Against a backdrop of a generally weak semiconductor industry, there have been a few bright spots tied to smartphones and tablets (think Broadcom (Nasdaq:BRCM)). Although touch controllers are central to smartphones and tablets, Atmel's (Nasdaq:ATML) touch technology has been undermined by intense price competition and the sales outlook continues to erode. While the company continues to push the capabilities of touch forward, the risk is increasing that Atmel is going to find itself locked into a sharper cyclical pattern in the future.

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Q2 Wasn't Great, but It Could Have Been a Lot Worse
It's tough to see how Atmel had a good quarter, other than from the perspective that things could have been so much worse. Atmel doesn't supply Apple (Nasdaq:AAPL) (Texas Instruments (Nasdaq:TXN) does) and is increasingly losing traction at Samsung, and if you aren't a strong supplier to those two phone/tablet companies, you're in parlous shape.

Revenue dropped 23% from last year and rose just 3% sequentially. MCUs were up 10% sequentially, but touch continues to soften and the ASIC market hasn't turned around yet. While a few companies have seen some improvement in industrial demand, larger companies like TI and Maxim (Nasdaq:MXIM) continue to report generally soft conditions.

Margins continue to improve, but at a slow pace. Gross margin fell eight points from last year, but did rise almost a point and a half sequentially. Likewise, operating income was sharply lower on an annual comparison, but up strongly on a sequential basis.

SEE: Understanding The Income Statement

Guidance Gets Real
I don't think it's unfair to say that Atmel management has been too hopeful and optimistic with respect to guidance and market commentary. Now, though, they seem to be acknowledging the realities of the market - touch shipments will fall 10-15% this year, and ASPs could drop below $1.

With that, guidance for maXTouch and ASIC revenue, as well as gross margin, came down for the third quarter. The midpoint of the revenue outlook calls for no growth, an 8% drop versus expectations before this quarter.

Is Back and Forth the New Normal?
Atmel has good technology in touch, but the roster of competitors is formidable - Cypress (Nasdaq:CY), Synaptics (Nasdaq:SYNA), Broadcom, TI and Melfas, among others. I fear, then, that Atmel may be locked into a situation where its product advantages are either quickly matched or rendered moot by aggressive pricing. That, in turn, could lead to something of a yo-yo pattern where Atmel gains share (and revenue growth) with new wins, only to lose the sockets in subsequent iterations.

For instance, the loss of the Samsung Galaxy S3 socket to Melfas was a big disappointment, as was the erosion of business at HTC, but now there's talk of solid wins for designs coming out in late 2012 and 2013. Elsewhere, the company is expecting big things from Windows 8 (which will support touch functionality in a significant way) in tablets, phones, and ultrabooks. The question has to be, though, whether Atmel can hold whatever ground it may gain with these cycles and recent history suggests that the answer is "no."

SEE: 5 Must-Have Metrics For Value Investors

The Bottom Line
For Atmel to really work as a stock, I believe that the company has to regain momentum at Samsung. I may be too skeptical on the prospects for Nokia (NYSE:NOK), Research In Motion (Nasdaq:RIMM), HTC and LG, but I just do not believe that a chip company can build prosperity by supplying these lesser rivals to Apple and Samsung.

Atmel's shares look cheap, but only if revenue guidance stabilizes and margins improve as promised. If touch controller ASPs stay so low, or if new technologies like xSense can't catch on, that will prove difficult. Consequently, this is a pretty typical tech risk-reward story - the risks are indeed high, but shareholders will be rewarded if Atmel can reverse these socket losses and rebuild its growth and operating leverage story.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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