By Amrit Tewary Standard & Poor's remains neutral on the outlook for semiconductor stocks over the next 12 months. Despite the significant year-to-date decline in chip-stock prices (the S&P Semiconductor index fell 24.2% through Oct. 29), we think current valuation multiples are warranted in most cases, given our view of above-average near-term macroeconomic uncertainty and inventory risk, and our expectation for moderating sales growth in 2005.
Although we expect the current inventory correction to be short-lived, we think significant gains are unlikely for most chip stocks in the near term, given our belief that the industry is entering the latter stages of its current upcycle. We expect chip sales growth to moderate from a projected 25% this year to about 10% in 2005, before weakening to a flat to down year in 2006.
Despite our neutral outlook for the industry overall, we do think a few chipmakers should outperform their peers. We'll highlight four of our favorite names in the group.
BUILT TO LAST. First, we like Microchip Technology (MCHP
; ranked 5 STARS, or buy; recent price: $29.96), which has built strong market leadership in the relatively steady 8-bit microcontroller business. We're attracted by what we see as a superior business model vs. peers, a below-average risk profile given its diverse end markets and low cost structure, and above-average financial flexibility. Given our view of these competitive strengths, we expect Microchip Technology to continue gaining share from smaller competitors in this fragmented segment.
We expect Microchip's revenues to advance 26% in fiscal year 2005 (ending March), as the global economy grows and the use of 8-bit microcontrollers becomes widespread in a variety of electronic gadgets, including portable computers, wireless and wireline applications, auto products, digital cameras and music players, remote-control devices, robotic applications, motor controls, and security systems.
Microchip reported a gross margin of 57.3% for the September quarter. We see the fiscal year 2005 gross margin averaging 57.5%, up from 54.6% for fiscal 2004. As of June 30, 2003, it had consolidated production of its two oldest chip-fabrication plants. That remaining fab is now running at high utilization rates, and we believe this is contributing to strong margin performance. The September-quarter operating margin was 34%, a company record.
We estimate fiscal year 2005 earnings per share of $1.15. Our 12-month target price of $37 is based on our price-earnings and price-sales analyses. Our target price applies a p-e of 30, above peers but below historical norms, to our forward 12-month EPS estimate. Our target also applies a price-sales multiple of 7.7, in line with historical norms, to our fiscal year 2006 sales per share estimate.
DIVERSE MARKETS. We also like Maxim Integrated Products (MXIM
; 5 STARS; $44) and Linear Technology (LLTC
; 5 STARS; $38), two high-end analog chip outfits that have similar businesses. We think this category has more attractive long-term growth prospects than most other chip segments. Also, we believe Maxim and Linear, like Microchip, are both well-run companies that have a diverse customer base in a number of end markets such as automotive, consumer, communications, data processing, industrial, instrumentation, and medical. We believe this diversity results in a lower risk profile for these companies as it limits exposure to weakness at any one customer or end market.
Both Maxim and Linear are highly profitable, with well-above-average gross and net margins. In addition, with no long-term debt and plenty of cash, both have what we see as healthy balance sheets. Furthermore, we think both stocks are attractively priced at current levels, based on p-e and price-sales analyses.
For Maxim, we see fiscal year 2005 (ending June) EPS advancing 48%, to $1.77, on sales growth of 27% and significant operating margin expansion. Our 12-month target price of $60 is based on our p-e model, and values Maxim at a forward p-e of 33, which represents a premium to most peers but a discount to the stock's historical average multiple.
For Linear, we see fiscal year 2005 (ending June) EPS advancing 32%, to $1.35, on 29% sales growth and continued margin expansion. Our 12-month target price of $50 assumes a forward p-e of 36, above most chip peers and below historical averages. We believe both Maxim and Linear merit premium valuations to most peers, given our view of their above-average prospects for growth and profitability and below-average risk profile.
POWER PLAYER. Lastly, we have an accumulate opinion on International Rectifier (IRF
; 4 STARS; $39.19), a maker of power semiconductors that are used to enhance performance and efficiency of electrically powered products. We see sales growth of about 19% in fiscal year 2005 (ending June), driven by increased power-management content in personal computers and other electronic devices, market-share gains, and demand for new proprietary products.
In the September quarter, bookings increased 20% from a year ago, but declined 8% from the previous quarter due to seasonality and a contraction in order lead times. We believe customers reduced inventory to adjust for more moderate end-demand expectations. However, we think most customer inventory adjustments will be completed during the next few months, leading to improved order trends.
For the longer term, we see strong growth prospects for International Rectifier, as the overall market for power-management chips is projected to post a compound annual growth rate of 20% over the next 10 years. Our 12-month target price of $52 is based on our p-e analysis and applies a p-e of 22, below historical norms but about in line with peers, to our forward 12-month EPS estimate.
Risks to our opinions and target prices for the semiconductor companies mentioned here include semiconductor industry cyclicality, increased competition, the risks of wafer fab ownership, and an above-average reliance on stock-based compensation.
Note: Amrit Tewary has no stock ownership or financial interest in any of the companies in his coverage area. All of the views expressed accurately reflect the research analyst's personal views regarding any and all of the subject securities or issuers. No part of analyst compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed. Price charts and required disclosures for all STARS-ranked companies can be found at www.spsecurities.com Analyst Tewary follows semiconductor stocks for Standard & Poor's Equity Research