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11/1/2002
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Taking Stock: Chipping Away At A Market Recovery

The top semiconductor segments will change this time around.

Humans have an inherent bias toward focusing on the positive and shutting out negative information. Watching the semiconductor market these days, though, is a reminder that sometimes business fundamentals just continue to get worse, despite our best efforts to see the bright side.

The overall semiconductor market will most likely shrink again this year. Next year might be slightly better profit-wise, but with below-average growth, according to IDC. Judging from company fundamentals and the earnings calls I've listened to, it might be late next year before much happens. For the most part, companies such as Intel and Texas Instruments paint a bleak picture.

This cycle also is shaping up to be different from previous cycles. In several segments, unit volume is increasing but the semiconductor companies have no pricing power and have seen average selling prices fall. The primary culprit is excess capacity at all levels in the industry. Taiwan Semiconductor, the world's largest semiconductor foundry, expects that capacity utilization will be less than 60% in the upcoming quarter. The situation is similar at Texas Instruments and other semiconductor companies. Let's look at some of the different market subsegments.

Anything related to telecom equipment looks weak. A glut of long-haul capacity in telecom networks, combined with bankruptcies of numerous alternative carriers and renewed fiscal discipline at the regional Bell level, have dashed any hopes of a near-term recovery in this sector. Suppliers of communication semiconductors and optical components will probably be some of the last to recover. This also appears to be the case for suppliers of components for wireless base stations.

Corporate networking appears to be doing only marginally better. There's some interest in upgrading networks to Gigabit Ethernet, but spending remains tepid on other parts of the network. A wild card could be wireless LANs, which, depending on adoption rates, could provide much-needed growth. The segment will probably recover in line with the industry as companies start to either upgrade or replace aging networking equipment.

The PC market is still relatively weak. If one believes Intel, Christmas season might not even provide much of a boost. Intel has cut prices aggressively to stimulate demand, but any increase in unit volume hasn't been enough to offset the price cuts. Texas Instruments also reported weak conditions in its PC peripherals business.

The only area where there's reasonable growth is the consumer segment. DVD players, digital cameras, and video-game consoles continue to sell at a rapid clip. Broadband adoption seems to be picking up speed, with the cable-TV industry recently reporting its best-ever quarter in terms of high-bandwidth subscriber additions. Cell phones also are selling reasonably well, even Nokia's new color-screen phones. Like the other segments, unit volume growth hasn't been followed by price increases, at least not yet.

A recovery in the semiconductor industry still appears some way off, though different subsegments will recover at different speeds. Trends in capacity utilization and average selling prices will be key to watch. What makes my job fun is that it looks like the real performers this time around will be completely different from the last cycle.

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

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