More Chips On The Table

By Daniel Kadlec

You probably haven't given much thought to the growing number of computer chips in popular gadgets like digital cameras, cell phones, DVD players and those portable devices used to play downloaded music. Why bother? You don't need the recipe to enjoy the soup. But anyone struggling to understand what has been a remarkable turn in orders for semiconductors and the high-tech equipment needed to make them should take note: products such as cars and medical devices--from pacemakers to hearing aids--are taking up a lot of the slack left after the telecom bust. APPLIED DIGITAL SOLUTIONS' new VeriChip, for example, is injected under your skin and when scanned--say, in the emergency room--gives doctors a complete medical history. The semiconductor recovery won't be complete without renewed demand from traditional users such as CISCO and NORTEL. But if they kick in later this year, it could be a great time for the industry.

Already, chip-equipment and chipmaker stocks have taken wing. Shares of chip giant INTEL are up 71% since the Sept. 21 market bottom, while shares of APPLIED MATERIALS, the world's biggest maker of equipment used to manufacture chips, are up 76%--twice as much as the NASDAQ composite. Behind the surge has been a string of reports that chip inventories have been pared, and new orders are flooding in. From November through January, orders grew at an annualized rate double that of the same period a year earlier.

The demand has come mostly from manufacturers of PCs, next-generation cell phones and consumer electronics, including ever more sophisticated game consoles such as Xbox and GameCube. But telecom companies have stepped up their pace too. "Later in the year, we could see a real surprise," says analyst Chris Chaney at A.G. EDWARDS. "Someone like Intel could come in with a big order for new equipment." Chaney favors the equipment makers, which he views as better values than the chipmakers. The equipment companies' shares also tend to be earlier movers, because chipmakers must buy more equipment before they can produce more chips.

With computer chips used in so many products, new orders for them and for the equipment needed to make them faster and smaller serve as a leading indicator for the economy. A surge suggests that many manufacturers are ramping up. One risk: these stocks could drop 50% in a blink if the recovery is weak or delayed. And that's no long shot. Key clients like LUCENT remain financially strapped.

Meanwhile, the lift-off thus far has been more projected than real. "We've seen stabilization, but the end market hasn't recovered," notes analyst Jeremy Lopez at MORNINGSTAR. At Applied Materials, revenue will be down 40% this year, and the firm will earn just 25[cents] a share, Chaney estimates, compared with $2.39 in the peak year of 2000. It will be two to three years before earnings per share top the previous peak, he says. And you shouldn't own the stock unless you believe that will happen.

Given the recent run-up in chip and equipment stocks, and their often extreme volatility, the wise course may be to wait for a pullback before buying. Applied Materials, recently trading above $50, would be compelling below $40. Rival KLA-TENCOR, just added to the GOLDMAN SACHS recommended list, recently traded above $65 and would be attractive near $50. NOVELLUS and TOKYO ELECTRON are other equipment companies to buy on weakness. Also well positioned are TERADYNE (just added to the Goldman list), LAM RESEARCH and Netherlands-based ASM LITHOGRAPHY. In any case, plan on holding at least two years to let the semiconductor cycle play out.

Analyst Eric Ross at THOMAS WEISEL warns that among chipmakers, stocks of the big guys--Intel and TEXAS INSTRUMENTS--have got way ahead of themselves. He likes NVIDIA, MICRON TECHNOLOGIES and ANALOG DEVICES. Also attractive are Asian contract chipmakers, including TAIWAN SEMICONDUCTOR. If you prefer a mutual fund, FIDELITY SELECT ELECTRONICS is loaded with chip-related stocks. No fund like it comes close to its record: a 24.6% average annual gain for 10 years.