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Quarter-End Insights

Our Outlook for the Hardware Sector

Some promising opportunities exist.

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Amid the recent market pessimism, we decided to focus our quarterly outlook on the semiconductor firms on Morningstar's coverage list. We'll also take a look at several other promising hardware firms.

Canaries in the Consumer-Spending Coal Mine
Semiconductors have long been considered canaries in the investment coal mine. The high fixed production costs that many chipmakers and chip-equipment suppliers have in the form of their fabrication plants (or "fabs") and equipment mean that when demand is brisk, the firms make money hand over fist. When demand falls off, however, the firms are left struggling to scrape together enough revenues to pay for their fixed assets. Those in the financial world characterize companies with business models like this as having high "operating leverage."

We believe that changes in demand dynamics may end up exacerbating the effects of semiconductor operating leverage in an economic slowdown. While semiconductor demand in earlier years came from the more stable government and corporate sectors, nowadays the vast majority of chip demand comes from consumer applications such as mobile phones, laptop and desktop computers, video game consoles, and plasma televisions. The proliferation of electronic products used in our daily lives has been a great boon to chipmakers, which have enjoyed a rapid expansion of sales since the start of this century. However, consumer demand is a double-edged sword. Product cycles are short and demand trends are faddish, and if consumers don't have enough money for their monthly mortgage payments, they certainly won't be in the market for the next leading-edge electronic gadget.

Finding a Harbor in the Storm
In light of these macro- and microeconomic issues, we have considered what chip firms would serve as the best safe havens for investor capital. In general, we tried to find firms that have relatively less exposure to U.S. consumer markets, offer generous dividends, are exposed to countercyclical demand, or have strong economic moats that might be further strengthened in a downturn. A few of the stocks that meet these criteria from our coverage list are  Analog Devices (ADI),  Microchip (MCHP), and  Texas Instruments  (TXN).

Valuations by Industry
Reviewing the industry valuations below, we were particularly struck by how well semiconductors have held up over the past three months. While other sectors in the hardware universe are down double digits compared with the last quarter, chips have stayed relatively steady.

 Hardware Industry Valuations
Segment

Current Median Price/Fair Value

Three Months
Prior
Change
(%)
Components 0.83 1.01 -17.8
Computer Equipment 0.83 1.01 -17.8
Contract Manufacturers 0.96 0.87 -9.4
Data Networking 0.86 0.86 0.0
Optical Equipment 0.98 0.92 -6.1
Semiconductors 0.83 0.85 -2.4
Semiconductor Equipment 0.82 1.00 -18.0
Wireless Equipment 0.81 1.02 -20.6
Wireline Equipment 0.55 0.90 -38.9
Data as of 03-14-08.

We think this can be attributed to the "canary in the coal mine" effect.  Three months ago, the semi group was one of the hardest hit--in our opinion, this was because investors sold chip stocks at the first whiff of an economic slowdown. The trip southward that semi stocks took last quarter was taken this quarter by sectors surrounding chips on the value chain. This lag was also evident in the most recent round of quarterly conference calls. CEOs of chip companies who had been dour last quarter sounded upbeat this quarter; non-chip-company CEOs were bullish last quarter and cautious this one.

Several other hardware groups display the same cyclical sensitivities that semiconductors do, and this is evident when looking at the wireline equipment sector numbers in particular. With many telecom carriers still in the throes of large mergers, the wireline equipment providers have been caught in a cyclical downturn just as the economy seems to be weakening. Making matters worse for wireline equipment is that many firms in this sector are smaller-capitalization stocks, which tend to feel disproportionate pain when the economy turns south. Our analysts believe that there are some compelling bargains in this sector now and one of our non-chip recommendations is a fallen star from this group. The other non-chip recommendation comes from the semiconductor-equipment sector. This group also saw steep declines over the last quarter; we think the decline results from slowing equipment orders--especially from firms specializing in memory chips (for more details, see the recent Stock Strategist article "Tiny Circuits, Big Profits").

