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Chipmakers are looking at one of their best years in 2004. That's why you should avoid them--with certain exceptions

Christmas came early for chipmakers. Personal computers, cell phones, DVD players and other silicon-powered gadgets have been sailing off the shelves. Intel, Texas Instruments and National Semiconductor raised sales and profit estimates in the past two months. Flash memory buyers are scrambling to find what they need, and capacity utilization is revving up to around 90%, from 82% at the beginning of 2003. That might not sound like much, but 90% is where price increases start to take hold. Those few percentage points can mean the difference between a profit and a loss.

"We're making more chips than ever," says Fred G. Ramberg, a former chip equipment executive who now advises hedge funds about the industry. Worldwide semiconductor production, 23 billion integrated circuits last quarter, now exceeds its rate in the previous peak, in third-quarter 2000.

All this, paradoxically, makes for a bad time to buy chip stocks. They anticipated the volume upturn and have had their run. In early December the Philadelphia Semiconductor Index was twice its February low. The biggest surges have come from companies making low-end chips used in consumer machines ranging from TVs to autos: National Semiconductor, for instance, has nearly tripled since last winter. Price/earnings multiples, where they are not meaningless by dint of losses, are dizzying. National Semi goes for 141 times trailing earnings. Try to make some sense of these prices by looking at enterprise multiples (equity market value plus debt minus cash, all divided by earnings before interest, taxes and depreciation) and you still have to conclude that the business valuations are quite steep (see table, below). Bear in mind that enterprise multiples deserve to be lower in this field than in, say, publishing, because capital expenditures are a real cash drain. Semiconductor manufacturing gear wears out or becomes obsolete in the space of a few years.

The Charge of The Chips
Their stock prices are up near their highs while valuations, as seen by enterprise multiples, show how pricey they are. And the shorts are largely staying away.
 
  -----PRICE-----  
Company recent 52-week high 1-year change Enterprise multiple Short interest*
Advanced Micro Devices $15.27 $18.50 97% 21 10%
Applied Materials 22.42 25.94 56 160 2
Cypress Semiconductor 19.99 23.70 222 16 14
Fairchild Semiconductor 24.28 27.00 95 14 4
Infineon Technologies** 14.00 15.95 80 7 0
Intel 30.86 34.51 70 17 1
Micron Technology 12.14 15.66 -11 49 8
National Semiconductor 39.57 45.25 134 23 4
Taiwan Semiconductor Mfg** 10.10 12.93 35 15 0.5
Texas Instruments 28.72 31.67 65 29 2

Semiconductors are a binge-and-purge business. As soon as sales pick up, so do orders for new equipment--and oversupply inevitably follows. In the new year Semiconductor Equipment and Materials Institute, an industry association, forecasts that sales to chip companies will expand 39%.

Most integrated semiconductor companies, the ones that both design and manufacture chips, are just now beginning to invest in new equipment. By 2005 Asia will outfit as many as ten new fabrication plants, according to Isuppli, a market research firm. Who is going to buy all those chips that spew out? The growth rates for new cell phones (20%) and personal computers (14%) may be dwarfed by the amount of new supply the semiconductor industry has in store for 2004 and beyond.

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