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Back to Part XI

By Mark Bern, CPA CFA

I have chosen to combine these two related industries because I can justify a total of only three master list entries from the two industries combined based upon the merits of this process. For the semiconductor industry I expect that growth over the coming five years is likely to slow considerably over what has been experienced over the last five years so it becomes even more important to choose wisely because many companies in this industry tend to have highly volatile stocks. However, even growth in the high single-digits is good when combined with an above average dividend yield. Overall, I expect continued growth driven by the increased use of chips in everything from autos to home appliances. The more applications that are created for the chips, the greater will be the demand. And the demands for more applications appear almost endless, limited only by the imagination of electrical and design engineers and anyone else with a great idea.

Only two companies from semiconductors survived the process for long-term investment, Intel (NASDAQ:INTC) and Altera (NASDAQ:ALTR). I'll discuss why some of the other companies in the category didn't make my list a little later in the article. First I want to provide a little information about the two finalists. Intel manufactures integrated circuits for the computer, communications, industrial automation, and electronic equipment industries. It also serves military/defense applications. The company derives about 84 percent of all sales from outside the U.S. from its global manufacturing footprint, positioned to serve the entire world. Let's see how INTC rates against my metrics.

Metric

INTC

Industry Average

Grade

Dividend Yield

3.1%

2.5%

Pass

Debt-to-Capital Ratio

13.0%

6.5%

Neutral

Payout Ratio

33.0%

25.0%

Neutral

5-Yr Average Annual Dividend Increase

13.7%

N/A

Pass

Free Cash Flow

$0.45

N/A

Pass

Net Profit Margin

24.0%

22.5%

Pass

5-Yr Average Annual Growth in EPS

40.0%

36.1%

Pass

Return on Total Capital

24.4%

20.5%

Pass

5-Yr Average Annual Growth in Revenue

16.4%

5.5%

Pass

S&P Credit Rating

A+

N/A

Pass

In this industry, with the debt-to-capital ratios so low on average, I am giving companies a neutral rating as long as the ratio does not exceed three times the industry average, which is still below 20 percent. When assessing the debt we also need to consider the credit rating of the company which determines its ability to access additional debt if needed. I believe that the 20 percent threshold, combined with a rating of at least A-, provided sufficient capital flexibility to compete in this industry. The other neutral rating is for being a bit high on the payout ratio. Intel has managed its payout ratio very well over the years, allowing it to increase in bad years while bringing it back down when times are good. The current level is near the lower end of the spectrum for Intel. This is a trait I like to see, especially when combined with consistent annual dividend increases. Intel has increased its dividend in each of the last nine years. The company passes on all other metrics and, because of its size and dominant position in the industry, sets the bar high for many competitors. I have a 5-year price target of $40 on Intel and expect the annual total returns to average about 13 percent over that period.

Altera was a distant second place but managed to make the list. Altera is a global leader in programmable logic devices (PLDs) and computer-aided logic development tools. The company primarily serves the telecommunications, data communications, computers and Industrial applications industries. It derives about 81 percent of revenues from outside the U.S. giving it an excellent position to compete globally. Demand from the telecommunications industry has fallen off in 2012 but revenues should get back on track in 2013. The company's customer base is diversified enough to buffer the company from dramatic swings in earnings. The company's EPS fell in 2009 but rebounded to record levels in 2010. But Altera is not as dominant as Intel and the risk is greater.

Metric

ATLR

Industry Average

Grade

Dividend Yield

1.0%

2.5%

Fail

Debt-to-Capital Ratio

14.3%

6.5%

Neutral

Payout Ratio

16.0%

25.0%

Pass

5-Yr Average Annual Dividend Increase

11.4%

N/A

Pass

Free Cash Flow

$1.76

N/A

Pass

Net Profit Margin

37.3%

22.5%

Pass

5-Yr Average Annual Growth in EPS

21.7%

36.1%

Fail

Return on Total Capital

25.7%

20.5%

Pass

5-Yr Average Annual Growth in Revenue

12.4%

5.5%

Pass

S&P Credit Rating

A-

N/A

Pass

Two fails, one neutral and seven passes. That is a fairly good result, but pales in comparison to Intel. If I wanted to own more than one company in this industry (which I do not) I would add ATLR, but until that time I'll stick to owning INTC for my own account. I have a 5-year price target of $47 on ALTR and expect the total return to average slightly below 9 percent.

