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5 chip stocks that look like buys now
The conventional wisdom is that chip makers face a long list of woes in 2005. But the beaten down group's prospects are better than many believe.
By Robert Walberg
For a sector with solid fundamentals, chip stocks had a lousy 2004.
When all is said and done, the chip sector likely finished 2004 with year-over-year revenue growth of nearly 30%. Average selling prices were surprisingly strong, probably climbing almost 10%.
Despite such rosy conditions, the bellwether Philadelphia Semiconductor Index ($SOX.X) dropped nearly 15% last year. The disconnect between sales growth and sector performance can be attributed to a number of factors that left investors fretting, including excess inventories, slowing second-half growth and earnings that fell short of possibly overly optimistic expectations.
What to expect this year? Most brokerage firms place revenue growth in the 8%-to-13% range, while chip prices are expected to be flat to marginally higher. The list of issues that could hamper the sector is long:- A drop in memory prices.
- Ongoing inventory issues, especially in the flash and analog markets.
- A likely slowdown in growth for the microprocessor and digital-signal segments.
- A slew of fourth-quarter sales and earnings warnings. This will be especially true during the year's first half, when comparisons to 2004 will be more challenging. Growth in 2004 peaked at about midyear.
But Im encouraged by Wall Streets more cautionary tone about the chip sector. Tempered expectations, combined with some residual fourth-quarter profit warnings, have taken some of the steam out of the sectors late 2004 recovery try. The rally pushed the Philly index up nearly 27% from its 2004 low on Sept. 8, but the index has fallen back 8.2% in the last month.
In addition, many chip stocks sport price-to-earnings ratios below their five-year averages and near the low end of their five-year ranges. More often than not, this is the time to start buying rather than selling. Now is a good time to start increasing exposure to the group before investors begin to anticipate easier second-half comparisons, more balanced inventory conditions and improving earnings momentum.
The giant is starting to look like a buy
One stock that looks particularly attractive is industry titan Intel (INTC, news, msgs). Citing strong notebook, server and chipset sales, the company recently raised its fourth-quarter sales target. Intel also pleased investors by suggesting that inventories have been worked down and that factory utilization would begin to increase. Though offering no new guidance for 2005, improved sales, inventory and margin trends bode well. The stocks return on equity of 19.9% and dividend yield of 1.4% dont hurt, either.
Technical indicators mirror the improved fundamental tone, as Intel has rebounded nicely from its September low of $19.64 per share. Next resistance is in the $26 a share area, with penetration setting the stock up for a longer-term run at the $28 to $29 range.
Next up is QLogic (QLGC, news, msgs). When you think storage, think QLogic. The company produces the controller chips, management-enclosure chips, host bus adapters, fabric switches and management software that provide the connectivity infrastructure for every size of storage network. Sales over the past year have slowed from historical norms due to pricing pressures and a less favorable product mix. However, an upcoming array of new product offerings and expectations of a more stable pricing environment later this year suggest that QLogic is poised to extend its recovery gains.
Admittedly, the stocks P/E ratio of 22.4 is a bit steep relative to the group, but its strong financials and industry-leading position warrant such a premium. Investors should note that the company has nearly $8 per share in cash, no debt, operating profit margins of 37% and a return on equity of 15.4%. At the slightest hint of improved sales momentum, look for the stock to blow through minor resistance near $42 on its way to the $45 area.
Relative weakness in the analog market in the latter half of 2004 contributed to big price declines in stocks such as Analog Devices (ADI, news, msgs), down 19.1%, and Maxim Integrated Products (MXIM, news, msgs), off 14.5%. Two stocks that fared a little better were National Semiconductor (NSM, news, msgs), down 8.9%, and Linear Technology (LLTC, news, msgs), off 7.9%. Given that stocks that hold up best during difficult industry conditions often lead during recoveries, Ill add National Semi to the list of sector buys, as its valuations are a bit more compelling than Linears.
Improving business conditions ahead
Though industry conditions are apt to remain soft for the next couple of months, excess inventory should be worked off by the beginning of the second quarter. As the market begins to anticipate this improvement and seasonal patterns and soft comparisons begin to kick in, look for the news cycle surrounding National Semiconductor to improve as well. The stock trades at discounted multiples compared with its peers and its historic averages, but look for National Semi to make a run at the $22 area once industry conditions improve. Traders should note that National Semi also sports the most attractive chart configuration within the analog sub-group.
Finally, I continue to like flash industry leaders SanDisk (SNDK, news, msgs), M-Systems Flash Disk Pioneers (FLSH, news, msgs) and graphic-chip maker ATI Technologies (ATYT, news, msgs), all of which were featured in my Dec. 2 column, Happy Holidays for gadget stocks."
2 areas to ignore
Knowing what to avoid is as important as knowing what to buy, so here are two areas within the sector that should underperform. Concern over the inventory buildup in the dynamic random access memory (DRAM) market, and the potential for declining prices in 2005, suggest that it's best to avoid stocks such as Micron Technology (MU, news, msgs) and Taiwan Semiconductor Manufacturing (TSM, news, msgs), even though valuations there are among the best in the sector.
Investors will also want to shy away from the programmable-logic-device segment, as several stocks, including Altera (ALTR, news, msgs) and Xilinx (XLNX, news, msgs), recently warned of much weaker-than-expected results. Overall sales trends in this area have also been relatively sluggish compared with the sector.
Sector growth might slow in 2005. But with expectations more realistic and valuations near historical lows, now is a good time for selective buying in this beaten down, out-of-favor sector.
At the time of publication, Robert Walberg neither owned nor controlled shares in any equities mentioned in this column.
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