SemiConductor Investing:
Ride the Semiconductor Craze

In the current market environment, the dot.com companies continue to lead the current market downslide. Many technology stocks also have followed the dot.com lead and continue to experience high volatility. Even stocks with strong fundamentals that continue to beat market expectations cannot break out of this downward sprawl. Market sentiment still hasn’t recovered enough to start a sustained upward trend.

Expect this condition to continue through at least part of the summer, when technology stocks usually perform poorly and earnings are rather stagnate. However, by the end of the fourth quarter and into the first quarter of next year, the market is poised for a rebound. The only thing holding the market back is the Federal Reserve. All eyes are on the Federal Reserve. The actions the Federal Reserve takes will dictate where the market goes from here and will have a profound effect on market sentiment.

Use this time to identify and research potential future equities to purchase. The expected or, should I say, predicted upturn in the market (especially the NASDAQ and the technology sector of the NYSE) during the fourth quarter, if not sooner, should be a time to sell your highly volatile and speculative equities. Although New Age Investors are aggressive, they aren't stupid.

Market segments and stocks that rode out the recent downward trending storm with relatively low volatility are the keepers. Several of these stocks are in the wireless sector (e.g., Nokia and Ericsson), as discussed in the previous New Age Investor article "Think Wireless Telecommunication Long Term."  Another promising sector is the semiconductor industry. Although some semiconductor stocks have experienced recent volatility, this market segment has a positive outlook.

Looking Forward
The semiconductor industry provides hardware to computer manufacturers, telecommunication equipment manufacturers, car manufacturers, and TV manufacturers (including high definition television), and is instrumental in the development of the World Wide Web. The semiconductor industry is known for its cyclic nature. Therefore, there is moderate risk involved with investing in this sector. However, the potential rewards for many stocks in this sector far outweigh the risks once adequate research has been performed.

The semiconductor industry has been on a wild ride lately. The Philadelphia Semiconductor Index, or SOX, is widely used to track the semiconductor industry. The Philadelphia Semiconductor Index includes 16 U.S. companies in both the capital equipment and chip-producing segments. Since the inception of SOX on December 1, 1993, the index is up over 600% compared to approximately 200% for the S&P 500 Index. This includes the recent downturn in the market. The year-to-date (YTD) price appreciation is better than 40%, the last six-month appreciation is better than 50%, and the one-year appreciation is better than 130%. A good way to see these kinds of returns is to invest in fundamentally sound semiconductor stocks.

The Semiconductor Industry Association (SDI), the sector’s leading trade group, announced that semiconductor sales reached 14.96 billion this March, a 33.8% increase from a year ago. This growth was fueled by sales in Flash, Digital Signal Processors (DSP), programmable logic, and standard cells. Flash memory sales posted the most dramatic increase, soaring 197.5% from last year. Programmable logic-chip sales increased 77.8%, DSP increased 52.8%, and DRAM increased 33.4%. Growth in the semiconductor industry is expected to continue for some time. Leaders of the world’s computer chip industry trade groups spoke recently at the fourth annual meeting of the World Semiconductor Council and stated that the growth of the Internet is expected to power a 10-year period of expansion for semiconductor companies. This estimate may be overly ambitious, but the fundamentals are present for a prolonged semiconductor expansion.

To better understand the semiconductor industry, it is first important to know that there are two general types of semiconductor manufactures: front-end and back-end. Front-end companies like Applied Materials (AMAT) primarily manufacture equipment that make and manufacture the wafers. The front-end companies ramp up early in the semiconductor cycle. AMAT is actually the leader in the semiconductor equipment manufacturing business called fabs. Back-end companies such as Credence Systems (CMOS)  develop semiconductor equipment that is needed after the chips are made. CMOS is a promising company whose products test digital logic, mixed-signal, analog, and nonvolatile memory integrated circuits used in such products as televisions, cars, PCs, telephones and cameras. 

Why is it important to understand whether a semiconductor company is primarily a front-end or back-end equipment manufacture? Since the industry is highly cyclical and the most recent semiconductor cycle is already more than 18 months old, you can see why. The front-end companies may do well for some time, but sooner or later the back-end companies will prevail. It’s not only important to understand if the semiconductor manufacturer is front-end or back-end, it is extremely import to track supply and demand in the industry.

When revenues at companies like AMAT start to decline, it's time to move out of the front-end companies and into the back-end companies. There already may be some indications that front-end manufacturers like AMAT are seeing a decline in their growth rate. AMAT reported earnings per diluted share of $0.55 for its fiscal second quarter, which ended April 30th. Revenues were $2.19 billion with over bookings of $2.93 billion. The company also displayed strong margin growth, including an increase in net profit of 74% versus the same time last year. Sounds good, right? Believe it or not, these numbers did not beat Wall Street’s consensus expectations for earnings, revenue or order bookings. The company did not meet the "whisper number" target set by many analysts. In addition, growth rates actually slowed sequentially in the quarter. The growth rate decline may be a warning that AMAT and similar front-end manufacturer growth rates have peaked.

Based on the possibility that the growth rate for some front-end semiconductor companies may have peaked or are nearing a peak, it is wise to invest in primarily back-end companies in the semiconductor industry at this point in the semiconductor growth cycle. It is even wiser to identify semiconductor companies that have a strong foothold in the Internet and wireless telecommunication industry since growth in these markets are in their infancy. By 2004, about 1.4 billion users will hook up to the Net via cell phones, according to an International Data Corp. report cited by SDI.

Semiconductor Picks
LSI Logic Corporation (LSI) is one of those primarily back-end companies that target the Internet and wireless telecommunication industries. LSI targets the fast-growing communications and network computing markets. The company designs and makes standard chips, as well as application-specific integrated circuits based on its CoreWare library of industry-standard building blocks. LSI specializes in piecing together different function on a custom chip (i.e., systems-on-a-chip). These chips combine the microprocessor, logic, and memory functions of an electronic system onto a single chip. Workstation giant Sun Microsystems is the company's largest customer. Recently, LSI has moved into the storage area network market with such products as storage servers and network management software. The company has operations in Asia, Europe and North America.

Sudeep Balain, a Senior Technology Analyst at Chase H & Q, states, "We have an $85-price target and a buy rating. If you believe the Internet is here to stay and is growing, LSI Logic is basically an enabler of the Internet, in our view. They have six vertical markets. Each vertical market makes products that feed into or enable the Internet. It a very good story, in our view." The point being, LSI has several vertical markets (i.e., revenue streams) related to the Internet.