Semiconductor Stocks Rally As Chip Sales Rebound Seen

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The semiconductor industry, one of the most volatile in the technology sector, has been sending mixed signals.

On one hand, as a group, shares of chip manufacturers have been climbing steadily since November. Makers of chip manufacturing equipment have advanced even more sharply. Chip designers -- the so-called fabless chip group -- have marshaled a much less impressive gain.

Robust smartphone and tablet computer sales are expected to help push chip sales into a positive growth mode this year following a year-to-year decline in 2012, says Michael Palma, research manager for market tracker IDC.

"We are going into a better market environment, it's a better economy," he said. "There is going to be an increase in consumer spending and a better end market will help a wide array of providers."

This year, the chip sector is also expected to see a mix of capital investment, increased research and development spending and even some change in business models as firms fight for share in a fast-moving and increasingly competitive market.

1. Business

Among the 44 companies in IBD's Electronic-Semiconductor Manufacturing industry group, about half trade above $10 a share. Only about one quarter of the group have market capitalizations of more than $5 billion.

But size doesn't necessarily equate to profit. The six chip companies with EPS Ratings of 90 or better have market capitalizations of $8.7 billion or less. The largest players in the group includeIntel ( INTC ), with a market cap of $120.3 billion andTaiwan Semiconductor ( TSM ), weighing in at $98.3 billion.

The most profitable players includeMagnaChip Semiconductor ( MX ),Maxim Integrated Products ( MXIM ) andCree ( CREE ).

MagnaChip showed EPS growth of 76%, 196% and 212% as earnings rebounded in its last three quarters. Maxim climbed from 2% to 24% and 36% in the same period while Cree jumped from 8% to 28% and 70% over the last three quarters.

The players don't compete with one another, but tend to dominate their niche markets. One key to success in the chip business is offering a best-in-class technology in a competitive market, says Samuel Wang, an analyst for Gartner, a research firm.

"If you identify a special market and you are really good at it you can grow very fast," he said.

MagnaChip owns more than 3,000 patents on chips generally targeted to commodity based, high-volume markets. It also operates a foundry that fabricates chips for other companies. Maxim makes analog chips that power a wide array of sensors and controls. Cree's line of LED chips are used for everything from TV backlight illumination to street lights.

All three companies have seen profits rebound in the past three quarters following a series of declines. Cree has six quarters of solid sales growth under its belt. MagnaChip has seen some recovery in revenue growth in the past three quarters, while Maxim's sales have posted a much more modest rebound.

2. Market

Chips have become central components in everything from cars to consumer electronics. The health of the semiconductor industry is largely dictated by demand for such products.

Global sales of semiconductors are expected to rise between 3% and 4% this year from $295 billion last year. Chip sales declined 2.2% in 2012, according to a May 22 report from IDC.

In March, Gartner predicted that global chip sales would grow this year to $312 billion, up 4.5% from last year and reach $382 billion in 2017.

Even with declines in sales, PCs still account for the highest percentage of chip sales. Though smaller, sales of chips designated for smartphones and tablets are growing fast.

Global shipments of smartphones are expected to rise 33% this year to 932 million vs. 700 million last year. Similarly, worldwide shipments of tablets are expected to jump 32% to 225 million vs. 171 million last year, says Strategy Analytics, a research firm.

Demand from consumers and companies for better and faster devices capable of handling new technologies should drive more growth, says Wang.

"Human's desire for faster speed, faster communication and more power to serve their data use is endless -- companies want to make better products, better cars, so all of those require better chips," he said.

3. Climate

Climbing chip sales also help boost the fortunes of companies that provide foundry and assembly services.

By 2017 global revenues from chip foundry companies -- those that manufacture chips as an outsourced service -- will reach $47 billion, up 27.3% from an expected $36.9 billion this year, says Gartner. Worldwide revenue from semiconductor assembly and test services will reach $35.3 billion, up 36.8% from an expected $25.8 billion this year, Gartner says.

Taiwan Semiconductor Manufacturing ( TSM ), the world's leading foundry, grew revenue by 19% last year. A similar performance is likely this year, says Wang.

"That was tremendous growth and this year we think they can double-digit growth again -- their growth was mainly driven by the fast rise of chips in mobile devices," he said.

But the chips are not up for all players.Intel ( INTC ), a multibillion-dollar gorilla in the chip market, has been stung by the declining PC market. Company revenues were flat last year and have declined in the last three quarters.

"Intel is very challenged," said IDC's Palma. "They have a very weak outlook in the PC market and they are trying to expand into phones and tablets."

With profits and revenues in decline since 2011,Texas Instruments (TXN) exited the smartphone and tablet market on Jan. 1 to focus on its core analog and embedded processors used in automotive, industrial equipment and enterprise communications.

Many venture funds are avoiding chips. In Q1 venture investments in chip companies fell 41.5% to $132.6 million vs. the year-earlier quarter, says PricewaterhouseCoopers and the National Venture Capital Association. And funding likely won't approach last year's $936 .9 million, which fell 30% from 2011, says Tracy Lefteroff, global managing partner of PWC's venture capital practice.

"They are capital intensive (deals) and they take a long time to put together -- it's not like a plug and play Internet-related company that you can get up and running in a couple of months," he said.

4. Technology

The chip industry revolves around rapid technical advances. Intel, Taiwan Semiconductor and Samsung all recently announced capital spending plans for 2013 with one clear goal, says Andy Ng, an analyst for Morningstar, in a May 20 report.

"(They) are making significant investments this year for strategic purposes, aiming to expand capabilities in the most advanced semiconductor fabrication technologies," he wrote.

Progress in the chip business depends on continual R&D investments. About 50% is software. Size is a concern but not the only one, IDC's Palma.

"It's about speed and having a design that works at a tiny scale; that is crucial and expensive," he said.

Investments come at a price. One example is MagnaChip. Company EPS is expected to shift from growth of nearly 23% in Q2 to year-to-year declines of 7.4% in Q3 and 14% in Q4 as its R&D spending increases, says Suji De Silva, an analyst for Topeka Capital Markets.

"They have made some acquisitions and they are investing in some areas that we think will bear fruit and that is hurting the year-over-year EPS," he said.

5. Outlook

The chip market is dictated by factors ranging from consumer spending, the macro economy and changes in technology.

• Upside: Demand for chips is expected to rise this year. Smartphone and tablet sales are a primary driver. But so is speed and performance, says Gartner's Wang.

"You want to store your data in the cloud, store more photos on your computer or your iPhone or take more photos with higher resolution or get a higher definition HDTV with better resolution -- the appetite for those better features is endless," he said.

• Risks: In the past, the industry has been cyclical largely due to oversupply issues. It's likely to happen again, Wang says. "You can never manufacture chips perfectly matching what is required by manufacturers and consumers," he said. "You can only estimate how many TVs you are going to sell this summer."

Some chip companies rely on only a few customers for a large amount of their revenue. Intel's three largest customers accounted for 38% of its revenue in Q1 whileSanDisk 's (SNDK) 10 largest customers comprised 49% of its revenue in the March quarter.

The demand for speed and performance also supercharges competition. Not all companies will win, says IDC's Palma.

"Winners are the ones that are able to execute on unique value proposition, so sometimes it's about being in tablet or having a strong position in automotive," he said. "If you can't differentiate yourself, this is a very brutal market to be in."



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: CREE , INTC , MX , MXIM , TSM

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