Word of flagging sales at consumer electronics outfits should give chip investors pause. Stores such as Best Buy ( BBY) and RadioShack ( RSH), which sell a hodgepodge of computers, digital cameras and stereo equipment, have recently warned that their sales and profits will be lower than expected in the current quarter. That news could signal a further weakening of demand for semiconductors. A quarter of semiconductor sales go directly into consumer electronics and PCs. "Consumer sales is something we will be watching pretty closely because up until now, demand has pretty much been buoyed by consumer sales," says Shane Rau, a PC semiconductor analyst at IDC. "So if consumers are starting to pull back on spending now, that doesn't bode well for the third and fourth quarters." Best Buy
cautioned earlier this month that its sales had fallen below expectations over a four-week period, hurt by an across-the-board softening in demand for its computers and gadgets. The comment was worth noting because, with $6.9 billion in annual sales and 1,900 stores scattered throughout North America, the company is a sort of canary in the coal mine for consumer demand. Its sales hinge largely on PCs and gadgets. For the fiscal year ending in March, Best Buy drew 31% of its sales from the home office segment, which is made up primarily of desktop and notebook computers, and another third from consumer electronics such as TV sets, DVD players and cameras. In issuing the profit warning, Best Buy management referred to worries about slipping consumer confidence, commonly viewed as a harbinger of consumer spending levels. The Conference Board's index of consumer confidence dropped 8.6% between June and July, to its lowest reading since February. "Through the summer, consumer sentiment has weakened, and there are concerns that consumer spending on end markets that support chip sales will fall or slow down," says Tom Smith, an equity analyst at Standard & Poor's. Making matters worse, consumer demand seems to be flagging just at the time of year when it's most crucial. Consumers usually account for a bigger portion of tech purchases in the second half of the year, due to seasonal back-to-school and holiday season buying. Since 1998, back-to-school spending has helped push up demand for microprocessors by about 9% between the second and third quarters, notes IDC's Rau. "Normally we see that bump up, but it's not a given this year that we will see that same kind of rise." But third-quarter business at semiconductor companies looks weak, so far. Many chip companies still need lots of turns orders (bookings made and shipped out within the same quarter) to make their numbers for the current underway, says Smith. "It's still kind of thin ice out there. If the consumer doesn't go to the electronics shop, then everything could drop lower." Consumer gadgets -- not counting computers --account for a relatively small portion of the overall semiconductor market, measured in dollars. The segment was responsible for only about 6% of revenue in 2001. But until recently the sales of such gadgets had represented a bright spot in an otherwise sagging market. More importantly, about 60% of the total semiconductors sold end up in computers. And just under a third of those boxes are purchased by consumers, often at retail stores like Best Buy or Wal-Mart. The bottom line: Combined consumer demand for PCs and electronics can sway a sizeable portion of the semiconductor market. At this point, waning consumer demand is all the more worrying because, from a fundamental standpoint, the outlook for the biggest end market for chips was already somewhat precarious. Americans aren't exactly beating down the door for new hardware. "There's a high level of saturation in the consumer market," says David Daoud, a senior PC analyst at IDC. Plus, "the new technologies out there are not sufficient incentives for people to go back and buy new equipment." According to IDC data, the number of desktop PCs shipped to retail outlets nose-dived 69% between the peak in the fourth quarter of 1999 and the second quarter of this year. In the same period, laptop sales rose 6% -- not enough to offset the declines in desktops, which account for two-thirds of PCs sold.