Our Outlook for the Hardware Sector
Our picks and pans from among semiconductor firms.
Stock Strategist
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The chip sector continues to be mired by sluggish demand. Excess inventories that began accumulating in the electronics supply chain last year continue to persist. The good news for investors is that downturns in the cyclical chip industry have historically offered the most opportune times to purchase stocks. During these periods, we believe the market tends to extrapolate poor near-term business results into long-term trends, which offers some attractive bargains for investors.
The slowdown has dragged down sales across the semiconductor industry, although it has been more pronounced in certain segments than others. Over the course of 2006, the industry went from an inventory shortage to a surplus of $4.3 billion, according to iSuppli Corp. Before chip firms see a rebound in sales and profits, the electronics supply chain has to first work through these excess inventories. Investors should be careful with their stock selections and avoid the trap of buying just any chip stock because the industry is in a downturn. While we are finding bargains in some segments, others remain overvalued and are brimming with land mines that should be avoided.
Valuations by Industry
Our average star rating for the semiconductor industry is 2.82. Although we would expect this number to be higher given that we're in a slowdown, we believe some segments within the space are vastly overvalued, particularly the foundry and outsourced semiconductor and test (OSAT) segments. Our favorite stock picks can be found in the analog/mixed-signal segment of the industry.
| Hardware Industry Valuations | |||
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| Industry | Average | Average Price/Fair Value | Stocks Covered |
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| Components | 2.50 | 1.29 | 8 |
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| Computer Equipment | 2.82 | 1.03 | 28 |
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| Contract Manufacturers | 4.11 | 0.79 | 9 |
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| Data Networking | 3.10 | 0.98 | 10 |
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| Optical Equipment | 2.80 | 1.04 | 5 |
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| Semiconductors | 2.85 | 1.15 | 60 |
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| Semiconductor Equipment | 2.04 | 1.27 | 25 |
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| Wireless Equipment | 2.90 | 1.01 | 10 |
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| Wireline Equipment | 3.46 | 0.94 | 13 |
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| Data as of 03-15-07. |
The analog/mixed-signal portion of the chip industry has been particularly affected by the inventory build and is where we're finding most of our bargains. Analog/mixed-signal chips can be found in pretty much all electronic gadgets, ranging from PCs and laptops to mobile phones and MP3 players. More importantly, this segment of the semiconductor industry offers its fair share of quality companies for the long-term investor.
| Picks & Pans--Semiconductors | |||||
| | | | | |
| Company | Star Rating | Fair Value Estimate | Economic Moat | Risk | Segment |
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| Linear Technology |  | $45.00 | Wide | Average | Analog/ Mixed Signal |
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| Maxim Integrated | | $52.00 | Wide | Average | Analog/ Mixed Signal |
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| Vimicro | | $13.00 | None | Above Avg | Analog/ Mixed Signal |
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| United Microelectronics |  | $2.50 | None | Above Avg | Foundry |
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| Amkor Technology | | $7.50 | None | Above Avg | OSAT |
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| Data as of 03-22-07. |
We believe that the supply chain has been much more responsive during this downturn than in the past at reducing buildups in analog/mixed-signal inventory, which should help lead to a faster recovery. Our view appears to be supported by recent announcements from some of the top names in this market, including Analog Devices (ADI), Texas Instruments (TXN), and National Semiconductor , indicating that there are signs of inventory declines. With an inventory situation that appears to be under control, the segment should be able to avoid the prolonged and severe downturns of the past.
Given the plethora of analog/mixed-signal companies, it's important for investors to separate out the attractive names before investing. Our top picks in this sector include Linear Technology , Maxim Integrated , and Vimicro .
Linear Technology and Maxim Integrated are two well-diversified and very profitable analog/mixed-signal wide-moat names. These companies have the engineering talent and technology expertise to develop highly sophisticated and proprietary chips that command solid profit margins. Further, we believe that these firms will be capable of growing faster than the broader semiconductor industry over the long term.
Vimicro is a leading chip design company in China. Inventory buildups of PC-related semiconductor devices have slowed demand for the firm's webcam processor chips. But now that Microsoft's (MSFT) Windows Vista has launched, we expect Vimicro to see a steady recovery in demand throughout the next year. We are excited about the long-term prospects of this company, as it diversifies into the mobile phone multimedia chip market. With China's rapidly emerging semiconductor industry as a backdrop, we believe that Vimicro has some bright opportunities ahead.
In our opinion, the foundry and outsourced semiconductor assembly and test (OSAT) segments rarely represent good long-term holdings, and today they are no exception. Despite lower revenue levels in recent quarters resulting from the industry downturn, we believe that the companies have yet to see the steep profit declines that generally accompany business slowdowns. Most foundries and OSATs have long histories of destroying shareholder value, and we don't see any fundamental changes in this difficult industry to alter our viewpoint.
One of our pans is the world's second-largest foundry, United Microelectronics (UMC). UMC has been largely unprofitable throughout its history, and by our estimates, posted operating margins of only around 3% in 2006. While the market was overjoyed with these paltry returns, believing it is evidence of UMC turning its business around, the company lacks the scale enjoyed by rival Taiwan Semiconductor (TSM), leaving UMC at a competitive disadvantage in the capital-intensive foundry market.
In the OSAT space, we are bearish on the second-largest player, U.S. firm Amkor (AMKR). While pricing held up in 2006 as the stars aligned for the industry, we believe OSAT is fundamentally a low value-added, no-moat business that competes primarily on price. Although the stocks have performed well recently, we attribute this to excitement over recent M&A activity in the space, rather than any fundamental improvements in their competitive positioning or intrinsic value.
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