Holiday Cheer Eluding Chips

While most chipmakers have wrapped up their quarterly earnings season, it's the holiday season that is already looming large for investors.

With the semiconductor industry's fortunes tied more than ever to consumer spending, the holidays will prove critical to maintaining the sector's momentum. But for many investors, what they saw in the recent spate of quarterly earnings reports didn't make for reassuring reading.

"There's certainly apprehension as we close out the year of some further slowing down within the industry," says Bill Gorman, vice president of equity research at PNC Advisors.

Although profit growth showed strength among chipmakers in the third quarter, top-line revenue was less impressive, with Intel(INTL), Texas Instruments(TXN) and LSI Logic(LSI) landing at or below expectations. More significantly, many companies guided down their forecasts for the fourth quarter.

"Clearly, the orders for a lot of the companies lightened up a little," says Douglas Whitman, the president of Whitman Capital, a tech-focused hedge fund. "I think people are very concerned about what consumer demand is for Christmas. We're still growing, but we are in the fourth quarter, which is normally a seasonably good [one]."

As of Thursday, the Philadelphia Semiconductor Index was down 7.5% from its 52-week peak, but has fought back to its level of a month ago as the tech sector began to rally in the past two weeks.

However, little of the news in the past few weeks has suggested a further move higher.

After a strong 2004, in which worldwide revenue in the chip industry grew nearly 30%, the current year is on track to produce a more moderate 6% growth rate, according to the Semiconductor Industry Association. And the sector's 800-pound gorilla, Intel, said sales for the fourth quarter would be less than expected, due in part to a $100 million surplus in inventory that accumulated in the third quarter.

It's still unclear whether Intel's recent woes are due to competitive pressure from Advanced Micro Devices(AMD), which boosted its financial numbers and its market share in the quarter, or to weakening consumer demand for PCs in general. But with Microsoft's(MSFT) next-generation operating system, Vista, not scheduled for release until mid to late-2006, it seems consumers will have little incentive to upgrade their machines this Christmas.

However, not all consumer demand is created equal.