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Semiconductors at a Turning Point?

It doesn't take an Adam Smith or Alan Greenspan to see that the economy in general -- and the technology sector in particular -- has taken a Rocky-like beating in the past few months, with company after company lowering earnings and announcing restructurings. What's harder to see is when the numbers will claw their way out of the current trough.

For those seeking a sign, semiconductors -- the foundation upon which almost all hardware is built -- may be the indicator to watch, according to Goldman Sachs.

"Now that everybody understands that no place in tech is safe, we believe that it would take a more substantial economic meltdown to generate meaningful stock price downside from here (another 10 percent to 20 percent is just weekly volatility in semiconductors)," GS said in an investment research report it released Tuesday. "In that event, we do not see how non-tech sectors could continue to hang in as well as they have. Thus either way (economy bottoming soon or not), we believe that tech has a good chance of outperforming from here and that semiconductors will move first."

Still, the company indicated that the announcement of earnings cuts are probably a given in April.

"We believe that investors should start rebuilding positions in the sector, especially after the next round of earnings cuts in April," GS said in an investment research report it released Tuesday. "Yes, the fundamentals are awful with little sign of a turn, but sentiment is much more realistic than it was two months ago."

Merrill Lynch agreed with GS to a point, saying that weak end-market demand and inventory news is likely to put pressure on the sector in the near-term but that it is positive about the sector's long-term fundamentals. However, Merrill said it believed inventory levels were still too high, and cut estimates on a number of companies, including Applied Micro Circuits Corp. , Broadcom Corp. , TranSwitch Corp. , Exar Corp. , PLX Technology Inc. , and Conexant Systems Inc. .

But GS said it saw good things in Texas Instruments Inc. . It added the stock to its recommended list Tuesday with a 12-month target price of $46.

"TXN is arguably the major chipmaker most leveraged to the wireless communications market," GS said. "No segment of the electronics market is yet showing signs of recovery, but the wireless market got sick first, has had nearly a year to recuperate, and, in our view, is likely to be the first to recover."

It is, of course, impossible to talk semiconductors without tipping your cap to the big boy on the block: Intel Corp. There too, GS sees a hint of light on the horizon, though whether that light is false dawn or true it is a little early to say.

Intel -- the seventh largest company in the S&P 500 and the second largest company in the NASDAQ 100 (after Microsoft Corp.) -- in GS' words "hit the wall last September in what initially looked like a reaction to easing capacity constraints but later turned out to be an old-fashioned PC demand problem."

For Intel, a PC demand problem is a big problem: The company has more than an 80 percent unit share of the PC microprocessor market. But PC demand may be turning a corner.

"We are not calling bottom of the economy or the PC market, but we think that the PC business will turn north before most other electronics sectors do," GS said. "Since the advent of the 'Dell model,' PC component supply chains have been tight compared with other electronics sectors (notably the communications equipment side), and OEMs have been working on channel inventories for two full quarters now. Show us a better near-term PC market, even if it is just a return to sleepy (but positive) long-term growth, and we will show you a stock (Intel) that throws off the many concerns held by investors at the moment and rocks and rolls."

And data out of Asia, and some news from Micron Technology, indicate that there may be cause to hope for a return to growth in the PC market. GS said the news from the Taiwan motherboard establishment and Asian test/assembly houses is that business picked up in February, though Goldman Sachs' Asia Pacific Technology Research Team warned not to read too much into the pickup. But Micron Technology reported in its recent conference call that it is now seeing 'true demand,' indicating that PC OEMs' have worked down their DRAM inventories to the point where they are reordering DRAMs in line with their actual consumption.

Also, like most other firms, GS is of the opinion that corporations which upgraded early for Y2K will not be able to hold off another upgrade cycle much longer. And GS suggested that Windows 2000 implementation may help drive that trend.

"The economy has no doubt put lots of corporate Windows 2000 upgrades on hold, but we suspect that the implementation budgets will come back when the headwinds relent," GS said. "By 2002, some of those PCs that were upgraded in 1997-1999 in preparation for Y2K will be getting long in the tooth."

GS also noted that the tech sector's troubles may have provided Intel with an upside by camouflaging some of its Pentium 4-related problems.

"The P4's large die size hardly matters when Intel's capacity is underutilized," the firm said. "The P4's Rambus ball and chain should be relieved by SDRAM- and DDR-supporting chipsets to be introduced by Intel and at least three licensees in 2H2001. By the time investors expect anything interesting from Intel financially, the company will be close to moving P4 to 0.13 micron and prepared to capture upside demand."

GS rated Intel a market outperformer with a $36 price target.

Meanwhile, the programmable logic (PLD) space may also be an area to watch.

"PLDs usually mark the infection point in semiconductor cycles, but this is a harder call for the next recovery, given the hangover in the communications space," GS said.

The three PLD players are XILINX Corp. , Altera Corp. and Lattice Semiconductor . GS called XILINX the top of the heap, with one of the best business models in semiconductors. The firm rated it a market outperformer with a 12-month target price of $61. Altera, the leader in the PLD space until 1999, may be looking at an upswing. GS said XILINX still has the upper hand, but Altera has a number of interesting product families coming in 2001 that may change the balance yet again in 2002. GS rated it a market outperformer with a 12-month target price of $32. Lattice, meanwhile, is hovering near its historical cyclical troughs, which GS said gives it enthusiasm for the company. The firm rated Lattice a market outperformer with a 12-month target of $26.

LSI Logic Corp. is another company hovering near the cyclical troughs it hit in 1996 and 1998. The company is a key player in the custom logic (ASIC) market, with only a handful of competitors, according to GS. The firm was hit hard by the downturn because it is a capital-intensive operation. GS assigned it a market outperformer rating with a 12-month target price of $23.

Meanwhile, GS is still waiting for the other shoe to drop in the analog semiconductor space.

"The analog semiconductor segment nearly always gets hit last, and we are waiting for that to happen, and we think probably soon," GS said.

GS is watching National Semiconductor Corp. , Linear Technology Corp. and Analog Devices Inc. . GS rated all three as market performers. The firm noted that NSM's valuation is "in the basement," which indicates that it probably has limited downside at this point, but also noted that it will wait for clear signs of a fundamental turn before becoming more aggressive. GS said Linear has a high-performance analog business model that is hard to beat, but also said it does not believe that estimates for the March quarter reflect the seriousness of the downturn. Finally, GS said it believes ADI is a far stronger company now than in past downturns, but also noted that EPS estimates probably need to come down.



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