Sector Spotlight: Wall Street Waiting on Strong Second Half for Semis

The bullish note Salomon Smith Barney issued on Micron Technology (MU) on Aug. 14 made clear that even the most skeptical industry observers are ready for semiconductor companies to put together a strong second half this year.

It was, after all, Salomon that upset the chip sector just over a month ago with a harshly negative note from analysts Jonathan Joseph and Clark Westmont. They wrote that the favorable supply/demand dynamic that had been buoying the stock of makers of commodity components like flash memory was beginning to turn for the worse.

The authors were greeted with nearly universal scorn for their iconoclastic stance; Joseph reportedly received death threats. So when the brokerage upped its second-half earnings estimates on Micron in expectation of a fall boom in dynamic random access memory, or Dram, which can hold data for only a short period of time, many in the investment community reacted with glee over what they saw as the backtracking at Solly. (The firm hasn't performed underwriting for Micron.)

But that's not the case at all, protests Westmont. "Nothing's changed from our point of view," he says. "We did not downgrade Micron [last month]. We felt at the time, and continue to feel, that the second half of the year should be seasonally good for PC component companies, and Micron certainly fits that description. Generally, most semiconductor companies should have continued good results for the remainder of the year."

Hot for a While, or for 18 Months?

The overwhelming majority of sell-side analysts agree. They feel that the second-half performance for semiconductor companies, including Dram makers like Micron, will be boosted by the traditional acceleration in PC production that happens after Labor Day. But the big difference is that those same analysts are also very bullish on the longer term, believing the Dram cycle will stay positive for another 18 months to two years.

Does Solly's position on Micron basically amount to a short-term buy, long-term run-for-the-exits? That's not too far from the truth, to hear Westmont tell it.

"The nature of last month's call was not that companies would start blowing up in the next few weeks. It was a six-to-nine-month call. At the time, we only downgraded four stocks, so we still have a lot of buys. Some, we believe, will escape the downturn. But there are others that are more trading oriented in nature. We felt that because of seasonal issues or earnings-driven estimate revisions yet to happen, we wanted to maintain the buys."

The estimate-raising that Joseph did on Micron last week is testament to the wisdom of that strategy. "I stressed Micron as a buy on a seasonal trade five or six weeks ago," he says. "And it's still a buy. The quarter's coming in great." Joseph acknowledges that Dram is a commodity like flash memory. But he maintains that the Dram industry "has not attracted anywhere near the capital that the flash market has attracted," referring to the large commitments flash-memory producers have been making to increase production capacity.

Wrong

Fred Hickey, the editor of the bearish High-Tech Strategist newsletter, is on Joseph's side, up to a point. "They have to recommend things," he says. "When he made his call on the semi sector, he was still bullish on Micron. There's nothing inconsistent about this. It's just wrong." Hickey is short Micron because of his conviction that major PC makers have been building up Dram inventory in anticipation of coming price spikes -- spikes that, in Hickey's mind, just won't materialize.

Possibly because of stockpiling, Dram prices have indeed been falling on the spot market lately. But it's hard to extrapolate much from those data. Major PC manufacturers buy most of their Dram not on the spot market but on contract, locking in prices weeks in advance. Ultimately, the second-half story for Micron, and many other semiconductor companies, is deeply dependent on PC demand.

As in the semiconductor industry, most PC analysts expect demand to accelerate as the year goes on, with consumer sales moving toward the frothier holiday months and corporate sales heating up in concert with greater adoption of Windows 2000. But with the commercial PC business clearly ramping more slowly than many had hoped in the early, bright days of 2000, investors might do well to exercise caution.

Please Don't Pound the Table

Merrill Lynch chip analyst Joe Osha expressed that caution Friday when he explained why, in the midst of an extremely bullish conference call on the semiconductor industry, he wasn't "pounding the table" on Intel (INTC). (Merrill, which rates Intel an intermediate-term accumulate, has done no recent underwriting for the company.)

"We've been doing a lot of checking in Taiwan," he says. "Looking at the Hewlett-Packard (HWP) numbers, looking at the Dell (DELL) numbers, talking to other companies. And I don't think the actual demand environment, especially in corporate, is extraordinary. It's doing what it normally does seasonally. But it doesn't seem appropriate to pound the table, given the fact that expectations are for sort of a nearly epochal demand environment."

In other words, if a normal seasonal rebound materializes in PC demand, you'll see a normal seasonal pickup in PC-component manufacturers like Micron and Intel, but nothing more dramatic than that.

And then?

"As an analyst, you don't like to box yourself in," says Solly's Westmont. "But over the next six to nine months, I think there'll be more earnings impact to the downside in the cycle, presuming that analysts have to stop raising or start reducing estimates in the next six to nine months."

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