Are Chips About To Dip? Probably. Semi stocks have gotten a bit too zesty lately. But we found three that are safe to snack on while you wait for the real comeback.
By Julie Creswell

(FORTUNE Magazine) – Over the decades chipmakers have learned to take a fair portion of bust with their booms. It's part of life for a product whose demand is tied to the ebb and flow of new technology. But the industry's dropoff in the past few years has been particularly brutal. After a stunning 2000, when worldwide semiconductor sales soared to a record $200 billion, the bottom fell out of the market in 2001. Revenues slumped more than 30% that year and stayed flat throughout 2002. Shares have been hit even harder. Names like Advanced Micro Devices and LSI Logic have fallen more than 80% from 2000 highs.

Analysts and investors in the sector, desperate for signs of life, latched on to the idea of a rebound late last year when bellwethers Intel and Texas Instruments signaled improving sales. That positive momentum has continued in 2003, as investors propel the benchmark Philadelphia Semiconductor Index up 17%, outpacing the 5% gain in the S&P 500 and even the 12% rally of the tech-heavy Nasdaq.

But investors should beware of confusing a short-term surge with a real recovery. Chips could well be ready for a dip. Valuations have soared in some cases to levels last seen in the late 1990s. (Texas Instrument trades with a price/earnings ratio of 67 times 2003 earnings.) And with revenue growth this year expected to be in the mid-single digits, the earnings needed to support lofty valuations may be pushed back. Why? For one, inventories are rising for some chip segments. There are also concerns about the impact of severe acute respiratory syndrome (SARS) on PC and cellphone sales in Asia and on the region's overall economy. Last, U.S. companies still seem hesitant to shell out cash on technology this year. "Investors got caught up in the momentum of the market, and the move up was strong," says Seth Wunder, an analyst at OppenheimerFunds. "But we've grown more cautious at these levels."

That said, there are trends forming that should drive real sales going forward. Research group IDC forecasts revenues to soar 16% in 2004 and 13% in 2005. Thus, any dive in the stocks this year could provide a good opportunity for investors to load up anew. Not all semi growth will be equal, however. Companies that make chips for the mobile Internet craze should grow at a much faster rate than those that manufacture memory or microprocessor chips. Furthermore, this industry typically grabs market share by slashing prices. So it's best to look for leaders or companies positioned to take share, which may offset any profit crunch arising from a chip price war. With that in mind, we found three stocks that seem fairly priced but, more important, poised for strong growth in the next couple of years.

If you're seeking a dominant player in semis, look no further than Intel (INTC, $19). The semiconductor giant controls a whopping 83% of the market for microprocessors (a PC's brain), and analysts expect that Intel's sales will be driven by the next corporate PC replacement cycle. That upgrade push, once expected to begin as early as this fall, probably won't happen until 2004.

After charging up 21% this year, Intel isn't cheap on a P/E basis. But using a different ratio of enterprise value (market capitalization plus debt minus cash) divided by free cash flow, Intel is actually a bargain, says Dan Chung, chief investment officer at Fred Alger Management. Intel trades at around 24 times 2003 free cash flow, while cash-generating giants like 3M and Coca-Cola trade at 25 and 29 times 2003 free cash flow, respectively. "Free cash flow is an important indicator [of good management] because it shows the ability of a company to generate cash in a down cycle," says Chung. And Intel put that cash to work, investing in R&D to enter new markets. This year it released its highly anticipated Centrino chip, which gives it a foothold in the fast-growing wireless chip arena.

Indeed, a business in store for explosive growth is Wi-Fi. Through laptops or handheld devices, individuals will soon be surfing the Internet wirelessly at their local laundromat or diner. "Consumer electronics and Wi-Fi are two of the brightest spots in the semiconductor industry," says Russ Craig of tech research firm Aberdeen. Unfortunately, plenty of companies have figured that out and hope to get a piece of the action. "About 45 companies make Wi-Fi chips, which means, even if there is growth in demand, prices will drop," cautions Craig.

One company, Intersil (ISIL, $19), stands out. Last year it acquired Elantec Semiconductor, which expanded Intersil's product offerings. Today it controls about 51% of the wireless chip market. No doubt it will come under attack as giants Broadcom and Intel elbow their way in. Says Alger's Chung: "We think the growth in the industry is strong enough that Intersil will do fairly well going forward."

If there's one semi segment everyone loves to hate, it's the DRAM market. That's partly because DRAM, which stands for dynamic random-access memory, is tied to the PC cycle, as the majority of DRAM chips go there. Plus, low-cost producers have flooded the market. But change is afoot. In April the U.S. and European Union imposed preliminary but stiff tariffs on South Korean semiconductor firm Hynix after they ruled that the chips were unfairly subsidized and had put global chip prices under pressure.

Hynix's woes could be an opportunity for Micron Technology (MU, $9), the largest memory-chip maker in the U.S. "Micron has been beaten up by investors because it's in the DRAM industry, but we see a pretty good floor on the stock at around $7," says Quinn Bolton, an analyst at Oppenheimer & Co. If the tariffs on Hynix are made permanent, that will constrain its ability to compete. Furthermore, technology changes should cause PCs to require increased amounts of memory. Says Bolton: "Within the next two years you could see a doubling in Micron's stock price." And that's the kind of "boom" chip investors were waiting for.