4 Top Chip Buys
08/18/2011 9:30 am EST
The correction has provided investors a great opportunity to buy some top-notch chip companies at bargain prices, observes Peter Staas of Personal Finance.
It’s impossible to overstate the importance of the semiconductor to modern society. Since Jack Kilby of Texas Instruments (TXN) devised the integrated circuit chip in 1958, semiconductors have directly or indirectly contributed to most technological advances of the past half-century.
The semiconductor has shaped the evolution of even mundane commercial enterprises, as computers have streamlined production processes and improved the efficiency of distribution networks.
But the ubiquity of these chips has spawned a new challenge over the past few decades: generating meaningful revenue growth. Many investors regard semiconductor stocks as a cyclical growth story that hinges on macro trends.
As such, the semiconductor industry tends to attract value-oriented investors who rotate money to the group in anticipation of a cyclical upturn. This strategy explains why these stocks’ valuations have declined over the past decade. The severity and suddenness of these cyclical swings also dissuade many investors from betting on them.
But the recent correction could represent a buying opportunity—though stock selection will determine success at this stage in the up cycle.
The top-down case for investing in the semiconductor industry is simple. Demand continues to recover in mature markets, while a growing middle class in emerging markets bodes well for sales of the consumer electronics and information technology central to a service economy.
The wage inflation in China that economists often fret about is good news for the semiconductor industry over the long term.
At the same time, the amount of semiconductor content in key product categories continues to expand. For example, market research firm International Data Corp (IDC) estimates that the typical fourth-generation smartphone contains 50% more semiconductors than the average third-generation model.
IDC also expects the worldwide smartphone market to grow by 55% in 2011, and at a compound annualized rate of 25% from 2010 to 2015.
But investors often overlook the growing use of semiconductors in automobiles and industrial products (roughly 10% to 20% of the industry’s 2010 revenue), two end markets that offer stable demand and solid margins relative to the fickle technology end market.
The growth opportunity in the auto industry doesn’t hinge solely on porting popular features from consumer electronics—GPS, touch screens, and digital media players—to car dashboards.
Ford (F) and other car companies have played up this trend successfully in their latest marketing campaigns, but what’s going on under the hood makes the auto industry one of the fastest-growing end markets for semiconductor content.
For example, an increasing number of car manufacturers are replacing traditional mechanical or electromechanical systems related to the drivetrain with semiconductors. This transition reduces a vehicle’s weight and improves its overall fuel efficiency.
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Cars are also getting smarter in other ways. Analog sensors and semiconductors that detect and interpret changes in real-world phenomena—for instance, rain or tire pressure—make today’s automobiles safer to drive.
Many of these advanced features debut in luxury automobiles, but eventually migrate into lower-end models. Sensor and controls manufacturer Sensata Technologies (ST) remains one of our top plays on this trend.
A similar focus on energy efficiency has changed the internal component of washers, dryers, and air-conditioning units, many of which now feature variable-speed motors.
In the near term, shares of Fairchild Semiconductors (FCS) represent a bet on a reacceleration of US and global economic growth in the back half of 2011. Management recently reaffirmed that third-quarter revenue should hold steady or increase by up to 3%, a reassuring forecast at a time when many worry about weakening PC demand.
Meanwhile, the company’s exposure to attractive end markets should separate the stock from its peers. Industrials and auto manufacturers accounted for about 48% of Fairchild Semiconductors’ 2010 revenue, while the firm’s mobile, computing, communications, and consumer segment represented 41% of sales.
Management is particularly bullish on its smart-power module (SPM) business, which stands to benefit as industrial end markets switch from single-speed to variable-speed motors. The value proposition of making this transition is compelling—for example, a commercial-scale air-conditioning unit outfitted with a variable-speed motor can produce energy savings of 50% to 60%.
This transition is in its early stages and offers plenty of long-term upside. Fairchild Semiconductors’ SPM revenue was up 20% sequentially in the second quarter, and had doubled from year-ago levels.
The stock rates a buy.