How To Think About Semiconductor Stocks

How to Think About Semiconductor Stocks

What to expect:

• Reasons to invest in semiconductor stocks

• Making heads or tails of popular business models

• 3 Important metrics to watch

• Putting it all together.

Rags or riches?

Stocks in the semiconductor industry can be

tempting…but you have to learn the ropes first.

Big winners abound…

… But satisfaction is not guaranteed

How to beat the semiconductor market

Find the winners

The AMEX Semiconductor Index is not a market-beater.

You need to know where to find the big winners.

Core thesis:

The biggest winners tap into

stable or growing markets…

…with room for error.

For example…You may have heard of the next

game-changing

mega-trend

in technology…

The Next Big Thing: Internet of ThingsSource: Cisco Systems.

Who’s betting on the Internet of Things?

Source: Texas Instruments.

Better question: Who isn’t?For example, Texas Instruments sees all sorts of growth opportunities opening up…

…and Internet of Things is the key to almost all of them.

Remember: IoT is machines sending data to other machines.

Another big name going all in: QualcommQUALCOMM already dominates the last

game-changing market:

mobile communications.

But Qualcomm wants more…

IoT is an easy stretch for Qualcomm

Source: Qualcomm.

But that’s only half the battle!Picking the right market is a great start…

…but you have to execute on those big-ticket plans, too.

So let’s find out how to sift the wheat from the chaff.

Business models: Fab-less or not?Source: Intel.

Strategies vary; Apples…

Strategies vary.

Intel sees its chip factories as

a competitive advantage.

Source: Intel.

(Factories can be risky)Intel’s Fab 42 in Chandler, Arizona is a $5 billion investment.

Technology upgrades nixed, the facility sits empty today.

Intel would love to have that cash back today.

Source: Intel.

…and oranges.Others may focus on chip

design only.

Known as fab-less chip companies, they outsource

manufacturing to specialized foundries such

as Taiwan Semiconductor.

Source: TSMC.

(Factories can be very helpful, too)

When dozens of chip designers rely on a handful of foundries,

they can run into bottlenecks.

For example:OmniVision Technologies got a huge order from Apple in 2009.

The iPhone 3GS needed millionsof OmniVision’s camera chips.

Being fab-less, OmniVision needed

tons of capacity from TSMC. Right

away, please.Source: Wikimedia Commons.

Oops!But TSMC had its hands full with even bigger orders. OmniVision didn’t have exclusive access to manufacturing lines anywhere.

OmniVision’s huge order never led to massive sales in 2009. Apple had to get camera sensors from multiple sources.

…All for lack of a

company-owned factory.

Fab-less chip designers are not inherently

better or worse than factory builders.

Investors simply need toknow the difference.

One style mayfit your portfolio

better than the other.

In-house factories give you more control over operations.

Using foundries instead provides more flexibility.

Metrics to watch

Source: Wikimedia Commons.

Numbers can tell the storyHigh and rising/stable gross margins show pricing power and efficient manufacturing.

• Qualcomm is a leading fab-less chip designer.

• Margins are still strong, but have been falling since 2011.

• Qualcomm’s mobile products moved from boutique to commodities very quickly.

• Intel is king of the factory owners.

• If the PC is dead, Intel never got that memo.

• Pricing Power 101.

Choices in the mobile eraQualcomm sacrificed margins to protect growth.

Intel sacrificed growth to protect margins.

3 powerful prediction tools: Book-to-billSome (but unfortunately not all) chip stocks report book-to-bill ratios.

• Book-to-bill above 1.0 means orders are coming in faster than shipments of finished products are going out.

• A 1.12 book-to-bill ratio means the company received $112 worth of firm orders for every $100 of products shipped and billed in the same period.

• This is a bullish sign, pointing to solid revenue growth in coming quarters.

• Low numbers make semiconductor investors nervous, as the order pipeline dries out.

Source: Intel.

3 powerful prediction tools: Book-to-billThis is chiefly an industry metric, compiled and reported by bodies like Semiconductor Equipment and Materials International and the Semiconductor Industry Association.

• Many companies report it separately.• Texas Instruments likes to talk about book-to-bill numbers. Cypress

Semiconductor reports it often. So do Freescale and Linear Technology.

• Increased visibility and transparency is a beautiful thing. When available, this metric is very helpful.

• Just getting your feet wet with semiconductor stocks? Start with companies that report book-to-bill numbers, to easily get the hang of how sales forecasting works here.

3 powerful prediction tools: Book-to-billReporting book-to-bill at all is evidence of a certain swagger.

In particular, I appreciate seeing this optional metric when it’s below 1.0.

Why? Because there’s a management team that respects shareholders and loves transparent reporting.

Ideally, the company can explain why bookings ran low – and describe how to turn the metric around.

3 powerful prediction tools: Order backlogsMany companies report order backlogs instead of book-to-bill ratios.

• Backlogs are orders received but not yet shipped.• Like high book-to-bill ratios, large backlogs point to

guaranteed sales growth.

• Unlike that ratio, there is no hard and fast rule to evaluate the strength of backlogs – every company is different. Source: ON Semiconductor.

3 powerful prediction tools: Order backlogs

• For example, ON Semiconductor feels good about backlog orders accounting for 80% of the coming quarter’s revenue.

• Taken from a recent earnings report, this figure represented a two-year high for Atmel.

• Intel, on the other hand, declines to report order bookings and backlogs at all – because they are generally too small to make a difference.

• “Over time, our larger customers have generally moved to lean-inventory or just-in-time operations rather than maintaining larger inventories of our products. […] Only a small portion of our orders is non-cancelable, and the dollar amount associated with the non-cancelable portion is not significant,” the company says in SEC filings.

3 powerful prediction tools: ResearchStrong R&D budgets always get my seal of approval.

So do muscular capital expenses – putting the research results to work.

Source: Marcin Wichary via Flickr, under CC2.0.

3 powerful prediction tools: ResearchThis is a key reason why I own Intel.

• R&D budgets have grown 75% in 4 years.

• Infrastructure investments nearly tripled.

• Intel is investing heavily in its future.

3 powerful prediction tools: ResearchBig R&D budgets are no guarantee for producing the right

inventions.

But it’s a great start and the right thing to do in this industry.

Following up with meaty capital expense budgets says that management believes in the current direction.

They may be wrong, but have more information and bigger incentives to get it right than anybody else.

Take this home with you:

Source: Texas Instruments.

Some semiconductor stocks are poised for takeoff; others may crash. You must learn to tell the difference.

• Picking the right markets is half the battle – stay on top of macro trends in technology.

• Execution is the other half. Watch the right metrics to judge this part.• You want to see:

• Strong gross margins• Healthy revenue growth• Solid book-to-bill ratios and/or order backlogs

• Confident R&D and CapEx budgets are special. High growth here can override other weaknesses – because it means the company is planning for the very long term.

Are you ready to profit from this $14.4 trillion

technology revolution?