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Chips Stocks Test Investors' Fragile Faith

Semiconductors are holding up better than other sectors, but investor anxiety is building.

SAN FRANCISCO - Like a late-summer tropical storm, the dangerous winds of the subprime mortgage business and the volatile stock market have left a trail of debris.

For investors in chip stocks, the question now is whether the semiconductor industry's expected upturn will also join the list of casualties.

With its strong ties to consumer spending, the chip business is particularly vulnerable to a spending slowdown. And a credit crunch is never welcome news to the capital intensive semiconductor industry.

All of this has added a layer of anxiety to a picture that looked pristine only a few weeks ago.

The

Philadelphia Stock Exchange Semiconductor Sector Index

, which saw a big run-up ahead of second-quarter earnings reports last month, is off more than 8% from its 52-week high in mid-July.

But while some investors in chip stocks may be a little nervous, they aren't rushing for the exits just yet.

"Obviously, if this gets worse, it's tougher, so the environment is more uncertain," says Dan Niles, of Neuberger Berman Technology Management.

"But relative to other investible segments, I feel better about semis," Niles says.

Parnassus Investments President Jerry Dodson says he's holding his ground on semiconductor stocks such as

Intel

(INTC) - Get Intel Corporation (INTC) Report

and

Altera

(ALTR) - Get Altair Engineering Inc. Class A Report

, even as he slims down in other sectors such as retail.

Investors are taking comfort in the fact that chip firms are in the beginning of an industry upturn, as the inventory glut that stunted sales earlier this year abates. The recent batch of earnings reports confirmed that the recovery remains on track, with companies generally meeting Wall Street financial expectations.

Graphics chipmaker

Nvidia

(NVDA) - Get NVIDIA Corporation Report

offered a striking example of the changed business environment, when it disclosed late Thursday that its

internal inventory is actually too low and that the third-party chip manufacturers are capacity-constrained.

"We are just tight, and we know that the entire industry is tight, from PCBs to DRAMs to others," said CEO Jen-Hsun Huang in a conference call last week, referring to various semiconductor memories.

The inventory glut is ending during what it traditionally the best time of year for chip companies, with the back-to-school and holiday shopping seasons both on tap to juice demand.

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So far, the U.S. economy appears to be growing at a healthy pace, and employment figures are holding up, despite the stock market turmoil.

Moreover, the chip industry can fall back on its broad exposure to international markets in the event that fallout from the subprime mortgage collapse causes U.S. consumers to tighten their purse strings. According to the Semiconductor Industry Association, 83.5% of industrywide chip sales in the first six months of 2007 came from outside the Americas region.

More importantly, the electronics products the chips go into are big sellers overseas. Roughly 75% of worldwide PC sales occurred outside the U.S. in 2006, according to industry research firm Gartner. Buyers outside of North America snapped up 83% of all cell phone shipments in 2006.

"If demand stays fairly good, which it appears to be, and inventories are lean, I think there might be some restocking

by chip customers for the next six months," says Mike Binger, a fund manager at Thrivent Financial.

Even so, the chip industry's recovery may be more muted than in previous cycles.

In a typical semiconductor upturn, customers double-order from multiple chipmakers in order to guarantee their supply, creating big spikes in chip sales. In the current period of uncertainty, however, some industry-watchers expect chip customers to behave more cautiously.

This was already evident in the order book of chip giant

Texas Instruments

(TXN) - Get Texas Instruments Incorporated Report

, whose

second-quarter book-to-bill ratio was a respectable 1.0, but up only modestly from the prior quarter.

And not everyone is convinced that worldwide consumer demand will hold up.

American Technology Research analyst Doug Freedman wrote in a recent note to investors that there's no guarantee the U.S. credit squeeze won't spill over the borders, triggering a worldwide slump in consumer demand for electronic devices.

"Even though we could be in the final stages of cleaning out the communications and industrial inventory stockpiles, the other factors will be muted if consumer demand dampens," writes Freedman.

Meanwhile, chip companies looking to cut costs by unloading unwanted assets may have trouble finding buyers, given the tightening credit market, Freedman notes. He points to

Advanced Micro Devices

(AMD) - Get Advanced Micro Devices, Inc. Report

,

Micron

(MU) - Get Micron Technology, Inc. (MU) Report

and

LSI

(LSI) - Get Life Storage, Inc. Report

as firms that could have trouble selling parts of their businesses in the current business environment.

Chip stocks may be better off than their peers in other industries, but they're not completely out of the storm's path.