Why the chip ship will sink

By Bill Fleckenstein

Let's start off in an arena where dreams die hard: the semiconductor industry.

Two of its darlings, Intel (INTC, news, msgs) and Linear Technology (LLTC, news, msgs), lost at beat the number after the close last Tuesday. Intel managed to not only not win, but -- when you adjust its earnings for gain and impairment charges -- to actually make only 23.1 cents per share, instead of the 25.6 cents (aka 26 cents if you round up) it claimed to have made.

Too much junk when sales are punk

Turning to Intel's inventories: After a write-down, they declined a smidgeon from last quarter. However, as the company heads into its two slowest quarters, inventories stand at $3.4 billion -- which is roughly where they were last July when Intel headed into its two strongest quarters. Inventories are up 38% year-over-year, while revenues are down 5%. Makes sense to me!

Intel has been building inventory for more than a year as it continues to ramp up capacity. Advanced Micro Devices (AMD, news, msgs) is also ramping up capacity. These two companies are engaged in a price war while, at the same time, PC demand is nothing special.

Some folks think Microsoft's Windows Vista is going to drive PC demand, but what Vista is going to do is freeze PC demand. The only positive impact that Vista will have on demand is that knowledgeable consumers who are thinking about buying a PC will go out and buy one now, before they have no choice but to buy a Vista-bundled system in two weeks. As for what demand Vista can eke out of corporate America: It's not much. (Microsoft is the publisher of MSN Money.)

An outlook that spells 'look out'

Sometime in the next six months, when Vista doesn't spark any demand and the economy is weaker, Intel will be forced to bite the bullet and cut capacity as it finally realizes that it has way too much. But for now, even as more capacity comes on stream, Intel would have the world believe that its margins will rise in the second half of 2007. That ain't going to happen, and life is going to get very complicated for Intel.

Another interesting nugget last Wednesday was commentary out of Linear Tech, which is generally regarded as one of the better-managed companies in the business. Business is so great that Linear's president, David Bell, has just resigned and the board has decided to dispense with any replacement.

In any case, here's what Linear CEO Lothar Maier had to say about the second quarter, which is usually its strongest: "We are seeing an overall reduction in our inventories at our end customers, which, coupled with some general market weakness, has resulted in a decrease in bookings, sales and profits for the December quarter." As for the upcoming March quarter, he described it as "a challenge to accurately forecast. Visibility continues to be low and customers remain guarded in their forecasting and inventory management."

In addition, he specifically noted the slowness in Asia, which is, of course, where all the consumer-oriented doodads are built.

As I've been saying for some time, and as Fred Hickey has explained in excruciating detail in his High Tech Strategist newsletter, consumer-oriented tech products are the ones most vulnerable -- both because of the excess inventory and, more importantly, because of the emerging slowdown in demand (which is probably a function of consumer weakness generically and saturated markets in general).

That family tree ain't gonna tag me

As to how those crummy reports from Intel and Linear Technology were digested last Wednesday, tech was a bit bifurcated. Most chip stocks were weak, but Linear's twin cousin, Maxim Integrated Products (MXIM, news, msgs), which recently saw the resignation of its CEO (tainted by an options backdating scandal), was largely unaffected -- as though the two companies were in totally different businesses. Likewise, the equipment stocks barely seemed to notice, because AMSL Holding (AMSL, news, msgs) recently won at beat the number after having radically lowered its guidance.

Semiconductor-equipment bulls have apparently assumed that capital spending will go on forever, even though the industry has too much capacity. (They were dealt a rude blow, though, Wednesday night. That's when Lam Research (LRCX, news, msgs) essentially admitted that the cycle had turned, and the stock price was pummeled for 15% the next day, taking the rest of the semiconductor-equipment stocks with it.)

Of course, no part of the industry has more excess capacity than memory, as was seen last Tuesday night by the debacle in Intel's flash business. Revenues there increased by about $70 million quarter-to-quarter, while losses went up by a similar amount. Anything related to flash is doomed, including the companies that supply the flash-making equipment. As for the scene in the memory business, a friend shared a humorous analogy, which I'll use to close this week's column:

"If (the industry) was driving a car at 80 miles per hour in a 55 mph speed limit zone, and then there was a sign saying ROAD CLOSED, HIGHWAY NOT FINISHED, 10,000-FT. CLIFF AHEAD, why does the DRAM (dynamic random-access memory) industry then accelerate the car to 120 mph? Damn the torpedoes, full steam ahead. These guys make the flat-panel industry seem rational!"

Yeah, they do. In any case, I would expect more bad news from the chip sector as results are reported in the next two weeks.

At the time of publication, Bill Fleckenstein was short Intel, Integrated Products and Lam Research, and long Intel puts and Lam Research puts.