Fri, 4 Sep 2015
Chipmakers today are carving out competitive advantages through their proprietary chip designs, high customer switching costs, and exposure to the burgeoning market for electronic systems in vehicles.
Brian Colello: Often in technology, investors are skeptical of economic moats because of the constant fear of disruption. But for a variety of reasons, we don't see this in analog semiconductors. Our review of the industry looks at several firms with wide and narrow economic moats, such as Analog Devices (ADI), Linear Technology (LLTC), Microchip (MCHP), Maxim Integrated (MXIM), and Texas Instruments (TXN).
Looking at the industry, we think these firms have built economic moats based upon intangible assets around proprietary chip designs. This expertise is based off of decades of work from talented engineers. We view analog-chip design as more of an art than a science. We think it takes years of trial and error for these chipmakers rather than simply shrinking transistor sizes or learning designs from a textbook.
The second source of economic moat that we see in the analog space is from switching costs. Analog chips are low-priced parts--often less than one dollar--so design wins are often based on performance rather than price. When customers select an analog part, they tend to stick with it for the life of the product. The economics to switch to a competing part rarely makes sense, and the engineer will rarely run the risk of using a lower-quality part just to save a few pennies on a chip.
Looking at growth opportunities in analog, we see the automotive end market as most promising. The short story here is that analog chips are key components in the rising secular trend of increased electronics content per car, whether it's advanced safety systems (like radar, blind-spot detection, lane-departure warning, and parking assist), whether it's the rise of increasingly advanced "infotainment" systems--both in mass-market cars and luxury cars--increased connectivity solutions throughout the car, or more advanced powertrains--both in gas-powered cars and also hybrid and electric vehicles. We think demand will be supported for all of these products all across the value chain.
Governments are mandating safety features and fuel efficiency. Automakers are using these features as differentiators as they compete with one another. The auto-parts makers get to sell more advanced content, and consumer demand for this increased technology is favorable, while the demographics are favorable among consumers.
Picking stocks, we didn't see attractive buying opportunities in analog for the past couple of years; but in recent weeks, we've seen a bit of a sell-off. We're starting to see a margin of safety in a high-quality name like Linear Technology, at or below $40 per share. We also like Infineon Technologies (IFNNY), which is a no-moat name, but it's trading about 20% below our fair estimate--both in European and U.S.-traded shares. In addition, Infineon has terrific exposure to this fast-growing automotive market.
Just as important, the industry is cyclical, and sentiments can change quickly. So, we'd buy most of these firms with a larger margin of safety if we do get to see a bigger pullback.