Stocks Marching to an iPod Beat


Cell phones and iPods are everywhere -- and that's good for semiconductor makers and thus for the stocks of those companies, says Thomas Smith, Standard & Poor's analyst of stocks in the semiconductor sector. Shipments of cell phones are up a surprising 21% this year, according to Semiconductor Industry Assn. figures.

That's a boost for the makers of NAND flash memory, with iPods and cell phones putting "a premium on certain kinds of flash memory that retains information and turns on with instant information access," says S&P's Smith. One interesting play on NAND memory is the recent infusion of capital by giant Intel (INTC

, an S&P buy) into Micron Technology (MU

, a hold) so that Micron can accelerate its development of NAND memory.

Another area of chip demand related to the new products is in power-management chips, which allow better management of battery life. Companies making these include International Rectifier (IRF), Analog Devices (ADI), and Linear Technology (LLTC) -- S&P ranks stocks of ADI a buy and the other two as hold. Other buys on Smith's list include Intel, Microchip Technology (MCHP), and Nvidia (NVDA).

These were among the comments Smith made in an investing chat presented Nov. 29 by BusinessWeek Online and S&P, in response to questions from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow.

Note: Thomas W. Smith is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this chat.

Tom, semiconductors are a crucial part of the tech sector -- how have the stocks you track been doing as the market inches back up?

The semiconductor sector has been moving back up with the market -- and outpacing the overall market. As of last Friday, the semiconductor subindustry was up 13.8% year to date, vs. a 5.2% gain for the S&P composite 1500.

Overall, the semiconductor companies reported relatively strong earnings and were mostly able to guide higher through the November earnings reports, which indicated a bullish tone for the group. The trade association, the Semiconductor Industry Assn. (SIA), put out a new forecast on Nov. 16, which slightly raised its outlook for global industry sales in dollars for 2005. And it's looking for an 8% growth year in 2006.

Tom, what's your recommendation for chip stocks?

Our overall outlook for the industry is neutral... I see the overall demand situation as neutral in terms of the GDP outlook we have for 2005 and 2006, and also for the demand for chips. We're looking for chip growth of about 9% in 2006, which would be a normal year for chips.

The inventory levels within the industry are very bullish, in our opinion -- that is, the level of inventory in the distribution channels is low and needs refilling. Also, the utilization of wafer-fabrication plants is low, according to the SIA. So things are hot, but they could get hotter. I look at that as bullish for the industry.

When companies describe their order lead times -- another indicator of where things are heading -- lead times are described as generally short but are beginning to lengthen for some types of chips. When order lead times become very long, people are ordering for a future time frame, and things are hard to get, and things are getting hot. The p-s [price to sales] ratio for many chipmakers is below the recent historical average for these companies.

However, analysis by price to earnings is difficult to do at this stage, because stock options are going to be included in earnings beginning in 2006.

So what are some of the chip stocks that look best now?

We rank Marvell Technology Group (MRVL) 5-STAR (strong buy) right now. They're succeeding in some sophisticated designs for broadband data transmission and wireless data transmission, and seem to be able to command premium pricing, and are developing a good niche in the broadband area. It has shown growth well above the semiconductor industry for several quarters, and we expect it to continue to do well over the next 12 months.

Other chipmakers we like with 4-STAR (buy) ratings include Intel (INTC), Analog Devices (ADI), Microchip Technology (MCHP), and Nvidia (NVDA). Briefly on those, Intel is the industry heavyweight and something of a value play compared to the others. It carries a relatively high dividend [among chipmakers]. It carries some long-term debt, but we see that as negligible in the context of the size of the operations.

Intel needed more access to NAND flash memory and decided to partner further with Micron Technology (MU) (a 3-STAR hold). Intel has gotten capital over to Micron so that NAND flash development could be accelerated. We view this as beneficial to both companies.

ADI is a play on digital-signal processors and high-end analog chips. These chips are used in a wide variety of sophisticated consumer and industrial electronic devices. They're a leader in DSP chips used in telephone handsets, and we view these all as promising growth markets.

Nvidia is a maker of high-end graphics chips for digital entertainment and workstations. Nvidia's fortunes are often tied to tight competition with its single competitor, ATI Technologies (ATYT), which is not covered by S&P. Sometimes their near-term results can be seen as a sort of seesaw in the battle with ATI, which investors should consider as potentially risky. In recent months, Nvidia has been performing better than expected, and we expect it to do better on margins.

