In Chips, It's Good to Be Analog in a Digital World

Demand for computers and microprocessors may be moribund, but that'snot the end of the story for investors in semiconductors.

Sales and prices of analog semiconductor have remained more stable. Because analog chips have so many uses -- they show up ineverything from DVDs to digital cameras to cars -- they represent arelatively less-risky play on the chip recovery now underway.

The downside is that many consider leading analog names too pricey. ButMonday, an analyst at Lehman Brothers upgraded three stocks -- AnalogDevices ( ADI), Linear Technology ( LLTC) and Maxim Integrated Products ( MXIM) --contending prices have fallen far enough to represent some decentbuys.

The comments helped stem losses for the group on a day when most chipstocks saw somewhat heavier selling. Analog lost 2 cents, or 0.1%, to$22.90, Linear was up 19 cents, or 0.7%, to $27.65, and Maxim was off 2cents, or 0.1%, to $31.99. The Philadelphia Stock Exchange SemiconductorIndex closed down 1.2%.

Lehman analyst Joseph To isn't the only one making the case for analog companies. Plenty of technology fund managers include atleast one of the three names among their top holdings. That's becausefundamentals for analog semis are a lot more inviting than formicrochips and memory; both of those areas are mired in price wars, with sentiment bleak because of the lackluster PC outlook.


Analog in a Digital World
Analog chips have a wide variety of end uses
Communications as % of End Market Computing as % of End Market Consumer as % of End Market Industrial as % of End Market
Analog Devices 30 20 10 40
Linear 33 28 5 34
Maxim 33 28 N/A 39
Source: Lehman Brothers

But although analog stocks have seen double-digit slides in the past monthor so, not everyone is convinced they're good buys yet.

Why Invest in Analog?

Analog chips work by digitizing real world inputs such as pressure andvoice. Because they're used in a wide range of products, they boast arelatively diversified revenue base, which helps in a downturn like thecurrent one.

ADI, Linear Technology and Maxim generate at least 40% of theirrevenues from consumer and industrial customers, which helps to compensatefor the weak communications and computing markets, noted Lehmananalyst To in his upgrade of the stocks. He rates them "overweight," and Lehman makes a market in shares of Maxim and Linear.

Analog chips "have a little more diverse end-markets; they're not ascomputer-concentrated as other semiconductors," says Steve Pasbal, amanager for the ( SVBAX) JohnHancock Balanced fund, who has stakes in Linear and AnalogDevices. "And also, as the digital world grows, the analog world that it needsto communicate with grows with it. So there are market-expansion possibilities there."

Investors also like analog names because, within the semiconductoruniverse, they've resisted the sort of commoditization that's turned thememory chip arena into a price battleground.

"If we return to a world wherebuying companies with good business models matters, I think analog stockswill bubble to the top and memory will go to the bottom," says Banc ofAmerica analyst Douglas Lee.

He described Linear Technology as "the best-run company I've ever come across" out of some 40 companies he's covered over the past seven years. Linear boasts gross margins of 74%, with net margins of 39%.

"In the midst of the worst chipdownturn in the history of the industry, that's unbelievable," says Lee."They have net profit margins that rival software companies."

By comparison, consider Micron ( MU), which grinds out capital-intensive, highlycommoditized memory chips: Its gross margins for the last quarter were 17%,with net margins of -3%.

Even during the chip downturn, gross margins for ADI,Linear and Maxim have resisted steep declines. Because their chips arebased on proprietary technologies, making them less vulnerable to pricepressures, all three have seen margins drop by about 500 basis points orless, stated To in his research note. Meanwhile, some of the morecommoditized semiconductor companies have seen margins slide as much as2000 basis points.

Now valuations are improving, as investors have soured on thebroad chip universe. Share prices of ADI, LLTC and Maxim have tumbled anaverage of 17% since June 27 for the three stocks upgraded by To,compared with a drop of 10% for the Nasdaq.


Finding Value
P/E based on 2003 Earnings 5-Year Median forward P/E 5-year Low Forward P/E
ADI 22 31 16
Linear 34 40 20
Maxim 27 40 20
Source: Lehman Brothers

All three of the stocks he upgraded carry forward P/Es below theirfive-year medians, though the ratios remain above five-year lows.

Valuation Evaluation

Still, the proper valuation remains a matter of debate. "You don't buystocks just because they're good companies. You buy them because you wantthem to go up, so valuation matters," says Banc of America's Lee."Maybe you believe the well-run analog companies should have a valuationhigher than the rest of the chip group -- but how high do you want to pay?The S&P is trading at 16 times forward earnings and Linear Technology is 32 times."

Even if investors think that premium is deserved (and many probablywouldn't), it's hard to argue for much upside, he says. Because he thinksthe valuation remains relatively rich, Lee doesn't have a buy rating onLinear.

To acknowledged that the pressure isn't off analog chipmakers yet. August could be another tough month for the group, givenslowing business in Europe, and he believes more estimate cuts could ensuewhen Analog Devices and National Semiconductor ( NSM) report earnings Aug. 15 and Sept. 4, respectively.

Also, in a sign of potential trouble, electronics retailer Best Buy ( BBY) warned that declining consumer confidence had hurt sales over the lastmonth, when it recently lowered its profit outlook. If consumer purchases ofelectronics equipment drop off, shares of analog-chip companies would certainly suffer.

But fundamentals have been on the mend since year-on-year revenue comparisons for analog chipmakers turned positive in June. Tobelieves the group could see growth of 20% in 2003.

They may not be cheap now. But analog chips could be the way toplay a semiconductor recovery over the longer term.

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