Chip Fundamentals Stay Strong Amid Correction

An Interesting Way to Play

While waiting for history to repeat itself, I've been examining the chip distribution industry. I like what I see. It's been a while since these stocks have gotten the research coverage they used to, so I've been looking at Avnet (AVT Quote), the industry leader with annual revenue of nearly $10 billion.

Not too long ago, the short-sellers were circling Avnet on stories of possible bankruptcy. The company wasn't profitable, it had a bond issue coming due, and everyone was sure the chip industry was headed further south. Since then, the company's profits have returned, the stock has more than doubled, it refinanced its bond debt at very favorable terms, and interest in the company is perking up.

Avnet has two distribution businesses: chips and computers. The chip side (about 60% of total revenue) is strong: Its book-to-bill ratio is 1.2. The computer business (about 40% of total revenue) is so-so, waiting for corporate IT spending to pick up.

Even without all cylinders firing, Avnet's earnings are likely to jump to about 25 cents a share in the March quarter, from only 7 cents in December, and to hit 30 cents in the June quarter. That would make annualized earnings equal to the Street's full-year fiscal 2005 estimate of $1.20 per share, which provides for no further upside. In reality, growth of another 20% to 30% is more likely. In addition, management has taken a half-billion dollars out of selling, general and administrative expenses and has sharply lowered interest expense.

Like other distributors, Avnet has almost no inventory risk, because unsold products can be returned to suppliers. In addition, inventory is protected against manufacturers' price cuts after it's in Avnet's hands.

Avnet's backlog has been rising recently, and its business scheduled for shipment beyond 30 days is up to more than 50% of its total volume, compared with below 30% a few quarters ago. This makes it easier to forecast earnings and to plan inventory, which is up somewhat this quarter as lead times from suppliers lengthen.

Avnet also has a big play in China, with three warehouses serving 23 cities. By this summer, Avnet's sales in China will reach $1 billion, or 10% of worldwide sales, making the company the largest Western distributor there.

The company's stock has pulled back by almost 20% in the chip correction and now sells for only about 15 times fiscal year 2005 (June) earnings, which I see hitting $1.50 a share, not the $1.20 consensus. It's not a bad way to play the next leg up in the chip sector -- without the specific product and manufacturing risk of the chipmakers themselves.