The analog chip industry has undoubtedly encountered a mild slowdown, starting in June 2011 and accelerating through August as a shaky European economy and the United States debt downgrade led to global macroeconomic uncertainty.
While it still remains to be seen how much better or worse the global economy (and, in turn, chip demand) will get in the coming months, we believe that several high-quality analog and embedded chipmakers are trading at attractive valuations today. Specifically, we have our eyes on Analog Devices (ADI), Linear Technology (LLTC), Microchip Technology (MCHP), Maxim Integrated Products (MXIM), and Texas Instruments (TXN) within the space. We didn't see much of a margin of safety in these stocks in better times, but many of these stock prices have fallen about 15% since May.
Several of these firms have narrow or wide economic moats, generate healthy free cash flows, and offer nice dividend payouts. More importantly, regardless of the depth of the current chip industry slowdown, we believe that each of these firms will be able to weather the storm.
After suffering from a severe downturn stemming from the credit crisis in late 2008 and early 2009, the chip industry was on a tear in late 2009 and most of 2010, as most firms were reporting record-high revenue levels, boosted by favorable technology trends such as smartphone adoption, wireless infrastructure build-outs, and increased silicon content in automobiles. Business slowed down in late 2010 and early 2011, reverting back to what appeared to be normal seasonal patterns. However, the tragic earthquake in Japan in March 2011 has caused some disruptions and choppiness within the chip supply chain. Some firms suffered from fewer chip orders, either because of lower production or because their customers couldn't get enough parts from other suppliers in order to satisfy their production. On the other hand, some firms saw a short-term boost in chip orders in March/April, as customers wanted to make sure they had enough chip inventory on hand in order to complete their products.
Layered on top of these disruptions was the rise in global macroeconomic uncertainty in the months of August and September. The usual supply chain ups and downs that determine the near-term health of many chipmakers now appears to be a secondary issue, as the bigger concern is the overall health of the global economy. Industries with characteristics of long product life cycles and hefty capital spending, such as industrial, auto, and wireless infrastructure, appear to be cancelling or pushing back their spending until there is more certainty in the global economy. This simple pause in spending and new production typically causes a whiplash effect on chipmakers, as these firms in turn place fewer orders for semiconductors used in a variety of these products.
Current Business Conditions: A Case Study in Chip Cyclicality
Business conditions today are a prime example of why the analog chip industry has been notoriously cyclical and why stock prices spike and sell off accordingly. The most important factor to consider is that, unlike many digital chipmakers that design but don't manufacture chips, analog companies make most of their chips in-house, resulting in high-fixed-cost businesses. Fewer chip orders during a slowdown typically lead to a decline in factory utilization, gross margins, and, ultimately, profitability. Since analog chipmakers can't cut variable costs enough to offset the revenue decline, earnings suffer and stock prices tend to dip accordingly. Most of the aforementioned chipmakers were down about 10% in the month of July due to supply chain disruptions, and down an additional 10% in August during the wild market sell-off, although we should note that prices have bounced back a little bit in September thus far.
Companies such as Linear Technology and Microchip first saw this slowdown coming in July and forecast mid-single-digit sales declines in the third quarter. After the U.S. debt downgrade and market sell-off in August, business conditions appear to have deteriorated further, as firms like Texas Instruments, Intersil (ISIL), Altera (ALTR), and Xilinx (XLNX) each provided investors with third-quarter earnings warnings. Broadly speaking, a high-single-digit sales decline in the third quarter appears to be the new baseline for broad-based analog chipmakers this quarter.
That said, we do see a lone bright spot in the chip space, stemming from the handset industry. We believe that the handset market will show greater resiliency than other tech sectors, such as industrial, in the near term because demand for these devices tends to be driven more by new product releases (such as a new Apple (AAPL) iPhone on the horizon), rather than tied to GDP growth or macroeconomic conditions. Firms with a bit more exposure to the handset market, such as Maxim Integrated Products, may fare modestly better than the rest of the pack, thanks to seasonal strength in handset production during the quarter. We should also note that many other chipmakers with concentrated exposure to the handset industry, such as Qualcomm (QCOM) and Skyworks Solutions (SWKS), may report better earnings than analog chipmakers in the third quarter, again due to manufacturing seasonality. We also believe these wireless chipmakers are modestly undervalued as well, but for much different reasons, as most wireless and other digital chipmakers have different business models than the analog chipmakers discussed in this article.
Moaty Chipmakers Should Weather the Storm
Despite the vast uncertainty in the global economy, we believe that buying opportunities exist across most of the five aforementioned analog chipmakers (TI, Analog Devices, Linear, Microchip, Maxim), as we remain confident that each of these firms will survive this latest industry downturn. Taking a look at how these firms performed during the credit crisis, analog chipmakers saw a sharp decline in business conditions in the December 2008 quarter and another sharp falloff in March 2009. However, these firms saw a nice bounceback in revenue in the following months, as chip demand came back faster than anticipated and most chipmakers didn't have enough capacity on hand to meet the flood of new orders. Sales levels eventually recovered to pre-crisis levels by March 2010. Similarly, the average stock price of these five firms rose 28% from March 31, 2009, to July 31, 2009, as chipmakers were one of the first sectors to see the onset of an economic recovery.
Along the same lines, we still currently forecast that analog chip demand will exhibit "V-shaped" cyclicality in the near and medium term. Just as a pause in production has led to an exacerbated decline in chip orders today, the potential of a modest recovery in the coming months could lead to a boost in chip orders, and manufacturers may quickly realize that they don't have enough chip inventory on hand to finish production. In turn, stock prices for these firms may rise accordingly as earnings forecasts improve.
We like these five firms in particular because they have vast experience in navigating through the cyclical upturns and downturns in the chip industry. Each firm is highly profitable under normal business conditions, as they have low R&D and capital expenditure reinvestment needs. Barring a true macroeconomic calamity, we think that business conditions will bounce back in the not-too-distant future. Similarly, while these firms may trade at consistent P/E ratios during a market slide as both near-term earnings and stock prices decline, we believe these stocks are trading at an attractive multiple on a forward P/E basis once these firms revert back to normalized earnings.
Finally, we probably won't change our long-term theses for these companies based on any near-term turbulence. We continue to believe in several favorable long-term trends for the industry. For example, given the exponentially increasing data demands of wireless customers seeking instant video and Internet access on the go, we expect wireless carriers to continue to spend on infrastructure equipment in order to build out their 2G, 3G, and 4G networks. In automotive, we continue to anticipate an increase in silicon content per car, both in terms of more in-dash displays, sensors, and other chips in gas-powered vehicles, as well as additional sensors and power management chips in batteries used in hybrid and electric cars. STMicro (STM) estimates that cars currently include more than $300 of chip content today but that hybrid and electric vehicles will require $600 and $900 of silicon content, respectively. Finally, we don't see the change in product mix within the handset industry toward high-end smartphones slowing down anytime soon, which could benefit Maxim, TI, and other analog chipmakers that have long-standing relationships with leading smartphone makers.
