They can't keep up with demand..sorry it's so long...
Industry Analysis
Nov 12, 1999
Semiconductors: Handicapping Merrills Semiconductor Picks
Senior analyst: Chris Bulkey (11/12/99)
The outlook for the semiconductor industry continues to improve due in large part to a shift from PC-centric demand to applications used in wireless communications and Internet infrastructure settings.
Recent data from the Semiconductor Industry Association (SIA) confirms that industry growth is accelerating and poised to remain strong for years to come.
Worldwide sales of semiconductors increased 24% in September, from a year ago, led by communications and networking chips. In a recent press release, SIA President George Scalise said demand was broad-based and that September sales were the largest seen all year continuing a rebound from last year?s industry downturn. With Japan and Asia reporting sales increases of 37% and 36% respectively, industry momentum appears to be accelerating.
An important aspect to consider is that this upturn appears to be more well controlled than previous expansions when chip-makers had a propensity for adding capacity too rapidly, which then fueled volatile boom-bust cycles.
Semiconductor companies have also made a deliberate effort to lower cost structures and have hopefully learned from past over-capacity mistakes. This fact has also led many Street analysts to incorporate low margin assumptions into earnings projections for many companies, which should lead to more earnings surprises in 2000; yet another catalyst for semiconductor stocks.
Looking ahead, The SIA projects sales to rise 21% to $174 billion in 2000 versus a projected 15% gain in 1999. Two areas that should outpace the industry are flash memory and digital signal processors (DSPs), which are projected to grow 36% and 32%, respectively, in 2000. Flash memory chips, which retain information when power supplies are turned off, are vital in mobile phones, digital cameras and mobile computing devices. DSPs, which can be thought of as the central nervous system of a mobile phone, also have a strong outlook. Add in continued strong demand from data networking, PC and fiber optic markets and you have the landscape for a sustainable industry upturn.
Merrill Lynch (NYSE:MER - news) analyst Joe Osha is turning increasingly bullish on the industry and on Wednesday reiterated positive recommendations on nine semiconductor stocks.
The Lucky Lot
Among those singled out by Osha are Analog Devices (NYSE:ADI - news) , Applied Micro Circuits (NASDAQ:AMCC - news) , Broadcom (NASDAQ:BRCM - news) , Conexant (NASDAQ:CNXT - news) and Linear Technology (NASDAQ:LLTC - news) .
Merrill?s other picks are LSI Logic (NYSE:LSI - news) , Texas Instruments (NYSE:TXN - news) , PMC-Sierra (NASDAQ:PMCS - news) , Vitesse Semiconductor (NASDAQ:VTSS - news) and STM Microelectronics (NYSE:STM - news) .
Out of this group, Osha placed the highest ratings on Broadcom, Texas Instruments, PMC-Sierra and STM Microelectronics. While we do not disagree with Osha?s outlook for the aforementioned stocks, we would like to single out two that look particularly well positioned.
PMC-Sierra
We have written about PMC-Sierra several times in the past and although the stock has had a tremendous run, we think the outlook continues to be very positive. The company is well positioned in important high-speed networking standards including asynchronous transfer mode (ATM), T/E and Sonet.
PMC?s operating model of outsourcing wafer production affords it the highest margins of its closest rivals and allows for significant earnings leverage. The company?s design win momentum has accelerated tremendously in recent quarters and when you consider that over half of revenue year-to-date has come from chips designed in 1995 and earlier, future growth rates are poised to accelerate.
PMC also has two catalysts to drive further internal operating gains. The first is the company?s announced plan to shift Ethernet resources from enterprise applications to the public network. The enterprise or local area network (LAN) is more price-competitive, whereas the public network requires more high performance, application specific chips.
Meanwhile the acquisition of Abrizio, which will cause some near-term dilution, has great potential. CEO Bob Bailey confirmed on the third quarter conference call that customer interest has been overwhelmingly strong for Abrizio?s products, which will help keep design win momentum intact. Throw in a clean balance sheet and strong cash flow and you have a solid core holding.
Texas Instruments
Texas Instruments (NYSE:TXN - news) is another company we have written about and continue to favor due in large part to its dominant position in the DSP market. Aside from strong top-line growth, Texas Instrument?s transition from a diversified manufacturer to a broadband chip provider has led to a dramatic improvement in profit margins, which has led to torrid earnings growth and upward earnings revisions.
Texas Instruments has also made a few strategic acquisitions to expand its broadband portfolio, including Voice over Internet Protocol and cable modem applications. In addition, the company recently announced plans to develop a platform for use in next generation wireless information devices, such as GPRS and 3G wireless applications, both of which exploit the market for mobile data applications. Texas Instruments is well positioned to grow earnings beyond the 30% that the Street is currently projecting.
RF Micro Devices
There are also two related stocks that we believe readers would be well advised to take a look at. The first is RF Micro Devices (NASDAQ:RFMD - news) , a leading provider of radio specific integrated circuits (RFICs) for use in a wide range of wireless applications. A significant advantage for RF is its ability to internally manufacture GaAs HBT (gallium arsenide heterojunction bipolar transistor) wafers, which is helping the company to meet the incredibly strong customer demand. The ramp in capacity has also favorably impacted profit margins and has more upside left, as a new facility has only recently begun construction.
The ability to manufacture in large volume is particularly important, as many handset manufacturers have complained of component shortages. GaAs HBT applications have an advantage over traditional silicon due to increased linearity (greater clarity) and are favored for next generation applications based on CDMA technology. This has enabled the company to win a large percentage of South Korean business, which has accelerated tremendously, as these original equipment manufacturers (OEMs) look to expand their CDMA presence.
RF has also broadened a customer base that has historically been highly concentrated around handset leader Nokia (NYSE:NOK - news) . The company?s business with Motorola (NYSE:MOT - news) has expanded significantly and Qualcomm (NASDAQ:QCOM - news) was recently added back to the customer list after having left RF previously.
In summary, RF simply cannot manufacture enough product to satisfy customer demand, but that situation is changing. As the wireless Internet and increased mass-market penetration fuel industry growth for years to come, RF will be well positioned to benefit.
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