Meet the Street: What to Do When the Chips (Stocks) Are Down

For chip investors, anything sounds better than 2001.

Dan Scovel Analyst, Needham

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Last year, inventory levels soared, manufacturing facilities were working below capacity, and revenues rapidly declined. The market is ready for an upswing, but despite a fall 2001 surge in chip stocks, the industry isn't necessarily headed for a quick rebound.

TheStreet.com talked with Needham semiconductor analyst Dan Scovel about the year ahead and what has to be done before the chip business gets better.

TSC: We spent 2001 looking for the bottom. Have we hit it yet?

Scovel: The good news is yes. We found a bottom, and we hit it pretty hard at the end of 2001. On an industrywide basis in the semiconductor industry, 2001 was absolutely brutal. Almost every month of the year it continued to decline. We didn't really see any life until the October time frame.

TSC: Some of the December data isn't incredibly positive, either. When will we start seeing it go up?

Scovel: The industry numbers we got for December were a little bit disappointing. It was a weak month on a sequential basis, down about 4%. Usually December is down to some degree, but 4% was down more then we were hoping for. I think what it points to is that overall business conditions remain very weak.

The good news is that we have hit bottom here as part of this cycle. The bad news is I think we are going to stay here for a while. In round numbers I think we'll stay here for a few months. It will not be until the end of 2002 when we finally get some seasonal factors in our favor -- the overall economy has a chance to improve -- we get the last of the inventory flushed out, and we fill up some of that excess capacity. It's going to be the end of 2002 before we see any meaningful signs of life in the sector.

TSC: So if you're an investor, what do you do now? Sometimes we hear that stocks begin to pick up before the up-cycle begins. We have certainly seen that in the last quarter, stocks really went off to the races.

Scovel: In our view we are not very excited about the risk/reward trade off right now. We have seen a recovery in share prices since post-Sept. 11 lows, and there has been a nice rally there, basically betting on a recovery. In our view the certainty of that recovery is not very high.

I would argue that as a rule of thumb, the stock market likes to discount six or nine months into the future. I think discounting six months into the future is aggressive at this point, and nine months is the best we can hope for. I think the real story here on a fundamental recovery in business conditions is going to happen in 2003.

From a stock market perspective the issue is, do you believe that the money that has tumbled into the market since last September is going to be patient enough to wait for a real recovery that, frankly, doesn't happen till 2003? If so, I think you can hold your nose and wade in at these levels, but I think you have to realize that you're probably in for a one- to two-year time frame. From our perspective at this point it's not a real compelling investment situation. We would either like to see the business conditions improve, or we would like to see a softening in the share prices; frankly we'd like to see a little bit of both.

TSC: Where do you think inventory levels are now, and how will they change in 2002?

Scovel: Qualitatively, I would say the inventory levels are not as bad, clearly, as they were last year at this time. If you look at it on a sector-by-sector basis, for example in the PC end markets, the inventory situation is really not in very bad shape at all.

In the cell phone space it's a little bit of a mixed bag. There are some opportunities for growth perhaps in the 2.5G and 3G future-generation products, but with some of the more established products there are probably still some pockets of inventory out there. The consumer electronics market has held up quite well, but you have a pronounced seasonal effect where there is a lot of business that occurs in the second half of the year.

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