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Chips Get Caution Flag

The run-up has investors wondering how much rally is left.

The details varied, but the plot was the same.

As if reading from one script, the chip industry's chieftains offered strikingly similar narratives in discussing first-quarter results and the state of the semiconductor industry.

The message: Sales tanked in the first quarter, just as they did for everyone in the business. But recent order trends suggest that the industry's latest downturn is history.

Texas Instruments

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CEO Rich Templeton epitomized the mindset when he said the inventory correction that has plagued chipmakers since mid-2006 has "

largely ended."

That was the kind of talk Wall Street was waiting for. Within days of the earnings season kick-off for chipmakers, the

Philadelphia Stock Exchange Semiconductor Sector Index

was on the move, eventually rising nearly 6% and breaking 500. The index was recently off a half-point to 505.15.

The chip rally outpaced the gains experienced in the broader indices, with the

Dow Jones Industrial Average

gaining 4.1% and the

Nasdaq

rising 2.2% during the same period of time.

PNC Advisors Vice President of Equity Research Bill Gorman says the excessive stockpiles of chips that were keeping sales in check appear to have been worked down in the first quarter.

Although the picture looks better than it did a few months ago, he's sticking with

Intel

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as his lone chip holding rather than rushing into the sector.

"A lot of the stocks have moved," says Gorman. "We have to be selective at this point."

What kind of legs the recent chip rally has left is hard to say. Already some investors see reasons to proceed with caution, despite the improved chip inventory levels.

"Frankly, I'm long a lot of semis, but I'm nervous as hell," admits one investor, who asked to remain nameless.

A couple of disquieting macroeconomic reports came out right around the same time that chipmakers were pointing to improving business conditions.

In April, the Commerce Department reported that the U.S. economy grew at a mere 1.3% in the first quarter, down from 2.5% in the fourth quarter. And on Friday, the Labor Department reported that U.S. unemployment crept up to 4.5% in April, as businesses added the lowest amount of monthly new jobs in more than two years.

All of these are worrisome trends for the chip business, which is increasingly dependent on consumer spending rather than corporate capital expenditures.

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Order books at many chipmakers filled up in the first quarter. But some investors question how healthy the demand actually is for chips.

"You have this mathematical issue of burning inventory for six months, so, of course, the next three months should look better," says the investor, who is long semiconductor stocks. "But then the question is: What is really the underlying demand?"

In other words, the sequential growth in sales that many chipmakers forecast for the current quarter could prove to be a one-time rebound rather than a reflection of booming demand.

Sales of the electronics products that actually use the semiconductors appear to have lost some steam of late.

Worldwide PC shipments increased 8.9% in the first quarter vs. 12.8% in first quarter of 2006, according to industry research firm Gartner. Total cell phone handset shipment numbers are not in yet, but some investors believe growth has slowed from previous levels.

This has hedge-fund manager Pat Adams hunting for short candidates.

As chipmakers bring down inventories and look to start growing again, they may find there really aren't any good markets that can provide that growth, says Adams, of Choice Investment Management.

"It's a demand problem, and it doesn't look like it's getting any better," he says.

And because many chipmakers have repurchased large chunks of shares in recent months, EPS has gotten a boost that isn't backed up by gross margin or revenue, says Adams.

"We've always been investors that look to the top line for confirmation," he says.

On that score, chipmakers still have a lot of room for improvement.

Intel CEO Paul Otellini recently told analysts that

sales will not grow as fast as net income for the next two years.

And while TI's outlook calls for a sequential increase in second-quarter sales, the company expects sales to remain below the $3.7 billion in revenue it rang up at this time a year ago.

Then there are names such as

SanDisk

(SNDK)

,

RF Micro Devices

(RFMD)

and

Broadcom

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that might not even see sequential revenue growth in the current quarter.

Even so, some analysts believe that the overall chip industry is on the road to recovery. Wedbush Morgan Securities analyst Craig Berger expects better-than-seasonal performance in the second and third quarters of the year and a seasonal fourth quarter for chip firms, despite fears of adverse economic conditions and some lingering inventory in the handset market.

"It is clear that chip fundamentals have bottomed and that business is inflecting higher with ramping order growth," Berger wrote in a recent note to investors.