Demand for computers and microprocessors may be moribund, but that's not 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 in everything from DVDs to digital cameras to cars -- they represent a relatively less-risky play on the chip recovery now underway.

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

The comments helped stem losses for the group on a day when most chip stocks 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 2 cents, or 0.1%, to $31.99. The Philadelphia Stock Exchange Semiconductor Index 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 at least one of the three names among their top holdings. That's because fundamentals for analog semis are a lot more inviting than for microchips 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 month or 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 and voice. Because they're used in a wide range of products, they boast a relatively diversified revenue base, which helps in a downturn like the current one.

ADI, Linear Technology and Maxim generate at least 40% of their revenues from consumer and industrial customers, which helps to compensate for the weak communications and computing markets, noted Lehman analyst 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 as computer-concentrated as other semiconductors ," says Steve Pasbal, a manager for the ( SVBAX) John Hancock Balanced fund, who has stakes in Linear and Analog Devices. "And also, as the digital world grows, the analog world that it needs to communicate with grows with it. So there are market-expansion possibilities there."

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

"If we return to a world where buying companies with good business models matters, I think analog stocks will bubble to the top and memory will go to the bottom," says Banc of America 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 chip downturn 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, highly commoditized 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 are based on proprietary technologies, making them less vulnerable to price pressures, all three have seen margins drop by about 500 basis points or less, stated To in his research note. Meanwhile, some of the more commoditized semiconductor companies have seen margins slide as much as 2000 basis points.

Now valuations are improving, as investors have soured on the broad chip universe. Share prices of ADI, LLTC and Maxim have tumbled an average 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 their five-year medians, though the ratios remain above five-year lows.

Valuation Evaluation

Still, the proper valuation remains a matter of debate. "You don't buy stocks just because they're good companies. You buy them because you want them to go up, so valuation matters," says Banc of America's Lee. "Maybe you believe the well-run analog companies should have a valuation higher 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 probably wouldn't), it's hard to argue for much upside, he says. Because he thinks the valuation remains relatively rich, Lee doesn't have a buy rating on Linear.

To acknowledged that the pressure isn't off analog chipmakers yet. August could be another tough month for the group, given slowing business in Europe, and he believes more estimate cuts could ensue when 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 last month, when it recently lowered its profit outlook. If consumer purchases of electronics 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. To believes the group could see growth of 20% in 2003.

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