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Chips' Flavor Isn't Lasting

LSI Logic's (LSI) report Monday night typified the stunning crisis for chip sales. The manufacturer of integrated circuits for communications devices revised revenue estimates for the third quarter to $370 million to $400 million from $435 million to $465 million. That amounts to a quarter-over-quarter decline of as much as 17%, rather than the typical second-to-third quarter revenue increase of around 10%. Executives blamed the shortfall on too much inventory in the supply chain, and that is a problem that could take more than three months to work out.

LSI is not some Johnny-come-lately, new-age chipmaker. It pioneered the application-specific integrated circuit industry more than two decades ago, has $2 billion in market capitalization and employs over 4,000 people. And yet it cannot get out of its own way. Based on the guidance and other industry trends, Merrill Lynch now estimates revenue in 2004 will be flat with 2003, and 2005 will be flat again. The stock, which was recently trading within a hair's breadth of its 2002 bear-market low of $4, may well trespass that ugly border in coming days or weeks.

How about the rest of the group? Osha notes that even on existing earnings estimates chip stocks are, on average, trading at a 30% premium to the S&P 500, at 22 times next year's earnings, compared to 16 times for the broad market. He concludes that investors should expect the industry's valuation premium to contract, rather than expand, during the next several quarters as chip companies' earnings estimates follow LSI Logic's path of decline.

Some Short-Term Trades Exist

Trading is very often a game of relative, not absolute, value and many investors may wish to buy some chips now for a quick hit that may not give them a hangover if they decide to hold into next year. To investigate that idea, I screened for semiconductor stocks with measurable price/earnings multiples in the current year and past one to five years. I then calculated the discount of the current multiple vs. the prior year and five-year average multiple, and then ranked them by their MSN StockScouter ranking, a 1-10 scale that has proven its merit in the past three years.

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