Street Patrol Why semiconductors are about to surge Forget the traditional summertime slump. Prices have fallen enough to bring fundamentals in line, and businesses have lots of aging computers to replace. By Robert Walberg Semiconductor stocks have lagged the market badly the past few months, as bearsâ complaints of overvaluation energized sellers. But the setback may have gone far enough and lasted long enough to allow chipmakersâ valuations to come into line with their stellar earnings growth. The stocks now seem poised for a substantial recovery. While chip stocks have sunk 14% over the past four months, nothing in the companiesâ earnings reports or forward guidance has suggested that business has changed for the worse. The following factors have contributed to the groupâs miserable performance: Concern that future sales/profit growth will slow from current levels. Fear that Nokiaâs (NOK, news, msgs) sales warning means trouble ahead for wireless chip companies. Belief that seasonal bias will begin to work against the group. Worries that valuations are too high. Anxiety over the future is understandable, but a slowing in the rate of growth alone is no reason to run from the sector. Maybe Intel (INTC, news, msgs) wonât deliver a second quarter as strong as the first, in which earnings jumped 100% and sales rose 20%. But it shouldnât have to in order to impress investors. Likewise, does Texas Instruments (TXN, news, msgs) really have to post another 200% jump in earnings on a 34% rise in sales for investors to appreciate the simple fact that operations are lean and business conditions are much improved? I donât think so. Fundamentals fall back in line No question the semiconductor industry ran ahead of its underlying fundamentals during last yearâs impressive advance. However, current results -- witness Motorolaâs blowout numbers on Tuesday -- are now justifying the advance, as expectations align more realistically with results. If the marketâs worries regarding future earnings growth are misguided, then its fear that Nokiaâs troubles spell doom for the wireless-chip group is downright laughable. Nokiaâs sales shortfall is a problem of its own making and in no way indicates trouble in the handset market. Nokia is simply losing share to the likes of Samsung, Motorola, LG and Sony Ericsson Mobile -- all companies that moved more aggressively into camera phones, the hottest area of growth in the cell phone market. Despite Nokiaâs woes, most experts expect double-digit growth in handset sales this year, with continued strength in 2005. In other words, the wireless-chip group should be just fine. John Rossi, chief financial officer of OmniVision Technologies (OVTI, news, msgs), confirmed as much to me the other day when he noted that business trends for his company remain very strong despite Nokiaâs problems. OmniVision makes the CameraChip, an image-sensing device used to capture images in a wide variety of consumer and commercial applications, including digital still cameras, cell phones, video game consoles and security and surveillance cameras. Rossi noted (with some chagrin) that while OmniVision never did much business with Nokia, the overall market for wireless-chip companies remains bullish with exciting growth in the handset segment. Just how good has business been at OmniVision? Last quarter, the company delivered earnings growth of 216% on a 209% rise in sales. Despite such impressive growth, the stock hasnât done much this year. Maybe investors are simply worried that the companyâs growth rate will slow to only 150%. After all, the summer doldrums are just around the corner. No summertime slump? Speaking of the seasonal bias, history supports the notion that the May-to-October period is a good time to underweight the group. However, these are not normal times. Businesses are in the early stages of what is shaping up to be a material computer replacement cycle. In fact, after a strong first quarter, research firm IDC now expects PC sales for 2004 to exceed its early estimate of 13.5% annualized growth. Meanwhile, recent earnings reports from the likes of PMC-Sierra (PMCS, news, msgs), Cypress Semiconductor (CY, news, msgs), Advanced Micro Devices (AMD, news, msgs) and Texas Instruments indicate that the communications, wireless and consumer segments of the market also remain strong. With the economy continuing to grow at a healthy pace and with most chip companies indicating that the demand outlook remains promising, the traditional summer slowdown is apt to be more modest than normal. Toss in the facts that comparison periods arenât that strong and that investors have lost interest in the group, and the sector is poised for a sunny summer of besting expectations. Outpacing expectations may not guarantee higher stock prices, but it should alleviate the concern of slowing growth -- and thatâs a good start toward reigniting investor interest. There was some merit to the argument that valuations were too high very early in the year, when the Philadelphia Semiconductor Index ($SOX.X) was trading near the 560 area and the first-quarter numbers had yet to come in. But the recent slide, combined with the strong profit results, should have alleviated these concerns. Intel, Texas Instruments and OmniVision may all trade at between 22 and 29 times estimated current year earnings, but given strong conditions in PC and handset markets, improved operating efficiencies (which are supporting significant margin gains) and impressive double-digit earnings growth projections, these multiples arenât outrageous. There are exceptions, such as Genesis Microchip (GNSS, news, msgs) and Micron Technology (MU, news, msgs), which trade at 86 and 113 times current estimates. But as you can see from the table below, many chip stocks are trading well off their recent highs and at multiples that are reasonable, if not cheap, given estimated growth. With valuations now at reasonable levels and industry demand still strong, look for investors to warm back up to the industry in the weeks and months to come as company after company delivers better than expected top- and bottom-line growth -- even during the traditionally slow summer season. 5 stocks that should lead Which stocks will lead the recovery? Though gains should be broad-based, look for the fast growers and the industry bellwethers to assume leadership. One such stock is OmniVision, which is well-placed to capitalize on the growth in camera phones as well as digital cameras, as it recently introduced a new 2.0-megapixel CMOS image sensor to keep one step ahead of the competition. Top chip picks Stock % off 52-wk Hi Current earns est. Next yr est. Est. 5-yr growth 4/20/04 price OmniVision (OVTI, news, msgs) 22.8% $0.91 $1.42 20% $25.50 Texas Instruments (TXN, news, msgs) 18.2% $1.04 $1.38 20% $27.35 Intel (INTC, news, msgs) 23.5% $1.20 $1.43 15% $26.07 Analog Devices (ADI, news, msgs) 10.8% $1.46 $1.99 20% $45.95 Taiwan Semiconductor (TSM, news, msgs) 19.2% $0.56 $0.71 28% $10.25 Texas Instruments and Intel should also pace any recovery as margins are expanding, sales are relatively strong and the stocks are reasonably priced. I also like Taiwan Semiconductor (TSM, news, msgs) and Analog Devices (ADI, news, msgs). The former will benefit from the computer-replacement cycle and discounted valuations, while the latterâs diversified product lines, solid financials and better-than-sector growth prospects leave it well-positioned for renewed gains. If you can discount the noise and focus on the facts, the outlook for the chip sector looks pretty good. As a result, investors should take advantage of any near-term weakness to load up on the group in preparation for a strong second half. Iâll report back on the group and the stocks in the months to come. At the time of publication, Robert Walberg did not own or control shares of any of the equities mentioned in this column.