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Tickers in this Article: SWKS, AATI, RFMD, AAPL, NOK, MOT, TXN, IFX
Analog chips and integrated circuits play a critical role in many of the electronic devices we use, especially handsets (cell phones). We're going to take a closer look at three companies who supply the chips and circuits to the major cell phone manufactures. Unfortunately, this focus on components for handsets is a problem, as the cell phone business is quickly becoming an exclusive oligopoly.

Trying to Diversify
Skyworks Solutions (Nasdaq: SWKS) is a leading manufacturer of the amplifiers that go into cell phones. It also makes other cell phone components but power amps are its main business. In fact, handsets comprise roughly 90% of SWKS's revenue. The problem is that the list of cell phone manufacturers is getting thinner and thinner - to the point where there are only five major manufacturers now. This means SWKS has almost zero pricing power. The company is a price taker.

The upside is that there is also a consolidation in the chip and integrated circuit business and Apple (Nasdaq: AAPL) has chosen Skyworks product for its new, high-end iPhones. SWKS is well positioned in the growing mobile communications business and has devoted 18.6% of its sales to research and development.

The management at Skyworks is very cognizant of its over exposure to a handful of customers and is making a concerted effort to expand its product suite to non-cell phone applications. It wants to focus on products that carry a higher margin such as medical and broadband components.

Small Cap - Big Opportunity
Advanced Analogic Technologies, Inc. (Nasdaq: AATI) is a small cap company with only about $460 million. The firm has only been public since mid-2005, so there's no data that you could really hang your hat on. However, every company has to begin somewhere and the market is placing a 4.6-times premium on the market capitalization over its 2006 annual sales. The truly meaningful number with AATI is "29.6%" - as in, it budgets 29.6% of revenue to research and development. Perhaps this is the reason for the market-cap premium. (For more on the importance of innovation, see Buying Into R&D.)

Similar to Skyworks, AATI is very dependent on the handset business in general and has a few big customers in particular. Three customers account for over 60% of AATI's revenue. With a slim product suite, that is a risky proposition.

Going forward, AATI does have some products that are unique and offer some strong potential. The company plans on leveraging those technologies into several mobile, consumer-driven end products. Be advised, the list of major manufacturers that can use this technology gets thinner by the day, and with a product suite of limited scope this makes investment in this firm quite a risky endeavor.


Too Dependent on Two Customers

RF Micro Devices (Nasdaq: RFMD), with a market capitalization of $1.4 billion and sales of $1 billion, had a stellar year last year. The company's growth in earnings only jumped 33%, but its operating income grew a staggering 512%. The caveat in these numbers is that Nokia (NYSE: NOK) accounted for 40% of revenue with another 30% from Motorola (NYSE: MOT). Although RFMD has a terrific product, the company derives 90% of its sales from it. The leverage here is obvious, and as we know, leverage works both ways.

Just like our other two firms discussed, RFMD is making an effort to diversify its product lineup by focusing on platforms instead of individual components for handsets and striving to make them applicable to a variety of end products. The market is demanding devices that can handle not only more data but faster as well.

By diversifying away from its traditional product suite RFMD is going to run into some formidable competition such as Texas Instruments (NYSE: TXN) and Infineon Technologies (NYSE: IFX). One has to hope RFMD's research and development budget, 18.1% of revenue, is up to the task.

Hung Up On Handsets
At some point there could be an industry consolidation. It is already happening in the major manufacturers, and only time will tell if the same will happen with component producers. There is one aspect of these three companies share: They are all under $10 per share. How wrong can you be?

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