Chip Stocks: Who Knows What Will Be?

by: Shlomi Cohen

The technology sector correction stood out among chip stocks, with the Philadelphia Stock Exchange’s Semiconductor Index dropping 4.5% on Friday. Shares of companies in the memory sector, like Micron (NASDAQ:MU)(down over 8%) and SanDisk Corporation (Nasdaq:SNDK) (down more than 5%), dropped, and silicon wafer producer MEMC (WFR) collapsed 19%. At least for this specific correction, it's possible to free the Greeks from blame and place it on the Koreans.

On Friday, before the open of trading in New York, Samsung (OTC:SSNLF) held a conference call with the publication of its strong earnings, and in a bizarre turn, the good things it said about its investment plans were the excuse for the sharp correction in chip stocks. Samsung said that demand for chips was so strong that it had no choice but to significantly increase its investment in new and existing production lines, beyond what had been known by the market before. Samsung did not provide numbers, but a Korean economic newspaper claims that the huge sum of up to $17 billion over the next two years is being discussed.

Using somewhat questionable logic, investors decided that if the situation is so good, then it will end up bad, and sent all the chip stocks down. Paradoxically, the drops included chip equipment makers, who are in line for bigger orders from Samsung.

The sellers’ logic was that huge investments always lead to chip surpluses, which always leads to chip price collapses, which always leads to share price collapses, so that from their perspective it pays to press the button on the ejection seat already now, and not wait for the end of the process.

The problem with this logic is that no one - not investor, analyst, or chip company executive - knows if that bad ending will be this year, next year, or in two years. More than a few investors have already lost tens of percentage points of gains in chip stocks, because they exited based on the bad scenario which has failed to materialize. Bad scenarios sometimes arrive suddenly because of a global crisis, like in the beginning of 2009, and sometimes are delayed many years because of huge demand for gadgets, smartphones, and computers, like what has happened since the middle of 2009. As of today, no slowdown in the strong demand is seen on the horizon.

Why small EZchip has a very big valuation

A small Israeli chip company that will publish quarterly results this week is EZchip Semiconductor Ltd. (Nasdaq: EZCH; TASE:EZCH), which reports on Thursday. The market expects strong results and guidance, or else we would not have seen the share jump more than 60% since the beginning of the year, passing the $20 per share mark in March, for the first time since 2007.

The name of the game in EZchip's results is "you win some, you lose some". Sales to Cisco (NASDAQ:CSCO), through Marvell Technology Group (Nasdaq: MRVL), are rising each quarter, as opposed to sales to Juniper (NYSE:JNPR), which are supposed to have been falling since it became known last year that it had chosen to go it alone and independently develop a third generation of network processors.

In my opinion, as of now, the situation at EZchip is still "you win some, you win some", because Juniper continues to grow in sales of routers powered by EZchip's second generation processors, so it is ordering, at a growing pace, from EZchip. The drop will only take place in about a year.

From the other side, I believe that Marvell has significantly boosted its sales to Cisco since the beginning of the year, so that EZchip's profit level over the next few quarters will explain to the market why this company is traded at a huge valuation of half a billion dollars, when its annual sales are only around $60 million.

In a meeting with founder and CEO Eli Fruchter, at the end of the first quarter, I pointed out that he sold several thousand shares. I enjoyed hearing from him, "If I am selling, then you can be sure that there are no black clouds on the horizon.

Disclosure: Author holds shares as part of his portfolio tracked by "Globes".

Published by Globes [online], Israel business news - - on November 17, 2009; Reprinted on Seeking Alpha with permission

© Copyright of Globes Publisher Itonut (1983) Ltd. 2009