One thing that S&P has always excelled in is having wonderful hindsight. The article below doesn't disappoint in that regard. They lay out where the semiconductor sector has been and, I think, the standard view on where we are going and why semiconductor PEs remain low.
Chipmakers face slowing growth
By Standard and Poor's
July 28, 2010 10:58 am ET
Standard & Poor's Equity Research Services (ERS) has a neutral 12-month fundamental outlook for the semiconductor industry. Industry revenues, after dropping with the broader economy during the recession, have staged an impressive comeback that continues today. Results from the recent second quarter have continued the trend of beating Wall Street's projections; and S&P's semiconductor equity analyst Clyde Montevirgen still believes that by the year's end, the industry will have achieved 29% sales growth and posted record sales levels. However, Montevirgen also believes nothing good lasts forever. He does not think this fast rate of expansion is sustainable, and believes that chipmakers are approaching a short-term top of an industry cycle. He expects growth to continue at a more measured pace in coming quarters.
Chipmakers reduced production and underinvested in capacity last year in an effort to keep supply in line with anticipated demand. But when orders returned, the demand caught them off-guard, resulting in undersupply and pent-up demand. It has taken a year to replenish customers' stock, and inventory now appears to be at desired levels in most cases, according to ERS. Montevirgen believes the inventory replenishment cycle that has been one of the biggest drivers for fast revenue growth is largely over; and now it is dependant on macro factors, such as economic conditions, to support top-line advances, in his opinion.
Considering recent notes from S&P Economics, market and industry researchers, and chipmakers' earnings reports, Montevirgen sees healthy end-market demand, supporting reasonable, seasonal growth in coming quarters. He believe strong demand for fast growing end-products, such as computers, smartphones and related wireless infrastructure, and other consumer electronics products (these products make up a large percentage of the semiconductor industry's demand) will support increasing unit shipments. He also anticipates demand from industrial customers, who have recovered at a relatively slower rate but are employing more and more semiconductor content into their products, will provide a temporary boost to orders as global demand improves and as new product cycles begin.
Furthermore, with the top-line jumping, the bottom-line should skyrocket, in Montevirgen's opinion, this year. Chipmakers cut variable and fixed costs during the downturn, and as production rose with demand, the industry achieved higher profitability and stronger earnings power at lower sales levels. The impact of higher capacity utilization, in which fixed costs are spread over increasing volumes and thus reducing unit costs, has lead to decade-high profitability. This is evident in the sharp margin increases experienced by leading chipmakers: Intel's gross margin rose from 51% in the second quarter of 2009 to 67% the same period of 2010, Texas Instruments' widened from 46% to 54%, and Micron's increased from 10% to 37%.
Profitability has been through the roof; but Montevirgen thinks that chipmakers will start to face the law of diminishing returns. Now that plants are running very efficiently, he does not expect the same benefit from operating leverage and foresees slower margin expansion moving forward. He anticipates the industry capacity utilization, already at multi-year highs, to increase only modestly over the next few quarters; and as chipmakers increase capital expenditures to add more capacity, Montevirgen sees increasing business risk.
Chipmakers benefitted from both operating efficiency and fast sales growth over the last year, he says. But with companies now highly productive, Montevirgen thinks they will be less focused on efficiencies and more on generating sales as a way to maintain earnings growth. Specifically, he believes chipmakers will look to gain market share through price reductions or product differentiation, which can both have negative implications on margins. He also believes some customers may have ordered more chips than necessary over the last couple of quarters to hedge against future shortages. In previous cycles, this “double-ordering” has led to order cancellations and push-outs, causing inventory corrections that halted sales growth.
Montevirgen expects industry revenue growth to decelerate from 29% in 2010 to 10% in 2011, and he sees earnings growth for companies in his semiconductor coverage universe slowing as well, from over 100% in 2010 to the low-teens range in 2011.
With his view of steady but decelerating earnings growth and the possibility that chipmakers may be near the peak of the industry cycle, Montevirgen believes relative valuations are fair. The industry's below-market forward P/E is a reflection of similar-to-market growth over the next several quarters and the chipmaker's higher business risk.
For investors who agree with this thesis, the next question becomes how one goes about putting it into action in one's portfolio. Answering that question depends in part on gauging an investor's investment objectives and risk tolerance. For individual stocks, S&P Equity Research has buy (4-STARS) recommendations, as of July 27, 2010, on Intel and Altera, companies that Montevirgen thinks have strong sales growth opportunities. S&P Equity Research has a sell (2-STARS) recommendation on LSI, and a strong sell (1-STARS) recommendation on International Rectifier, companies Montevirgen views as having weakening end markets, notable business risk, and too-high valuations. (See stock table, with positive potential implications.)
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