ANALYST WATCH: Applied Micro pundits play guessing game

5 min read

COMMENTARY--It's fitting that Applied Micro Circuits shares enjoyed one of their biggest single-day gains in months on the same day that an analyst downgraded the stock and cut its fiscal 2002 earnings estimate.

Instead of buying on the rumor and selling on the news, investors have adopted a new strategy of selling on the rumor and buying on the delayed confirmation of bad news.

On Thursday, the communications chipmaker watched its stock shoot up 22 percent even though Robertson Stephens analyst Arun Veerappan cut the stock from a "strong buy" rating to a long-term "accumulate" recommendation and chopped its earning target for next year from 38 cents a share to 36 cents a share.

"On the demand front, it appears that March has proven to be another tough month for communications components companies, following what was clearly a weak February," Veerappan wrote in a research report. "Most communications components companies indicated that their customers continue to be silent in their ordering to the extent that some of the past weeks have seen no net bookings."

Despite this ominous—albeit tardy—warning, the stock managed to scamper up $4.44 a share, a textbook example of a dead-cat bounce if there ever was one.

In fact, Applied Micro Circuits (Nasdaq: AMCC) and fellow chipmakers Broadcom (Nasdaq: BRCM) and PMC-Sierra (Nasdaq: PMCS), up 19 percent and 18 percent respectively, all enjoyed strong gains Thursday while the Dow Jones industrial average was in route to closing below 9,400 for the first time since March 3, 1999.

"The question is how much of this bad news was already factored into these stocks," said Peter Andrew, an analyst at A.G. Edwards & Sons. "All these stocks have been beaten down lately. But there's always going to be demand for more bandwidth. It's just a question of when."

When indeed.

All three of these stocks were among the Nasdaq's high flyers back in the good old days of 1999, trading at insane multiples somehow rationalized by the unknown potential of the Internet and an insatiable demand for high-speed data communications equipment.

Applied Micro was trading at $109.75 in October and actually managed to stay above $80 in January before succumbing to the selling avalanche that had already engulfed most of the technology sector.

PMC-Sierra was cruising along at $246.25 in August before reaching its nadir of $29.75 this week. Broadcom's stock chart roughly mirrors that of PMC-Sierra, storming up to $274.75 in August before shrinking to $30.44 earlier this month.

Most of the companies' problems are a direct result of network-equipment makers such as Cisco Systems (Nasdaq: CSCO), Nortel Networks (NYSE: NT) and Lucent Technologies (NYSE: LU) slamming on the brakes for new equipment orders in the past few months, a trend that's likely to continue for at least the next two quarters.

"I just met with (Applied Micro executives) this week and I believe the (second) quarter will be flat compared to what's already looking like a tough (first quarter)," Andrew said. "It really all depends on what Cisco says in the next couple weeks. If it sees things improving sometime in the future, you can expect these stocks to react."

Applied Micro shares have been victimized by a steady stream of downgrades in the past month, mostly in response to the company's cautious outlook for the next couple of quarters.

"Guys are starting to realize that the second quarter is going to be bad but there could be some improvement in the third quarter," said Aalok Shah, an analyst at Pacific Crest Securities. "I rate the stock a strong buy but you have to take that with a grain of salt. They're the leader in this space but I wouldn't recommend investors aggressively buy the stock today."

But let's not get ahead of ourselves.

Applied Micro still has to report its fourth-quarter, which ends this month, before anyone can draw any significant conclusions about the first quarter of fiscal 2002 much less the second and third quarters.

Paul Brandeis, an analyst at Needham & Co., initiated coverage of AMCC with a "hold" recommendation last week and said it and other communications chip and equipment manufacturers are likely to see more pain in the immediate future.

"As a whole, the communications chip space will lay behind any recovery in the overall economy," he said. "But this has never happened before in this sector so it's difficult to predict how long it will take for these companies to recover."

It wasn't that long ago (mid-January in fact) that Applied Micro hurdled analysts' estimates by a couple cents a share in its third quarter when it earned $48.1 million, or 16 cents a share, on sales of $143.3 million.

At the time, Chief Executive Officer David Rickey reiterated the company's guidance for the next two quarters, citing "robust" bookings while warning of "some push-outs and cancellations" in the first couple weeks of the fourth quarter.

Then Rickey appeared on CNBC in early March and casually dropped the bomb that his company would miss estimates this quarter during a feature interview that was to be broadcast the next day.

If business conditions could deteriorate so drastically in just a scant six weeks, how could Applied Micro executives—much less the sell-side analysts following the stock—be so confident about their projections for even the current quarter?

Now analysts are projecting a fourth-quarter profit of 9 cents a share on sales of $121.8 million. That might be disappointing to shareholders but keep in mind this company only earned 3 cents a share on sales of $31.6 million in the year-ago quarter.

"These guys play at the high end of the market," Andrew said. "And look at the gross margins, around 75 percent for this year. That clearly demonstrates their parts are not a commodity by any stretch of the imagination."

For the next few quarters, it's obvious investors will have to use their imagination to visualize a point in the distant future when Applied Micro shares regain the momentum and valuation that they became accustomed to in the waning days of the bull (some might add another adjective here) market.

"Back then, the thought was Applied Micro and other communications chipmakers would get through a downturn because of all the excitement surrounding the Internet craze," Brandeis said. "In hindsight, we've learned that this obviously isn't true."