Does The Semiconductor Rebound Have Legs?

By Ryan Barnes | November 08, 2009 AAA

Investing in semiconductor stocks has always been a dodgy proposition. Long-term investors may sometimes feel that flipping a coin is just as likely to yield good results as pouring over fundamentals, reading earnings reports or studying charts.

The chip industry is defined by several key challenges, challenges like changing technology standards & patterns, long lead times for new products, low-cost competition and long-term commoditization through falling prices and squeezed margins.

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Intel - Follow the Leader
Take the heavy hitter as a prime example. Intel Corp (Nasdaq:INTC) is without a doubt the most successful chip company in history, yet even Intel typically sees net earnings fall more than 60% during recessions. While INTC shares are up over 50% from the March lows, they're still flat to down for investors that have been around since 2002, highlighting how truly difficult it is to carve a stable, sustainable business model around silicon.

There are some good rays on the horizon, however, as Intel's Q2-Q3 improvement was the best in decades, and the company raised sales guidance for the current quarter by $600 million, from $9.5 billion to $10.1 billion. More importantly to investors, gross margins are expanding rapidly; margins rose a full seven points to 58% in the latest quarter and are up 10 points from the low in the first quarter.

Expanding margins are key to any chip industry revival, and are one of the signposts bulls are using as they enter into long positions. As long as margins are expanding, any uptick in sales will have a swift and powerful impact on the bottom line.

Intel's medium-term prospects seem to be pegged on whether the much-proposed 2010 PC/IT upgrade cycle becomes a reality. If corporate IT spending picks up in 2010 and the new version of Windows Server is deemed a necessary upgrade, Intel will see solid sales of its new Nehalem processor. Meanwhile if Windows 7 gains traction and spurs a PC upgrade cycle, Intel will benefit on its mainstay PC business. If both occur, it could be a boon period for Intel shares in the next 18-24 months.

Intel also stands apart from its peers in terms of dividend action; the recently upped yield now stands at 3.1% and is higher than you'll find at nearly any tech company.

AMD Future Still Tenuous
One can hardly mention Intel without looking across at its smaller yet spunky rival AMD (NYSE:AMD). The AMD faithful are newly fueled by the recent $1.5 billion settlement from Intel and the agreement to a "cease-fire" with regards to ongoing patent infringement and antitrust issues.

While the most recent earnings report was solid, with a 18% sequential rise in sales, removing one-time events shows sales up only 1.8% sequentially and down 32% year-over-year. While shares are up over 200% from the March lows, AMD is still down over 75% since 2005 and seems doomed to the fates of a perennial second-place finisher. The balance sheet isn't as strong over at AMD, which has to look uphill to Intel in the PC arena and NVIDIA (Nasdaq:NVDA) in the graphics chip space.

Micron an Interesting Litmus Test
Few companies show the dangers of a commoditized industry more than Micron Technology (NYSE:MU), which manufactures RAM, DRAM, and other flash memory chips. Remember 10 years ago when a 16MB flash drive was actually expensive? These days you can get 20 times the storage capacity for what seems like 5% of the price.

Micron barely made it through the past few years at all, as the company has reported net losses since 2007. About the only thing that saved the company was that business got so bad several Asian competitors went belly-up, reducing the playing field for Micron.

If a broad PC upgrade cycle plays out, a big theme will be consumers looking for higher RAM requirements on their computers. After all, we've pretty much maxed out on hard drive storage; most people never hit that ceiling anymore. But RAM is always an issue, and will only become more so with Windows 7 and new software packages built around the new operating system. (For related reading, check out Technology Sector Funds.)

Marvell Riding Mobile Waves
Marvell Technology Group
(Nasdaq:MRVL) has a broad spectrum of products covering the enterprise, mobile, and design space. Marvell chips can be found in smartphones, eBook readers, and PCs, and because the company is a fabless chip producer, the balance sheet is much less weighty than for firms that produce in-house.

Marvel is set to report earnings on December 3, 2009, so this report will be an interesting one to watch as a possible harbinger for other tech firms. In late October, Marvel raised the midpoint of its revenue guidance by 10% to $770 million on the strength of new product lines and inventory rebuilding in the consumer space.

The Bottom Line
The general pattern is that there's about one good holding period for chip stocks during every new turn of the business cycle. The next 18 months could be just that time period for chip stocks, especially if the timing of economic rebound coincides with a new Windows OS that people actually decide to use.

Margins are sharply rising across the industry right now, and sales are starting to rise sequentially. To the always forward-looking stock market, that is a cocktail for success. Stick with the major players and you'll likely participate in 90% of the industry's upside without unduly exposing yourself to a bit player that may be one new tech change away from oblivion. (For more, see The Stages Of Industry Growth.)

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