New Year, New Rules: As Demand Ebbs, Chip Stocks Look Broken

Investors interested in chips for 2001 are going to be better off with salt and vinegar than semis.

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Given that the not-so-hot news from personal computer, software and semiconductor makers has driven chip stock valuations steadily down during the past several weeks, it may seem like a good time to start nibbling away at the sector. But the word from Wall Street is to think twice about doing that unless investing is for the long term. Old Economy long-term.

Semiconductor stocks may be cheaper than they were a few months ago, but that's because the supply-and-demand scenario has been falling apart. There's still supply, but not so much demand. What's still unclear is whether demand is slowing from middlemen like distributors and subcontractors because they've built up too much inventory, or whether it's demand from the end user that is cramping the sector. If it's just an inventory issue, it could clear up in six months. If it's the economy headed for a deeper retrenchment, semiconductors will go down with it.

All this means that the big-name stocks like Intel (INTC) and Advanced Micro Devices (AMD) could fall further for at least the next six months while investors try to figure out if demand will turn up. And while some chipmakers may find themselves less affected by this industry routing -- like SanDisk (SNDK), Silicon Storage (SSTI) and others with a large exposure to the still-in-demand flash memory used in personal digital assistants -- there won't be many places to hide.

"When one goes, they all go. Investors tend to sell everything and not worry about who is doing what to whom," says Jack Geraghty, an analyst at Gerard Klauer Mattison.

A Diminished Giant Intel's stock has had a rough year

The severity of the downturn in demand at the end of November and in the first weeks of December means that the Semiconductor Industry Association's forecasts for 2000 revenue growth of 37% and 2001 growth of 22% already are outdated. Since those numbers have come out, bellwether Intel has said that its own revenue would rise around 15% this year from last year, and most analysts see the figure growing by less than 10% next year.

Some of the first real signs of how much lower Wall Street will have to move its revenue and earnings estimates for 2001 will come in January, when the semiconductor companies announce fourth-quarter earnings. They'll also begin to let analysts know how they think the business will fare in the 2001, or at the very least in the first quarter. So far, those companies have been stingy with their projections, saying they need to wait and see what happens with PC demand.

But some independent analysts suggest that PC demand, a key indicator for chip demand, will continue to slow in the U.S. International Data Corp., for instance, said recently that it expects consumer demand in the U.S. will stay depressed for two to three quarters before accelerating again. And worldwide, IDC sees PC growth slipping to a gain of 16.6% worldwide in 2001, down from 18.8% in 2000.

The questions about PC demand come at a time when there are also inventory issues for certain kinds of semiconductors that feed into the communications sector. For instance, programmable logic devices, or PLDs, for the telecommunications industry are backed up in the hands of the contract manufacturers, the companies that build the pieces for the end customers, which are large telecom equipment makers like Cisco (CSCO). Altera (ALTR) and Xilinx (XLNX) are two large PLD makers.

Those inventory concerns and other worries about the end markets -- both PCs and telecommunication companies -- have already taken a chunk out of the valuation of the stocks. Since Sept. 1, the Philadelphia Stock Exchange Semiconductor Index has given up almost 50% of its value, having fallen from 1142.57 on that day to about 582 now. But even at current levels, the SOX is still far above the 200 and 300 levels it ranked in the late 1990s. Chips began a downcycle in 1996 that didn't end until after the 1998 Asian currency crisis worked itself out.

SOX Falling Down The semiconductor index has tumbled over revenue and earnings worries

Dan Niles, an analyst with Lehman Brothers, figures the next six months won't be good ones for chipmakers based on how the SOX has traded in the past. When chipmakers were facing deteriorating fundamentals in 1996, the SOX rallied after bouts of bad news. It started with a rally in January as investors came to believe the worst was behind them. Then another look at fundamentals drove the stocks down. It retraced its gains only to fall apart again in March, and then again in June before bottoming in July.

"It would not surprise us if that type of pattern repeated itself this year with two false trading rallies before the actual bottom was set during Q2 or the summer," he wrote in a recent report.

This, of course, is dependent on the extra inventory working its way out of the system in the next six months. The other scenario involves demand waning so much -- such as in the case of a recession -- that chip companies' profit margins began to erode. Then they'll begin to lose money and cut spending sharply, forcing them to build fewer plants, which will cut supply.

All this will eventually bring supply and demand back in balance. But by then, it won't be 2001 anymore.

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