Hardware Stocks for Your Radar

 Stocks to Watch--Hardware
Company Star Rating Fair Value Estimate Economic
Moat
Risk

Notes

Analog Devices $43 Narrow Average Industrial
Applied Materials $25 Wide Average Solar
Microchip $37 Narrow Average Dividend
Texas Instruments $46 Narrow Above Avg. Cash Flow
NetGear $36 None Above Avg. Cheap
Data as of 03-14-08.

 Analog Devices (ADI) is a chipmaker that focuses on the profitable business of supplying analog chips for industrial applications. Only 20% of its business is exposed to consumer spending, most of which is on the high end. This should enable ADI to weather an economic slowdown better than many of its semiconductor peers, as demand from industrial customers (50% of sales) will likely remain relatively stable, in our opinion. Additionally, a diverse customer base of over 60,000 customers globally should provide another layer of protection to shield ADI from a sharp decline in customer orders

 Applied Materials (AMAT) is not a chip firm, it's a semiconductor-equipment supplier. These companies provide the equipment that is used to manufacture semiconductor devices. Applied dominates that industry, thanks to its immense scale and broad product portfolio. The firm, along with the rest of the chip-equipment sector, is already in the midst of a cyclical downturn. While its smaller rivals tend to struggle during slowdowns in business conditions, Applied's sheer size and sturdy balance sheet allow the firm to maintain its massive R&D investments and stay at the technology forefront in tough times. In addition, the firm has been expanding into the emerging solar manufacturing equipment market. The endeavor appears promising and may become highly lucrative for Applied. We believe that the rapid growth of this noncore business should help Applied weather the chip-equipment industry downturn better than its peers.

 Microchip Technology (MCHP) stands out in the tech world because of its very healthy dividend policy and its ability to find gold in the lower end of high tech. Microchip manufactures chips called microcontrollers, which are found in almost any device that connects to electricity, such as toasters, vacuum cleaners, dimmer switches, and garage door openers. While Microchip's sales do have broad-based exposure to the U.S. consumer market, the products into which the chips are designed tend to be necessities rather than luxury or fad items. Readers who have been following our Microchip coverage had an opportunity to buy shares in the firm several months ago when the price fell to a low of $26.86 at the end of January before rebounding to the mid-$30s today--a 19% return in a month and a half plus a generous dividend of over $1.30 per share this year. We would keep your eyes on this stock; we'd consider buying if economic concerns drag the stock price down again.

 Texas Instruments (TXN) has a large exposure to the consumer market due to sales of chips bound for the mobile phones of its largest single customer,  Nokia (NOK). However, given that Nokia's sales are centered in Europe and Asia, we think there is a good chance that TI will be able to ameliorate the pain of a slowdown in the U.S. to some extent. What excites us most about TI is how successful the company has been in transforming its operating model and generating superb free cash flows. It has done this by outsourcing more leading-edge production to third-party chip manufacturers, hereby reducing the amount of funds spent buying capital equipment, and by making a push into the high-margin high-performance analog (HPA) market. The results have been astounding. In the last quarter of 2007, operational cash flows less capital expenditures--our definition of free cash flow--worked out to $1.2 billion. Dividing that by net revenue for the quarter of $3.6 billion gave a free cash flow margin of a whopping 35%. For the entire year, the figure was a slightly lower but still respectable 27%. Considering that TI's average free cash flow margin for the previous four years was only 13%, we think TI is an excellent value at today's prices.

 Netgear (NTGR) is a leading provider of home- and small-office networking equipment such as wireless routers, storage devices, and wi-fi phones. The company serves a market that is growing 15% to 20% annually--in which demand is driven by increased broadband penetration, new networking devices, and the need to interconnect more electronic devices. As a market leader, Netgear consistently grows faster than the market, averaging 20%-25% growth every year. It is number one or two in almost every country it serves, it's consistently profitable, and it generates more than 60% of revenue from international markets. Netgear has a size and cost advantage over most of its competitors, which tend to be smaller, private companies that compete solely in local markets. Given the long-term growth projections of the home- and small-office networking equipment market, and Netgear's many advantages, we think Netgear will outperform the market over the long term.

Analysts Dan Su, Andy Ng, Alex Dannin, and Jordan Zounis contributed to this article.

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Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.