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Chips: Too Much of a Good Thing?

The so-called "Great Enterprise Replacement Cycle of 2004" may have an adverse impact on some semiconductor manufacturers, according to a research report.

In a newsletter to investors Tuesday, Merrill Lynch analysts Joseph Osha and Srini Pajjuri wrote that stockpiles of chips continue to grow, even though computer makers and their related suppliers are keeping their inventories in relatively better shape. Bottom line: keep your eyes on chip prices in the second half of this year as a result of the supply.

The last six to nine months have been good to PC and server manufacturers as many enterprise firms replaced systems originally purchased for the Y2K period.

According to Gartner , the number of desktop computers, mobile PCs and IA-32 servers shipped worldwide totaled 45.3 million units in the first quarter of 2004. The number represents a 13.4 percent increase from the same period last year.

But what is past looks like the present. Merrill's survey of 30 companies showed that between April and June of 2004 surplus inventories rose to 77 days, up from 74 days in the first quarter and 71 days in the last three months of 2003. Although the numbers are well below the peak level of 105 days reported in the first quarter of 2001, Merrill noted that the number of days with a surplus in semiconductor inventory rose for two quarters in a row after declining for 11 quarters previously.

"In dollar terms, aggregate inventory of $10.7 billion is within a whisker of the $11 billion peak reported in Q101," Merrill said. "Intel accounts for a significantly bigger piece of the pie this time around, at 30 percent of total dollar inventory as compared to 24 percent for [the first quarter of 2001]."

And even though Merrill heard several management teams during the most recent round of earnings calls suggest that the Q2 build was seasonally normal, Osha's and Pajjuri's look at the data suggests otherwise.

"The increase in inventories is very definitely not seasonal, in our opinion, despite numerous claims to the contrary during this season's earnings calls," Osha and Pajjuri said. "We think that the semiconductor industry has over-anticipated demand in the third quarter."

While an oversupply is generally beneficial for consumers because it drives down prices, too much of a good thing can be dangerous for the industry. Historically, high levels of inventory have driven more aggressive pricing from semiconductor firms as they struggle to bring inventory back down. Because of that, Merrill said the pricing is now a significant risk for the third quarter. Those companies most likely to feel the pinch, according to Merrill, are Intel, Broadcom, and Xilinx .

"We've said several times this past year that risk appears to be migrating back towards semi manufacturers, who have been forced to carry increased inventory levels even while their customers keep balance sheets lean," Osha and Pajjuri said in their report.

"Aggregate dollar inventories at semiconductor companies have been increasing for 5 quarters, albeit from an unusually low level. However, sales growth had been keeping up with the dollar increase until recently. Combined with lower inventories downstream and increasing revenue expectations, we thought that that inventory growth was appropriate, if a little risky."

The good news, according to the analyst firm, is that 2004 is not a mirror image of 2000, a time when inventories were built downstream from semi companies. During the semiconductor industry upturn that ended in 2001, inventories built both at downstream customers (OEMs , distributors, contract manufacturers and the like) and at semiconductor companies.

"The mountain of inventory combined with much lower revenue produced a two-year hangover much worse than anything we're likely to see again," Osha and Pajjuri said.

The report said it is reasonable to expect the semiconductor business to work inventories back to normal levels during the next two quarters. Merrill said the workdown will however likely result in lower manufacturing utilization rates for the intermediate term. "That's bad news for margins," the analysts noted.