Note From Edward Hemmelgarn

Assorted market pundits continue to proclaim that the current economic rebound will be anemic and that we are in the midst of an “economic resurgence without earnings.” In contrast, I continue to remain in the camp expecting good economic growth in 2002. Admittedly, I was early in 2001 in my conviction that the economy would revive, but I was not expecting the events of September 11th.

Most companies took advantage of the economy’s slowdown in 2001 to restructure and streamline their operations. They continue to reduce inventories with a vengeance and they are positioned to dramatically enhance their profitability with a modest increase in revenues. A case in point is International Rectifier (featured in this issue’s Q&A), which continued to pour money into R&D in recent years and is emerging from the downturn with even higher margins on its proprietary products.

There are caveats, to be sure. The market growth we foresee could be dampened by any number of events, including renewed terrorism in the U.S. or among our major trading partners. But in general, the three factors from 2000 that slowed world economic growth in 2001 (1) High Interest Rates (2) High Inventories and (3) High Energy Costs reversed themselves in 2001 and will be significant drivers to economic growth in 2002. If this economic growth occurs, we will also see significant profit growth in 2002 and 2003. Currently, investors are having difficulty forecasting profit growth since company managements can’t yet see the profit growth and this is causing a retrenchment in stock prices. As the year unfolds and profits grow, I expect these positive earnings surprises to fuel stock gains. Therefore, we continue to use this time to position your portfolio in stocks that should benefit the most from a recovering economy.

Semiconductor Industry On Its Way Back
After Armageddon
Raymond Rund, Managing Director

2001 was the worst year for the semiconductor industry since the invention of the transistor in 1948. Worldwide semiconductor revenue dropped 43.5% from the $18.1 billion peak reached in 0ctober 2000 to the low point of $10.2 billion recorded in September 2001. As a result, U.S. semiconductor capacity utilization dipped to 59.4% in August 2001, the lowest capacity utilization recorded since 1975.

Two factors accounted for the severity of these declines. The first was the drop in demand which accompanied the onset of recession in early 2001, and the second was the subsequent massive liquidation of inventories. Exhibit I shows that demand for the three major consumers of semiconductors, PC’s, cell phone handsets and communications infrastructure increased steadily from 1997 and peaked in 2000.

As demand declined through 2001 and revenues dropped, OEMs, contract manufacturers and distributors took actions to liquidate the excess inventories that had accumulated at multiple points in the chain. First, the OEMs (communications equipment, PC, and cell phone manufacturers) canceled orders to the contract manufacturers, distributors, and semiconductor companies. This prompted the contract manufacturers to cancel their orders to the distributors and semiconductor companies, and return as much material as they could. The distributors then canceled their orders to the semiconductor companies and tried to return as much over inventoried stock as the semi-makers would accept.

At the end of this chain, the result was a virtual cessation of orders to the semiconductor manufacturers and a dramatic decline in revenue. Communications IC makers were hit the hardest, as illustrated by the case of PMC-Sierra, the largest pure play in chips for communications infrastructure. PMCS saw
their quarterly shipments decline 80% from December 2000 to December 2001. By the end of Q3 2001, total inventories at the 36 large OEMs, contract manufacturers and distributors we track had declined about 30%.

As 2001 ended, however, numerous companies in the chip space had begun to see the first signs of improvement. Many semiconductor companies enjoyed sequential growth in Q4, and most project low sequential growth for the March quarter. We expect the June quarter to show additional improvement as demand stabilizes and equipment manufacturers order parts at the same rate as they consume. As the economy emerges from recession, equipment manufacturers will see increasing demand and will begin to replenish inventories. This will cause semiconductor companies to see increased orders and growing revenues, and another cycle of expansion will begin.

The best semiconductor companies sharply reduced their operating expenses during 2001 in response to the revenue declines. These companies should experience very strong operating leverage and growth in earnings as revenues increase.

We have reason to be optimistic about future demand trends. We expect demand for high bandwidth and wireless communications to increase, and view the digitalization of home entertainment and photography, and the increasing sophistication of automotive electronics, as tremendous growth opportunities for the semiconductor industry. Overall, it is an industry that has grown on average at about 15% per year for the last half century, and we believe it will continue to grow, long term, at double digit rates.