4 Chip Stocks Bucking the Trend

10/25/2011 9:30 am EST

Focus: STOCKS

In the earnings reports delivered last Wednesday and Thursday, we got mostly "check-box" reports that are very well aligned with our previews, with just a couple of what I would call check box-pluses, say Paul McWilliams of Next Inning Technology Research.

In the earnings reports delivered last week, we got mostly "check-box" reports that are very well aligned with our previews, with just a couple of what I would call check box-pluses.

For the most part, sequential guidance from broad-line semiconductor suppliers is coming in between a decline measured in high-single-digit to low-double-digit percentages. There have been exceptions to this trend, but most follow this guidance. Outside these, however, is one that may be a bit puzzling.

Maxim Integrated Products (MXIM), which is reasonably well classified as "broad-line" and with growing exposure to various high-volume consumer sectors, appeared to fight this trend with midpoint guidance for a 6.5% sequential decline. However, once we normalize its guidance for a 13-week versus the 14-week quarter it will report, its guidance suggests a sequential decline of about 13.3%.

This is a bit worse than Linear Technology (LLTC) (which is often considered to be similar to MXIM), but during the last few years MXIM’s sector mix has moved more towards high volume consumer applications while LLTC has moved in the opposite direction.

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In short, given the sector exposure and the market conditions we’re seeing today, both companies are doing fine and provided guidance aligned with reasonable expectations. Please note, given the holiday scheduling for calendar Q4, the factoring I’ve used for MXIM is imprecise, but for our purposes here of relative comparison, good enough.

While Lattice Semiconductor (LSCC), the No. 3 player in the programmable logic sector, guided for a 6.5% sequential decline at the midpoint (which is obviously between the two leaders), there are a couple moving pieces in that equation that I think warrant giving it a "check-box plus" award.

As I’ve carefully outlined over the last couple of years or so, there are sound reasons behind my flip from a long-held bearish view on LSCC to what is now a decisively bullish view.

In short, LSCC is operating and executing in very good alignment with the predictions I made in 2008 and 2009, when the stock was trading below $2. In years past, LSCC was much more a science experiment than it was a viable enterprise. That changed in 2008 when LSCC began to change the composition of its board of directors and subsequently its executive management.

Like Dorothy in the Wizard of Oz, LSCC always had what it needed to bring home sustained growth and dependable profitability—it just never focused on leveraging its strength. That has changed, and along with it the potential for LSCC to become a highly successful growth story.

While most of what we learned from LSCC was "check-box" stuff for me, what adds the plus here is LSCC is illustrating with even more clarity now that it is executing the strategy successfully. It should be positioned in 2012 to leverage its improve operational structure and the business model it has developed to grow earnings much faster than it grows revenue.

In short, I think LSCC is very near to a positive tipping point. While the trajectory of LSCC, just like the rest of the industry, will be dependent on economic activity in the coming year, I think LSCC is positioned well to notably outperform the semiconductor sector and, quite possibly, its larger peers.

At this juncture, LSCC is still enduring some duplicate cost structures. As companies transition operating models to reduce costs—which in the case of LSCC includes moving some operating costs from a fixed to a variable structure—they have to maintain both operations at near full cost structure towards the end of the transition.

In short, while they build and deploy the new strategy, they cannot release the old one until the new one is stable. That is where LSCC is today. However, as we move through 2012 LSCC will wind down the old, higher cost structure, and with that favorably scale its operating costs as revenue rises.

In addition to this favorable scaling, LSCC will further flesh out its low-cost programmable logic strategy, and begin to build a rounded business in the various sectors where the lower prices open new market opportunities. This is important because with a broader base, the naturally high volatility of the individual deals inherent in these markets will tend to spread and mute the aggregate volatility for LSCC.

Flextronics (FLEX) also gave us some "check box-plus" data. Well aligned with our coverage on the Electronic Manufacturing Services (EMS) industry, FLEX is transitioning away from the PC sector.

When FLEX entered this sector, profit margins were reasonably high, but over time those margins dropped below what was appropriate for the FLEX model. Due to this, rather than trying to fight the tide and rationalize its prior decision, FLEX owned up to reality and filed publicly for divorce.

This divorce from its PC business will be completed a bit ahead of schedule. With this fact now staring Wall Street in the face, we’re seeing today the realization of what I’ve written the FLEX model has the potential to deliver.

As I see it, this accelerated divorce and the clarity FLEX provided investors merits adding a plus by its check box.

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