In a stock market version of water torture, chip stocks have suffered a painful, drawn-out selloff over the past six months. The latest earnings season only accelerated the declines, with analysts seizing on reports of inventory buildups while they proclaim the semiconductor industry has hit a cyclical peak. Plenty of tech poobahs say that's reason to exit the sector with due speed, with a minority arguing that chip sales can keep growing in line with the broader economy. While the debate winds on, the uncomfortable reality is that no one sees a fundamental catalyst to end the selling until early August -- although a technically driven oversold bounce is possible, even overdue. "One of the problems right now is that this is seasonally a very slow period for chip companies," said Banc of America's Sumit Dhanda. Back-to-school business "is not going to pick up until early-to-mid August and then people will start to get a conviction as to whether it's positive or negative. My guess is it's a little negative." Though investors may be tempted by compressed price-to-earnings multiples, Dhanda argues that forward P/Es aren't especially trustworthy because he thinks analysts may reduce their estimates in the fall. Such an outcome would mean stocks are more expensive than they may seem on a relative basis. "If you really want to own these stocks -- and I acknowledge there's been a lot of carnage -- you have to get some comfort with the relative stability in estimates. The problem is we don't have that now," he said. Reflecting that gloomy view, the benchmark Philadelphia Stock Exchange Semiconductor Index has been mired below its simple 200-day moving average since April, save for a few short-lived rallies. On Thursday, the SOX closed at 411.19, up 2.9% for the day and 5.4% since its intraday low of 390.10 on Wednesday. But the index is down 19% since Dec. 31 and nearly 27% below its 52-week high in January.
With chipmakers from Intel ( INTC) to Broadcom ( BRCM) to LSI Logic ( LSI) reporting inventory builds, investors have understandably grown nervous about the potential for weakened third-quarter growth. But those in the bull camp point out that the second quarter's widespread inventory problems only reflect miscalculations on the supply side, not softness on the demand side.
Though Mosesmann acknowledges the views of what he calls "industry luminaries," he believes the current chip cycle has more in common with the seven-year cycle that lasted from 1989 to 1995 than the most recent chip cycle from 1995 to 2000, which was cut short by the surge of Y2K-related hardware buys leading up to the millennium.
Unrepentant Bulls and Industry LuminariesThough Intel suffered a drubbing after it reported news of a 15% surge in inventories, the company said demand is running "normal to slightly positive," in the words of Chief Financial Officer Andy Bryant. IBM ( IBM) said customer spending has continued to improve, while Dell ( DELL) recently raised its quarterly earnings guidance. Schwab Soundview analyst Hans Mosesmann thinks more evidence will surface over the next few months, showing "things are indeed OK on the demand front and we've just seen a slight inventory adjustment in the past couple quarters -- basically the chip guys overshooting off a low base." Mosesmann, an unrepentant bull, recently issued a note predicting the sector's growth cycle could last all the way until 2006 or even 2007. He recommends that investors who are looking at least 18 months out consider buying into the beaten-up group. Other industry pundits anticipate growth will continue, albeit at a slower pace and only through 2005. The Semiconductor Industry Association in June projected that semiconductor revenue growth will slow to just above 4% in 2005 from projected growth of 28% this year, with the industry hitting a mild downturn in 2006. The shape of that growth trajectory was endorsed Thursday by Morris Chang, Chief Executive Officer of lead global foundry Taiwan Semiconductor Manufacturing ( TSM). He expects 2005 industry growth of 8%, with revenue flat to down in 2006.
|Semiconductor Cycles: Peak to Peak |
(absolute revenue, in billions)
|Sources: Schwab Soundview Capital Markets and Semiconductor Industry Association |
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As of the second quarter of 2004, the existing cycle had been under way just short of four years, he pointed out -- suggesting it's reasonable to expect a few more years of growth. Even if chip-industry revenue growth were soon to peak, revenue could continue to rise, just at a slower pace. Mosesmann is encouraged by the fact that semiconductor companies have added capacity cautiously, meaning that the industry is unlikely to find itself suddenly overburdened with extra capacity. Outfits like Micron ( MU), Cypress Semiconductor ( CY) and Texas Instruments ( TXN) are all opting to outsource incremental demand to foundries rather than adding more internal capacity. For now he calls the current cycle "generic and characterized by a gradual broad-based recovery." But starting around 2006, Mosemann believes "a planetary alignment of major drivers" could fuel acceleration in demand, including:
Around then, Microsoft (MSFT) will debut Longhorn, which is shaping up to be "a silicon hog," he says. (On Thursday, Microsoft said it will release a beta version of the next version of its Windows operating system in the first half of 2005.) Intel will likely start to step up its promotions of the broadband standard known as WiMax. New game consoles from Sony (SNE) and Microsoft are expected to hit the market in volume. To be sure, the economy is a big question mark. "If we're going into a recession, then all bets are off. But if the global recovery continues, the direction of semi sales is up and to the right," said Mosesmann. He views Texas Instruments, on which he has a buy rating, as a diversified play on a continuing recovery. (Schwab doesn't do investment banking.) Although Mosesmann offers some interesting fodder for chip groupies who usually home in on the short term, few investors seem willing to go against the overwhelmingly negative mood on the group. Even swooning valuations haven't prompted much in the way of chip-stock bargain hunting. At this juncture, contrarian institutional investors seem to prefer the more bloodied chip-equipment sector. The S&P Semiconductor Capital Equipment Index is lagging the SOX, down off over 30% for the year, even as some investors argue that chip-equipment spending could continue regardless of what happens in the chip cycle.