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Chip Cheer Seen Closer

Some investors are seeing signs that the bottom in semiconductor stocks is nearing.

In the cyclical world of semiconductors, bad times portend good times.

So amid the bleak streak of earnings reports that rained down on the Street for the past month, some investors are cautiously preparing for better days.

It was hard to find much to cheer about in the fourth-quarter financial results. Sales were generally weak, with many companies having pared back their projections midway through the quarter -- and guidance for the current quarter looks even worse.

According to Wedbush Morgan analyst Craig Berger however, there are already signs that the first quarter may be the bottom of the industry's latest downturn.

Berger points to

On Semiconductor

(ONNN)

and

Microsemi

(MSCC)

, both of which served up worse-than-expected guidance for the first quarter. Management at both companies however also called the first quarter the cyclical bottom, projecting that business would pick up in the subsequent quarters.

That these comments are coming from chipmakers like On Semi and Microsemi is important, says Berger, since their customer base and vast catalog of chips mean they have a broad exposure to various end markets. Wedbush Morgan makes a market in shares of On Semi and Microsemi.

"We are clearly in the seventh or eighth inning of this global supply-chain inventory workdown," says Berger.

Citigroup analyst Glen Yeung sees another sign that chip inventories are being worked down. According to Yeung, chip unit growth in the fourth quarter was below unit growth for PCs and cell phone handsets -- a discrepancy that suggests the industry's chip glut is being drained, as electronic goods being sold are using chips from their own warehouses.

Excess chip inventory has been at the heart of the current downturn, as distributors and electronics manufacturers hold off on placing more orders until they reduce their existing stockpiles of chips.

The resulting slowdown in sales has been particularly acute at companies that sell analog chips used in cell phones and other electronic devices.

Texas Instruments

(TXN) - Get Texas Instruments Incorporated Report

, the world's No.1 maker of cell phone chips, described demand as

"unseasonably weak" in its fourth-quarter conference call, delivering financial guidance below Wall Street expectations.

Earlier this month,

National Semiconductor

(NSM)

, another big analog-chip maker,

cut its quarterly earnings projections. The negative revision was National's third in a row, and would represent a 22% falloff in its revenue from a year earlier, before the downturn began.

In the market for NAND flash memory chips, the situation is particularly ugly. The popularity of flash memory in new types of gadgets like MP3 players has lured the likes of

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Intel

(INTC) - Get Intel Corporation (INTC) Report

and

Micron

(MU) - Get Micron Technology, Inc. (MU) Report

into the market while prompting existing flash makers to increase their chip output.

With flash supply outrunning demand, prices have fallen off a cliff.

SanDisk's

(SNDK)

stock got slammed in January

when it reported that its average price per megabyte declined 62% year over year.

The prospects for NAND remain cloudy, as the

absence of a hot new gadget featuring flash memory means there's no significant new demand-drivers -- and thus no telling when the bleeding will stop.

But some investors are already sifting through the wreckage of other corners of the chip market in anticipation of the expected recovery.

Atlantic Trust SteinRoe analyst Fred Weiss says he's looking at high-performance analog, programmable logic and microcontroller companies that currently have low revenue expectations but high gross margins. Weiss believes that once sales pick up again, those companies will be better able to cover their fixed costs, leading to operating margin expansion.

Weiss reckons there may be another three to six months before the chip industry's inventory is fully depleted. But the stocks start to move before the bottom is established, he says.

"Everybody wants to know when the end is, and nobody wants to miss it," Weiss says.

Of course, this being February, the chip industry is also in its seasonal hibernation, following the end-of-year holiday frenzy. Barring a surprise in PC demand from

Microsoft's

(MSFT) - Get Microsoft Corporation (MSFT) Report

new Vista operating system, the coming months have scant catalysts on tap to lift sales or stock prices.

Some analysts predict the

Philadelphia Stock Exchange Semiconductor Sector Index

, which has been stuck in a 50-point trading range since mid-September, may even retreat some before any upward momentum comes from an improved inventory picture and back-to-school orders that typically come in around May.

Many chip stocks right now are priced nicely relative to projected 2008 earnings, says Wedbush Morgan's Berger. But given the slow time of year for the chip market, Berger believes that better entry points could present themselves in the next few months.

The semiconductor downturn may be nearing an end, but chip stocks are not ready to rally yet.