April 9, 2001

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Taking $tock:
Semiconductors: the barometer for high-tech turnaround

A sales upturn will show when spending is set to rebound.

By William Schaff   (bschaff@bayisle.com)

he questions I hear most often these days range from "Where is the bottom for technology stocks?" to "Will they recover during my lifetime?" Most of the technology world is enveloped in doom and gloom. However, technology won't go out of fashion, and, in the long run, we know technology capital spending will continue to grow--not at the mind-boggling rates of the '90s, but yes, technology stocks will rebound.

Let's turn to the more important question of timing. This might sound crazy, but semiconductors are the area to focus on, even though they've been one of the hardest-hit technology sectors during the Nasdaq bear market.

Communications semiconductors in particular have been mauled. PMC Sierra, a maker of semiconductors bought by Cisco Systems, Lucent Technologies, and Nortel Networks, is down 91% from its 52-week high. Applied Micro Circuits, which makes similar semiconductors, has fallen 87%. Some well-known and widely held companies such as Texas Instruments have also experienced a decline to the tune of 69%. Intel, the leader of the semiconductor pack, is down 66% from its 52-week peak.

Before you toss this magazine in disgust, let me explain why semiconductors are worth keeping a close eye on. During the past de-cade, they've become an integral part of numerous products, and the amount of semiconductor content has been increasing. Semiconductors go into PCs, of course. But they also show up in cell phones, digital cameras, cable-TV set-top boxes, game consoles such as the Sony PlayStation II and Microsoft Xbox, MP3 players, PDAs, cars, LAN switches, and a host of telecom equipment. Because semiconductors are part of so many products with so many different markets, an upturn in their sales will be an indication that consumers and companies are willing to spend money on technology.

But not all parts of the semiconductor universe are created equal. Semiconductors for communications will probably languish longer than most other areas. The explosive growth in this area from 1996 to 2000 was driven by an unprecedented growth spurt in spending on telecom equipment. In hindsight, a good chunk of this spending was excessive. While these excesses are being digested, the appetite for telecom equipment will be limited--and with it the appetite for communications semiconductors. As a result, companies such as Applied Micro Circuits, PMC Sierra, TranSwitch, and Vitesse will turn upward later than other areas.

The wireless industry is suffering from most of the same woes as telecom equipment companies. In addition, it will see a delay in the deployment of next-generation wireless networks. Semiconductor companies with too much exposure to wireless will find revenue growth tough to come by over the next 12 months.

Semiconductors used in various consumer products will probably experience the first uptick in demand, along with the more commodity-oriented chips. This is where my attention will be focused.

In the next few weeks, most companies will be reporting earnings for the first three months of the year. Brace yourself for miserable earnings reports, but the conference calls will provide lots of data points. Inventory levels both at the semiconductor companies as well as at the end customers will be important. The pace of the continued decline in sales and the booking numbers will be data points to monitor.

Bottom line: Is it time to buy? Unfortunately, most semiconductor stocks still look expensive by historical measures. Take Altera. At the nadir of the last semiconductor cycle, its stock price bottomed at four times the last 12 months' sales; it's now trading at 6.5 times. Another example is LSI Logic, a manufacturer of custom logic, which is trading at two times the last 12 months' sales, double the valuation at the last trough.

I look forward to more weakness in the sector over the next couple of months, but the stocks will probably see a recovery this fall. Be patient and you can still make money investing in technology. And, remember, price does matter.

William Schaff is chief investment officer at Bay Isle Financial Corp., which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com.

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