2HRS2GO: Chip stocks still costly

COMMENTARY--Not cheap enough.

Many technology investors would like to hear a different phrase, but there's no point in putting a happy face on a horror show. Tech stocks have plunged over the past year, but if history is any indicator, many of them still have room to fall.

"You and the rest of these so-called analysts are a bunch of idiots," a reader wrote in an e-mail message yesterday. "You can not determine the fair price of technology stocks as you do with the old economy stocks. These tech companies are changing our lives and are worth a lot more than a company like Alcoa who produces aluminum. When will you f*****g idiots get this into your empty skulls?"

Leaving aside the fact that few products have changed our lives as much as aluminum, I'm amazed that there are people who still think this way.

There is no New Economy or Old Economy. There is only The Economy and The Market. Stock prices in optimistic times generally reflect expectations of strong growth. Unfortunately, the economy isn't growing as rapidly as before, demand for technology products has fallen precipitously, and equity prices are starting to reflect that.

This is not a secret to anyone, except folks like our aforementioned e-mail correspondent. But some observers are thinking that tech stocks might be bottoming out these days.

Don't take that bet, because in many tech sectors, stocks continue to trade at higher valuations than in previous downturns. Take the chip sector as an example.

Banc of America Securities' new chip analyst, Doug Lee, began coverage of 14 semiconductor stocks today. He rates all of them "market performer"--meaning don't buy the stocks--even though the whole lot already has given up much of its peak value.

Lee pointed out that the Philadelphia Semiconductor Index, or SOX, has beaten the tech-heavy Nasdaq Composite Index by a wide margin during this downturn. So far this year, the SOX has gained 7 percent, while the Nasdaq has lost 22 percent. The gap increases if you zoom out: The Nasdaq is down 13 percent from its level at the end of 1998, while the SOX remains 76 percent higher.

Talk about defying reality.

"Sentiment appears to be driving the group's out-performance, not fundamentals" wrote Lee, who led Goldman Sachs' technology research team in Asia before coming to Banc of America in February.

If anything, semiconductor companies might be suffering more than the rest of the technology industry, because hardware firms bought too many chips last year. Manufacturers and their subcontractors have plenty of inventory to clear before they'll start buying more silicon.

Banc of America estimates global chip sales in the first three months of this year will fall 20 to 30 percent from the December period. Semiconductor sales will slide 15 to 20 percent for the year, Lee predicted.

But the rest of the tech market probably won't fall as much. "We do not believe the semiconductor end-markets are falling off as rapidly as actual semiconductor shipments," he wrote in a research note released today.

Among previous slow periods in the chip industry, ྕ-ྖ most resembles the current situation, Lee said. That period saw a steep decline in sales of equipment to end-users, and preceded a U.S. economic recession. Sounds familiar doesn't it? The presidents even share the same surname.

Lee cited statistics from market research firm IC Insights showing that the United States produced $68 billion worth of computer hardware in 1989--or more than was made four years later in 1992, when computer equipment production totaled $67 billion. "We wonder if the sector may be heading for a similar extended slowdown," Lee wrote.

Faced with a future that has more gray tinges than rosy colors, chip stocks have no business trading so far above the Nasdaq. Lee estimated the companies he covers currently trade at an average of 5.8 times more than their book value. Over the previous 10 years, their price-to-book ratio has been 4.3. Their P-B average during the last industry downturn in 1998 was 4.2, although they dipped to as low as 2.6 at one point during that period.

Whichever benchmark you care to use, one thing is clear: chip stocks have more room to fall.

Although Lee doesn't recommend any chip stocks at the moment, he does see some stocks that might withstand the slowdown relatively well, including Semtech (Nasdaq: SMTC), Linear Technology (Nasdaq: LLTC) and Micrel Semiconductor (Nasdaq: MRCL). Notice that they're mainly medium-sized makers of analog signal devices--not terribly exciting or cutting-edge, but established businesses with low fixed-costs and many proprietary products with long life spans. They're reasonably stable businesses.

Other companies that Lee thinks might hold up better than others include Advanced Micro Devices (NYSE: AMD). "Their processors have been well-received," he noted.

Companies he thinks could take especially hard hits are companies with heavy manufacturing capacity of their own, such as DRAM (dynamic RAM) makers. "I'm a little wary of naming names because I don't want these companies to get mad at me," Lee said this morning, before laughing nervously and proceeding to name Micron Technology (NYSE: MU) ("They're a well-run company, but demand in their end markets still looks pretty soft.") and LSI Logic (NYSE: LSI).

Not that Lee thinks any of the companies he covers will go out of business. He chooses to follow them because he thinks they all have good potential in the long run. You can say that about most of the major names in the technology industry.

But that's not a reason to buy their stocks right now. 22GO >