus in inventory that accumulated in the third quarter.

It's still unclear whether Intel's recent woes are due to competitive pressure from Advanced Micro Devices(AMD), which boosted its financial numbers and its market share in the quarter, or to weakening consumer demand for PCs in general. But with Microsoft's(MSFT) next-generation operating system, Vista, not scheduled for release until mid to late-2006, it seems consumers will have little incentive to upgrade their machines this Christmas.

However, not all consumer demand is created equal. Flash-memory makers ranked among the third-quarter's high-flyers, with SanDisk(SNDK) and Micron(MU) both handily outperforming Wall Street expectations, thanks to demand for gadgets like MP3 players and digital cameras. SanDisk shares are up 39% since reporting quarterly results last month.

And the cell-phone market continued to be good for chipmakers, with wireless-chip companies like Freescale Semiconductor(FSL) and RF Micro Devices(RFMD) posting strong results.

On the other hand, Altera(ALTR) and Xilinx(XLNX), whose programmable logic chips focus more on infrastructure than on consumer products, turned in uninspiring quarterly results and a bleak outlook.

Consumers are now responsible for about half of all semiconductor purchases, according to the SIA. And with consumer spending continuing to drive the economy, the chip companies that play into the consumer market are getting the biggest benefit.

But in the wake of two devastating hurricanes, soaring energy prices and rising interest rates, it's hard to say how much longer this demand will last or what it will look like come Christmas. For chipmakers, who are effectively two degrees away from the end customer, the guessing game is even tougher: Decisions about the holiday season need to be made in late summer and early fall.

"By the very nature of what they do, they're very inclined to be wrong -- they're the furthest away from the customer," says Whitman. "How can they not have a lower batting average?"

Exhibit A this past quarter was Texas Instruments, which revealed that it was entering the fourth quarter with undesirably lean inventory levels. Having underestimated demand in the third quarter, TI was left with only 57 days of inventory, compared with the 69 days of inventory it carried the same time last year. Meeting a fourth-quarter surge in demand, TI acknowledged, could be challenging.

To some analysts, however, such a surprise end-of-year spike in demand seems unlikely, considering that Dell(DELL) cited a weak U.S. market in its recent guidance revision, and electronic contract manufacturers Flextronics(FLEX) and Solectron(SLR) each provided a tepid fourth-quarter outlook.

"Our conclusion is that demand is slowing, while chip companies are increasing production run rates (wafer starts)," First Albany Capital analyst August Richard wrote in a recent note. "Moreover, finished chips will be coming off the assembly lines in the seasonally slower 1Q."

In fact, many chipmakers are ratcheting up production. Taiwan Semiconductor Manufacturing(TSM), the world's largest provider of made-to-order chips, reported that its factories are currently operating at 96% capacity, up from 85% in the second quarter and 78% in the first quarter.

The outcome of such a scenario is a surplus of silicon, which could trigger a slowdown or perhaps even a downturn in the semiconductor industry. As unpalatable as a poor Christmas appears to chipmakers, a New Year's hangover could be even worse.