Microchip Technology is the maker of a low-cost chip known as a microcontroller that's used pervasively in all kinds of electronic goods, and it has the ability to make chips in low-cost fabrication plants and a record of persistent market-share gains. Microchip also pays one of the larger dividends in the semiconductor group and has no long-term debt. (Nvidia also has no long-term debt.)

I should also mention that Cree (CREE) is a 5-STAR (strong buy) -- they're covered by a colleague.

Looking down the road, what will be the hottest area for chips? And which company stands to benefit the most?

I'd say the hot area of this quarter is NAND flash. The demand for iPods and better and better cell phones has put a premium on certain kinds of flash memory that retains information and turns on with instant information access.

Also, power-management chips that allow for better battery management are in big demand. There are a number of companies that specialize in these, including International Rectifier (IRF) (currently a hold). Analog Devices and Linear Technology (LLTC) (currently a hold) are others that produce these.

Texas Instruments (TXN), a hold, also makes a broad line of analog and DSP chips and has a decently strong pipeline. For NAND flash, the interesting play would be Micron Technology, which has that additional capital made available to it from Intel, which has allowed it to really ramp up their production.

The problem with NAND flash is that so many competitors are planning to ramp up at once, and capacity could possibly outgrow demand. But demand is very strong, and if later-generation ideas come along in the region of cellular phones, etc., demand will remain powerful.

DRAM is a weak category of semis subject to continual bouts of soft pricing, and unfortunately for the investor looking at Micron, 75% to 80% of their sales are still coming from DRAM. So this is still a mixed picture for where earnings come out from Micron. They've been quite volatile in the past.

The high-end chips in video cameras and the like can often come with pretty high growth margins for some of the makers (again, TXN

, ADI

, LLTC). Recently, some smaller shops have tried to make their product line richer by adding more high-end analog. National Semiconductor (NSM) is one of those, as are Semtech (SMTC) (a 3-STAR hold), Micrel (MCRL) (also a hold), Intersil (ISIL) (again, a hold), Silicon Laboratories (SLAB) -- these are all players in this analog category, although they are all holds.

Are AMD and Intel still duking it out in the PC area? Is this segment still growing?

Yes, PC growth is still growing at about a 10% compounding annual growth rate -- at least that's the long-term outlook held by SIA. Within that context, the PC area is still a strong business for Intel and also for AMD. AMD over the past year or so has had some good product innovation and has been able to take some share from Intel.

There's a lively discussion within the analyst community as to whether AMD will be able to take more share and chip away at Intel's market leadership (i.e., 80% of the PC market). Time will tell -- AMD from my point of view has some risk, in that it has significant long-term debt, and Intel has negligible debt. Intel's also just plain larger and can move R&D and production to where it's needed. It also has excellent market clout and great relations with PC makers like Dell (DELL).

I'm ranking AMD a hold, because they still have the memory-expansion operation, which isn't doing very well. They're planning on spinning it off as an IPO, which would change the valuation situation. But these are both interesting companies, AMD because it seems to have a chance this year and next year to perform better than it has over the past decade, and Intel because it has been a big player in the industry and consistently carries a big dividend. Intel in some ways is so big that it will move at the industry's pace.

You mentioned iPods earlier -- are there other products that are driving sales, like the Xbox?

Certainly the Xbox is a good example of a new product.... Another one coming up is the PlayStation 3, which is coming out next spring. A number of chipmakers can piggyback on that -- Nvidia is a player in the PlayStation 3 move. Almost any new generation of equipment like that will require more power management, since the chips run hotter, and that could bode well for makers of less glamorous chips.

TXN has been a leader in trying to get the various functions of a cell phone onto one chip (the radio signal, digital processing, etc.), instead of a set of chips, so cell phones are certainly helping to drive sales. Digital cameras and digital-video cameras have been a nice add-on in the consumer area, and digital TVs have been a nice product line. These high product prices allow for some nice high-end chips, in the thousand-dollar area vs. the hundreds for cameras. This creates good possibilities for chipmakers.

Thinking about the SIA numbers, what they were surprised by was the strength of cell-phone shipments, at 21% growth, well higher than their estimates at this time last year. They're tracking PC shipments at 15% growth in 2005, and they were thinking that 8% to 10% would be a normal year. Part of that PC story is growing sales in developing countries, including China, India, Malaysia, and other nations that are getting more sophisticated.

Another area with a lot of growth is automobiles -- part for drive-train management, tire pressure, and simple remote controls, but also for entertainment systems and electronic gadgets like navigation systems. The semiconductor industry as a whole is therefore becoming more exposed overall to consumer spending, for better or for worse. This is compared to several years ago, where it was mostly a boom or bust cycle.


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