Merrill upbeat on chip stocks

Merrill Lynch sounded a hopeful note about the semiconductor market Wednesday, saying that it may have finally hit bottom.

In a research note titled "Train's back in the station--Climb aboard!" the brokerage firm's analyst team cited several factors behind the call: stabilizing earnings estimates, reduced capital spending and bottoming year-over-year changes.

Along with the note, Merrill Lynch announced a slew of ratings upgrades: RF Micro Devices, Taiwan Semiconductor Manufacturing, Texas Instruments and United Microelectronics were upgraded to "buy" from "accumulate". Analog Devices, Linear Technology, Maxim Integrated Products, and ST Microelectronics were upped from "intermediate-term neutral" to "intermediate-term buy."

In a separate note, analyst Brett Hodess upgraded several semiconductor equipment makers, raising Applied Materials, KLA-Tencor and Lam Research to "intermediate-term buy" from "intermediate-term neutral," and Novellus, MKS Instruments and Entegris to "buy" from "accumulate." He also raised Advanced Energy to "intermediate-term accumulate" from "intermediate-term neutral" and Teradyne to "long-term buy" from "long-term accumulate."

Applied Materials closed up $2.44 to $48.30, KLA-Tencor added 2.71 cents to $57.10 and RF Micro Devices gained $3.60 to $30.96. Texas Instruments gained $2.13 to $36.63.

The upgrades and the note follow some positive news from that sector. On Tuesday, semiconductor equipment maker KLA-Tencor posted fourth-quarter profits that topped analysts' estimates, although they were lower than a year ago. But the company said it had a six-month backlog of shipments, a sign that the market may be picking up.

Merrill was somewhat choosy about the sectors it upgraded. The research firm said it had a "positive" stance on wireless companies, but companies tied to the integrated-circuit communications market may not fare as well. And while a few PC-related companies got upgrades, "we remain concerned about the impact of (average selling price) erosion in that market," Merrill said.

Investors have become used to hearing warning after warning from tech companies, and they lower estimates further and further. But Merrill's team said that the bar may have finally been lowered far enough. Other brokerage firms have tried to call a bottom in the chip sector in recent months. In April, Salomon Brothers analyst Jon Joseph said things wouldn't get worse for chipmakers.

The semiconductor market traditionally follows boom and bust cycles, and when things are hot, capital spending takes off, eventually producing an out-of-balance supply-and-demand curve. Now, however "capital spending has been reduced sufficiently to bring supply into line by 2002," Merrill wrote.

But while things may finally be turning around, Merrill cautioned that "we do not believe it will be as easy to make money during the coming upcycle as it was in 1998."

"Valuations are significantly higher than they were in 1998, while at the same time the demand environment is more uncertain," the team wrote. "We expect the recovery in stock prices to be gradual, as earnings grow into the valuations already being paid in anticipation of a recovery."