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Why it's time to dip into chips
Take another look at the semiconductor industry.
May 31, 2005: 3:35 PM EDT
By Paul R. La Monica, CNN/Money senior writer

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NEW YORK (MONEY Magazine) - Semiconductor stocks aren't for the faint of heart. Companies that make the brains for personal computers, cell phones, MP3 players and other electronic devices regularly cycle through booms and busts.

But if you can stomach the ride, these stocks can pay off big when you buy at reasonable prices -- like today's, for instance.

What the bulls say

The Philadelphia Semiconductor Index, or SOX, fell 15 percent in 2004 as PC sales slumped and analysts slashed earnings forecasts for chipmakers.

The worst appears over. Earnings estimates for Intel and other big players are heading up for 2005, and the long-term outlook is bright too. The 20 firms in the SOX are expected to increase earnings 18 percent annually for the next five years. PC and server sales aren't robust now, but demand for gadgets is.

"The consumer market will be the driver of earnings growth," says Tai Nguyen, an analyst with Susquehanna Financial Group.

This sunny picture isn't reflected in stock prices. Intel, Taiwan Semiconductor and Texas Instruments are expected to increase earnings at three times the rate of the average company in the S&P 500, yet trade at only a slightly higher price/earnings ratio.

As a group, stocks in the SOX were trading at 25.5 times earnings for the past four quarters, or 1.4 times the comparable figure for the S&P 500. Historically they've traded at about twice the S&P's ratio.

"Pessimism about the short term has created opportunity," says Bob Straus, manager of the Icon Information Technology fund.

What the bears say

Sure, the consumer-electronics market is red-hot, but Kevin Rottinghaus, an analyst with FTN Midwest Securities, thinks that alone might not be enough to keep chip assembly lines humming.

"You'd like to see better demand for PCs and servers to make sure the upturn is sustainable," he says.

While some analysts predict that businesses will start investing in computers after four stingy years, others think it's too soon.

Arnie Berman, senior technology strategist with CreditSights, is among the skeptics. He argues that many companies are waiting for Microsoft's next version of Windows, Longhorn, to come out before they upgrade. Since that won't happen until late 2006, Berman sees no reason to rush into chip stocks. This lag in the PC market, he says, "isn't really baked into earnings estimates."

Another uncertainty: how investors will react when a new accounting rule requiring companies to count the cost of stock options as an expense takes effect in June.

Many semiconductor firms are big options granters, so the rule will slice profits. Both Intel and Texas Instruments have said that their 2004 earnings would have been nearly 20 percent lower had they expensed options.

Bottom line

Options expenses and slow PC sales are risks, but chip stocks look like they have a safety net below them based on consumer tech demand alone. A rebound in corporate IT spending could send them soaring.

You can take a broad approach by buying the Semiconductor Holders Trust (Research), an exchange-traded fund, or ETF, that owns 20 of the industry's largest firms and that was recently trading at $32. You have to buy in 100-share increments.

For a focused bet, Nguyen and Straus singled out ATI Technologies (down $0.05 to $15.12, Research), which makes graphics processing chips for video-game consoles, cell phones and digital TVs. At $16.50 a share, ATI trades at 15.8 times fiscal 2005 earnings estimates -- cheap, given that long-term earnings are forecast to jump 20 percent annually.

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