Even Specialists Aren't Immune to the Big Wheel

Microprocessors, flash memory, embedded processors -- semiconductor stocks of all sorts have gotten crushed in the month since it became clear that growth was slowing at industry leader Intel (INTC). And in the process, investors have learned an important lesson: Intel, Advanced Micro Devices (AMD) and Micron Technology (MU) aren't the only cyclical semiconductor stocks around.

More than anything else, the fortunes of stocks like those three trade according to the ups and downs of the personal-computer industry. The reason is obvious: PC sales are the single biggest determinant of the number of chipsets shipped by Intel and AMD and the amount of Dram, or dynamic random access memory, shipped by Micron.

Gains in market share can compensate for weak industry conditions, and companies can fail to execute in good markets. But, ceteris paribus, when demand for PCs heats up, so do those stocks. And when it slows, look out below.

Dram-maker Micron is particularly vulnerable to these forces, since its product is close to a pure commodity. The markets for products like Dram and flash memory trade very like much like oil: according to the strict laws of supply and demand. It doesn't just take flagging demand to knock the wind out of commodity semiconductor prices. Strong demand prompts suppliers to build new production capacity. And once they've built too much, prices tank.

Specialists

Not so for specialty semiconductor makers, right? After all, their products aren't commodities, and are sold into markets where spending seems as if it can never slow. But recent experience has proved otherwise.

Take the makers of programmable logic devices, or PLDs -- integrated circuits designed into communications, computer and industrial equipment, that customers are able to program for their own needs. PLD makers like Altera(ALTR), Xilinx(XLNX), Atmel(ATML) and Lattice Semiconductor(LSCC) have been tumbling fiercely for the last month, largely on cyclical concerns.

Ultimately, the cycle that indicates the health of specialty semiconductor companies is pretty much the same as in the commodity semi sector. As with Intel and Micron, the fortunes of PLD-makers are tied to the tension between supply and demand. Supply is a factor of the industry's production capacity, the state of which can be gleaned by looking at inventories.

According to Jack Geraghty, an analyst at Gerard Klauer Mattison, those have been rising lately at Altera and Xilinx, where they are starting to approach the 90 days those companies say they like to have on hand. At the same time, he noted, lead times -- the time it takes a company to fill customers' orders -- are starting to decrease, so the companies are coming closer to meeting demand. (GKM hasn't done underwriting for either company.)

But things have become especially tricky with demand lately. Because a great number of PLDs are designed into telecom systems components like switches, routers and base stations, the recent evidence of a broad slowdown in telecom equipment spending has many fearing that the demand for those specialty semiconductors may be reaching its peak.

Product Cycles

There's also the matter of product cycles. Last week's warning by Altera that growth would be at the low end of the 12% to 15% range it had recently forecast reinforced the perception that Altera is on the losing end of an industry shift toward PLDs made by competitor Xilinx.

The contracts that Altera won four to five years ago on the basis of its PLD designs drove most of that company's growth, says Merrill Lynch analyst Chris Danely. But he notes that with four to five years also marking the life of most telecom systems components, things are starting to change. For the last three years, Xilinx has dominated the design-win landscape, and the company is still in the early stages of the payoff. (Merrill hasn't done underwriting for either company.)

"We know that as soon as these products ramp, they'll get a dramatic increase in orders," Danely says. For example, the conventional wisdom is that Japan will be using third-generation cellular base stations by next year. But Europe won't get there until 2002, and North America won't follow until 2003. "That's a three-year uptick in PLD consumption," says Danely, "and Xilinx has gotten over 90% of the design wins in that space."

Xilinx remains a high-risk stock, largely because of the premium investors are willing to pay for those design wins. Although it's down about 20% since early October, Xilinx is trading at about 38 times its estimated earnings for 2001. Meanwhile, Altera, trading at about 21 times 2001 earnings, has the burden of reversing Xilinx's momentum.

But the market arguably has a better sense of the cyclical factors affecting both stocks than it has ever had. If nothing else, investors have figured out that there is indeed a cycle, and that we're no longer in its earliest stages.

>To order reprints of this article, click here: Reprints