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The Starting Line: Predicting chip bottom may be pure folly

Wall Street has once again said it can't get much worse for the semiconductor sector, but the real question is: What will 2002 look like?

Merrill Lynch became the latest Wall Street brokerage firm to predict that the worst is over for the semiconductor sector, telling investors they should buy shares of the leading chipmakers--especially those focused on the wireless markets--before it's too late.

Sound familiar? It should. In April, Salomon Smith Barney analyst Jon Joseph said a "fundamental bottom" was only months away. Using the it-can't-get-much-worse theory of investing, Joseph upgraded the chip sector to "buy." Historically, chip stocks are cyclical, benefiting from interest-rate cuts and rallying before business conditions actually improve.

Joseph carried a lot of weight at the time since he was among the first to predict the chip sector would unravel last year. Since Joseph's call, shares of some of the chipmakers highlighted--Intel, Micron Technology and Texas Instruments--are up slightly from their April levels.

At the time, other analysts, notably Merrill's Joe Osha, said Joseph may have been a little early with his prediction. Indeed, if the chip stock train was leaving the station, you would have had enough time to run and catch it. A brief chip rally in April turned out to be a "false bottom," a temporary state of optimism where stock prices stabilize and gain only to fall again.

Now Osha and Merrill Lynch's global chip analysts have changed their tune, even though they are using much of the same logic Joseph did back in April. The big question is not whether the chip market is at a bottom--analysts agree it can't get that much worse--but what 2002 will look like.

"We think a combination of stabilizing earnings estimates, reduced capital spending and bottoming year-over-year change should cause semiconductor stocks to begin outperforming, albeit slowly, over the next six to 12 months," Merrill said in its report. "We believe the worst of the downturn is now behind us."

Merrill admitted that anecdotal evidence that the chip sector is recovering remains thin, but if investors wait until there are concrete numbers, it'll be too late. Indeed, Merrill said it could be mid-2002 before earnings improve. And the June sales tally from the Semiconductor Industry Association showed chip sales were down 8.8 percent from May and 30.7 percent from a year ago.

Texas Instruments
Stock price from August 2000 to present.  
Source: Prophet Finance

Nevertheless, Merrill said it's better to be early than late when it comes to predicting better times. Other analysts tend to agree. Wit SoundView analyst Scott Randall upgraded the semiconductor sector on Monday, noting that "beginning signs of stabilization and early signs of improvement are finally being seen."

Randall and other analysts acknowledge that the signs of recovery are weak, but their job is to make forecasts.

"At the end of the day, Wall Street is about predicting the future," said Paul Leming, an analyst at ABN Amro. Leming quipped that predicting that the chip sector has hit bottom isn't such a hard call because "if it doesn't hit bottom in the next month or two, it'll cease to exist."

Leming said he's holding off on predicting a chip recovery since companies have little visibility into the fourth quarter or 2002. "I'm much more concerned about the state of the world three quarters from now. What is important today is focusing on 2002," he said.

In its report, Merrill Lynch's chip analysts acknowledged those concerns, but said major companies have set the bar low enough for the third quarter, eliminating a glut of profit warnings. Capital spending has been cut and inventories are clearing out in most areas, except for communications chip companies.

Largely based on recent comments from Texas Instruments executives, who noted that orders were improving, Merrill touted shares of wireless companies such as TI, Analog Devices and RF Micro Devices. The brokerage house said it wasn't sold on Intel and AMD's prospects because of pricing pressure, nor on communications chipmakers such as Vitesse Semiconductor and PMC-Sierra, who are still digging out from an inventory glut.

Leming agreed that wireless chipmakers seem to be in the best position, adding that other parts of the semiconductor sector are likely to see pricing problems. In other words, there are a lot of lingering question marks.

"In April we were hoping that we had seen the worst and there would be some improvement in the fourth quarter," Leming said. "Now it's August 1, and judging from all the comments we've heard there's no sign that things are letting up."