Merrill Call Whips Chips

Updated from 9:05 a.m. EDT

The swoon in semiconductors resumed Monday after Merrill Lynch issued negative research on both Intel(INTC) and the chip-equipment sector.

The brokerage downgraded Intel to neutral from buy one day before it reports earnings, citing uncertainty about technology demand and the stock's valuation relative to its peers. Demand has been a concern since last week's parade of software preannouncements, a series of warnings that led chip investors to sell down the Philadelphia Semiconductor Index 4.8% before it mostly recovered Friday.

The Semiconductor Holders Trust (SMH) was recently down 2.9%, while the SOX was off 3.1%.

"With questions about demand becoming tougher to answer, we're concerned about the impact that lower manufacturing utilization could have on Intel's gross margin in both the second and third quarters," Merrill wrote. "Intel came into the quarter with high inventory by historic standards, and may face pressure to bring inventory levels down in the third quarter."

Merrill also undertook a "broader shift to a more negative stance on the semiconductor business," citing a new belief that industrywide demand is likely to peak at a lower rate and earlier than it previously believed. The brokerage lowered its rating on the semiconductor equipment space to neutral from overweight, a move that was pressuring Applied Materials(AMAT), KLA-Tencor(KLAC) and Novellus(NVLS), despite the latter's strong second-quarter earnings report .

The brokerage said Intel is likely to hit its revenue target of $8.1 million when it reports Tuesday, saying flash-memory sales should offset any problems with microprocessors. While leaving its earnings and revenue estimates for the rest of the year unchanged, Merrill said its "confidence in those estimates has deteriorated."

Intel was recently down 64 cents, or 2.4%, to $25.93 on Instinet, a level that leaves it about 21 times the 2004 Thomson First Call consensus.

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