A new report out Friday shored up claims that the semiconductor industry clings to a frail recovery. But that probably won't give investors much comfort, because the outlook for the rest of the year is still getting uglier.

In the June quarter, sales of semiconductors climbed about 6% from the prior quarter, according to a new report from the Semiconductor Industry Association, an industry trade group.

But a market fixated on worst-case scenarios focused instead on signs of trouble going forward. Late Thursday, National Semiconductor ( NSM) acknowledged its August-quarter sales would be flat with the May quarter, down from an earlier forecast of 6% to 8% sequential growth. It chalked up much of the shortfall to weaker-than-expected PC sales.

The next morning, on Friday, an analyst at Morgan Stanley warned that even forecasts for flat semiconductor growth this year may be too optimistic.

Investors responded by pummeling chip stocks. The Philadelphia Stock Exchange Semiconductor Index closed down 3.4% to 301, after dipping below the 300 threshold in intraday trading -- a level it hasn't visited since November 1998. As recently as March 8, the index reached a year-to-date high of 638.

Among the leading losers in chipland, Intel ( INTC) surrendered 85 cents, or 4.8%, to close at $16.71, and Nvidia ( NVDA) capped off a bruising week by losing 66 cents, or 6.6%, to $9.35. National Semi was down 25 cents, or 1.5%, to $16.88.

Chips Looking Up -- or Not?

In a research note out Friday, Morgan Stanley analyst Mark Edelstone said July likely will be the first time in 16 months that the global semiconductor industry posts positive year-over-year revenue growth. But that's not much comfort in the current market.

Citing expectations of weaker-than-expected GDP next year, Edelstone throttled down estimates for revenue growth. He cut his outlook to 15% to 20% growth in 2003 for the chip industry, from earlier projections of a sales increase of 20% to 25%.

He also raised the specter that chip sales could finish the current year in the red: "If end demand (particularly for PCs) doesn't improve or consumer spending begins to waver, we believe that our 2002 growth forecast for 0% to 5% will prove to be too high, and there could be additional risk to our new 2003 estimate."

Worse, Edelstone predicted more companies are on track to miss earnings estimates, given that earlier predictions or a more robust recovery now look unrealistic. "We believe that the back-end loaded nature of the third quarter has combined with weaker economic data points to promote a further increase in earnings risk," he wrote.

In its report on June quarter chip sales, the Semiconductor Industry Association acknowledged that demand for computer-related chips lagged, though sectors such as flash memory and digital signal processors showed double-digit sales gains.

The assessment of lame PC demand fits with other figures out this week that show worldwide PC shipments slipped slightly in the second quarter, compared with last year. Gartner Dataquest said Thursday that unit shipments were down 1% in the period, compared to 2001. Sales of notebooks held up better, with shipments up about 6% over last year.

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