Chip Investors Skip Town

An amalgamation of ills and uncertainty in the semi sector has investors taking flight.
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Updated from 7:49 a.m. EDT

From suspicious stock-option practices to frightening inventory levels, investors have plenty of reasons to run away from chip stocks.

And run they have, as semiconductor companies of all stripes have suffered double-digit dips in their share prices, accounting for some of the biggest casualties in the market's overall slump.

The controversy over backdating employee stock options has battered the likes of

KLA-Tencor

(KLAC) - Get Report

,

Vitesse Semiconductor

(VTSS)

and

Brooks Automation

(BRKS) - Get Report

.

But they are hardly alone.

The correction has hit every corner of the chip sector, from microprocessors to memory, large-cap to small-cap. "Nobody is being spared right now," says Wedbush Morgan Securities analyst Craig Berger.

The Philadelphia Semiconductor Sector index has slipped by roughly 13% since the beginning of May. The

Semiconductor HOLDRs

(SMH) - Get Report

exchange-traded fund is off 12% over the same period, closing at $33.60 on Tuesday, above its 52-week low of $32.57.

The selloff comes in the wake of a relatively strong batch of quarterly financial reports from chip companies. With the exception of

Intel's

(INTC) - Get Report

well-known struggles, and even amid stalling desktop PC sales, many chipmakers boosted revenue and profits in the first quarter thanks to the consumer appetite for electronic gadgets such as cell phones and MP3 players.

But a spate of worrisome data points has snowballed in recent weeks, raising fears that the consumer electronics buying cycle, and the chip industry that depends on it, is nearing a peak.

"Consumer spending has been driving a lot of semiconductor growth these last couple years, and people are just worried that with energy prices being as high as they are that consumer spending is going to slow down," says Piper Jaffray analyst Tore Svanberg.

Rising prices of gold and copper -- both ingredients in the manufacturing of semiconductors -- and the possibility that the

Federal Reserve

will continue to hike interest rates round out the list of macroeconomic concerns that are spooking chip investors.

The view within the chip sector itself is equally troubling.

Svanberg says he believes bookings at chipmakers from distributors are starting to taper off.

"We don't know if that's just because inventories are adjusting from a pretty strong period in the March quarter, or anything to do with slowing end-market demand, but our sense is that distribution orders are substantially lower this quarter than last quarter," says Svanberg.

He recently downgraded

National Semiconductor

(NSM)

partly on those concerns, as well as other long-term issues affecting the company's growth.National Semi, whose financial calendar is different from that of most chipmakers, is due to report quarterly results in early June. (Piper Jaffray makes a market in shares of National Semi and has provided investment banking services to the company within the past 12 months.)

A look at the latest chip-shipment data from the Semiconductor Industry Association and A.G. Edwards, released early this month, offers some evidence of slowing growth.

According to the figures, total semiconductor unit shipments grew 24% year over year in March. That's less than February's 30% growth rate. In fact, March marked the lowest monthly growth rate of semiconductor unit shipments in the past six months.

Among the products whose growth decelerated in March were analog chips, digital-signal processors and NAND flash-memory chips -- all stars of the industry's consumer electronics makeover.

The SIA flagged inventory -- particularly in consumer-product segments -- as meriting careful monitoring going forward. Several chipmakers, including

Texas Instruments

(TXN) - Get Report

and

RF Micro Devices

(RFMD)

, reported that inventory levels have crept up in recent months.

Most in the industry say that inventories are being expanded to prepare for expected demand.

"There's always this risk that there's an inventory build going on out there," says Wedbush Morgan's Berger.

Although Berger says investor concerns over inventory levels are well founded, he says inventory is actually just getting replenished to normal historical levels after a stronger-than-expected holiday season.

Berger also says that advances in supply chain-management software mean that chipmakers are much better able to gauge the true demand for the products today than they were in the past, lessening the risk of an inventory glut.

Still, he says it's hard to predict the second half of the year, and with the industry entering the "summer doldrums," there's a dearth of near-term catalysts to turn things around for chip stocks.

This explains investors' cautious attitude, despite the increasingly attractive price points and multiples of many chip stocks at the moment. "We're kind of picking our spots, setting our limits and taking little nibbles," says J&W Seligman semiconductor analyst Sangeeth Peruri.

"I can't say we're loading up the truck, because there is uncertainty about the sector. We're heading into the summer season, which tends to be a fairly weak time for stocks," he says.

Peruri notes that many of the issues spooking investors today, like inventory levels and interest rates, existed four months ago yet had little impact on the rising prices of chip stocks at the time.

Expectations about the chip sector are now resetting from the overly exuberant levels of earlier in the year, Perururi says. And now that investor sentiment has turned, various issues are taking on greater, and more ominous, significance.

"It's really more symptomatic of the overall tape," says Peruri. "When people are bearish, everything's an issue."

And with a widening stock-option controversy hanging over the tech industry like a dark cloud, there's no telling when investors might turn positive on chips again.