Sector Spotlight: The Future Looks Worse for Semiconductor Companies

Communications semiconductor companies have fallen apart so quickly it's hard to believe tougher days could be ahead. But that seems to be the case.

Blue-chip companies like Broadcom (BRCM Quote), Applied Micro Circuits (AMCC Quote), PMC-Sierra (PMCS Quote) and Vitesse Semiconductors (VTSS Quote) have all issued earnings warnings this quarter as their largest customers -- telecom companies like Cisco (CSCO Quote) and Nortel (NT Quote) -- have pulled back on spending.

And with the companies facing massive inventories and light demand from the telecommunications providers, it's unclear when the chip companies that serve them will turn around. For instance, Nortel may have to cut its estimates again, possibly because WorldCom (WCOM Quote) is planning to cut spending.

Indeed, a similar situation occurred at Broadcom, which this past week lowered guidance to a revenue decrease of 14% to 16% this quarter from the most recent quarter, citing order delays and a major cancellation by 3Com (COMS Quote). Broadcom in early February had said it was starting to wonder about its guidance, which was for more than 20% growth. In addition, Broadcom could be in for worse trouble. It -- and the Securities and Exchange Commission -- are reviewing the way it accounts for certain warrants issued to customers like 3Com. Those complications will be a negative for the stock, according to Salomon Smith Barney analyst Clark Westmont, who downgraded the rating to neutral from outperform. (Salomon hasn't done underwriting for Broadcom.)

Bad All Over

Broadcom's warning comes at a time when semiconductor companies have been struggling with steep inventories and decreasing consumer demand in the U.S., Europe and Asia. It started with the cell-phone chipmakers last summer, then the makers of microprocessors, dynamic random access memory and other chips used in personal computers, and finally the companies making chips for telecommunications and networking companies.

It's been the news of spending cuts among telecommunications companies that has driven down chipmakers' stock prices.

Sinking Semis Communications chip stocks have had a rough year so far.

Part of the problem, for Broadcom and the other chipmakers, is that not only is the present weak, but the future is very uncertain. "We do not currently have the visibility to be able to predict when this softness will abate," Broadcom CEO Henry Nicholas said in a statement last week, echoing what nearly every other chip CEO has said during the past four months.

But predictions are exactly what investors need, because by the time they realize that the fundamentals of supply and demand have turned, it's often too late to get in on a run-up of the related stocks. On the other hand, get in too early and the stocks could still fall sharply.

False Valleys

"My best guess, if I had to pin it down, is that things are going to remain weak at least through September. ... Maybe then, there will start to be improvements in the fundamentals," says Jeremy Lopez, an analyst at Morningstar. "Stocks are going to run ahead of that, but I think there's going to be false valleys."

Others agree. Following Broadcom's warning, Robertson Stephens analyst Arun Veerappan wrote that he thinks all of the bad news isn't out yet. "While the stock is down significantly since Jan. 26, we believe that the company's fundamentals have deteriorated much more than Broadcom has indicated (i.e., its core business of cable modem and set-top box chips), which could lead to further weakness in the company's stock," he wrote. Broadcom reported earnings on Jan. 26 and gave its guidance at that time for the quarter. (Robertson Stephens hasn't done underwriting for Broadcom.)

If Broadcom hasn't come down far enough, where does that leave the other large communications chip companies?

Vitesse on March 5 lowered its March quarter estimates to $150 million to $160 million from previous estimates of $180 million to $190 million. That's a 3% to 9% decline from the December quarter, compared with previous guidance of a 10% to 15% gain. Vitesse also trimmed its earnings-per-share estimate to 21 cents to 22 cents, down from an earlier projection of 26 cents to 27 cents. President and CEO Lou Tomasetta said the company had a loss of visibility among communications customers and that storage applications also were on the decline.

Falling Guidance

Applied Micro Circuits on March 1 lowered guidance on revenue to $125 million to $135 million in the quarter, a 13% decline from the previous quarter instead of the rise to the $175 million that the company had previously spoken of. CEO Dave Rickey said that while the company had noticed some order delays and cancellations earlier in the month, it had started to notice a decline in new orders. "Our top five customers have all preannounced and are driving numbers down," Rickey said recently. Those customers include Nortel, Cisco, Alcatel(ALA Quote), Lucent (LU Quote) and JDS Uniphase (JDSU Quote).

PMC-Sierra hasn't said a word about its earnings estimates since its Jan. 25 earnings report when it said first-quarter revenue would fall 26% to 31% to $160 million to $170 million from the fourth quarter. For the year, PMC-Sierra estimated growth of 30% if the company returns to growth in the second half of the year.

Of course, one can argue that for investors these aren't the only communication stocks in the sea. But even that may not matter.

"If you're looking for an area that's going to escape this, I don't think it's really possible," says Morningstar's Lopez.