As for those more notable companies that did not make the list, I will simply list how each failed the process. The majority of companies did not gain consideration for the lack of dividends; there are too many to list and I am sure investors know which ones do not pay a dividend. Of those that do pay a dividend, Intersil (NASDAQ:ISIL), Maxim Integrated (NASDAQ:MXIM), Cypress Semiconductor (NASDAQ:CY), STMicro (NYSE:STM), and Tessera Technologies (NASDAQ:TSRA) exhibited too much volatility in EPS. ISIL also has a flat dividend. Taiwan Semiconductor (NYSE:TSM) cut its dividend in each of the last two recessions, a good move to conserve cash, but not a highly desirable feature from the shareholders' point of view. Linear Technology (NASDAQ:LLTC) has a debt-to-capital ratio of 58 percent which is a bit too high for comfort in this industry. The payout ratio for LLTC, MXIM and STM are also very high for the industry, ranging from 37 percent to 86 percent.

Now, let's move on to the semiconductor equipment industry. It is probably no surprise that I have only one company from this group that made my master list, Applied Materials (NASDAQ:AMAT). Business has been slow for AMAT for a few years now and the company did post a loss in 2009. The reason AMAT remains a candidate is because of its dominant position in the industry. Its largest competitor is only about one-third the size of AMAT measured by sales. The purchase of Varian improves the company's competitive position for the longer term even though the related acquisition costs are hurting the bottom line right now. As the global economy improves in years ahead, I believe that AMAT will derive significant benefits in terms of sales and profits. I take a long-term view on investment opportunities and that is what saves AMAT from being eliminated. Let's look at the metrics.

Metric

AMAT

Industry Average

Grade

Dividend Yield

3.3%

1.0%

Pass

Debt-to-Capital Ratio

18.0%

7.5%

Neutral

Payout Ratio

21.0%

11.0%

Neutral

5-Yr Average Annual Dividend Increase

13.5%

N/A

Pass

Free Cash Flow

$1.08

N/A

Pass

Net Profit Margin

18.3%

18.5%

Pass

5-Yr Average Annual Growth in EPS

6.7%

19.0%

Fail

Return on Total Capital

18.2%

18.0%

Pass

5-Yr Average Annual Growth in Revenue

4.1%

2.2%

Pass

S&P Credit Rating

A-

N/A

Pass

AMAT garnered one fail, two neutral rankings and seven passes. I gave the company a pass on net profit margin because the difference is really not significant. I have a 5-year price target on AMAT of $20 and an average total return expectation of over 18 percent.

Only two other companies from the industry that I am aware of pay a dividend, Electro Scientific (NASDAQ:ESIO) and MKS Instruments (NASDAQ:MKSI). Both of these companies have exhibited too much volatility in EPS for my liking. ESIO has lost money in four of the last ten years while MKSI lost money in only three of the last ten years. AMAT has lost money in one year in more than 15 years and has been able to increase its dividend in all but one year since it began paying dividends. The other two companies have virtually no dividend history of which to speak.

This concludes my assessment of the semiconductor and semiconductor equipment industries. If you are just finding this series of articles for the first time, you may find the original article that I used to begin the series helpful to understand the process I use in selecting companies for my master list.

Thanks for reading and, as always I enjoy your comments so keep them coming. Only through sharing our ideas, experiences and perspectives can we all learn to be better investors together. I wish you all a successful investing future.

Disclosure: I am long INTC, AMAT.

Source: The Dividend Investors' Guide: Part XII - Semiconductors And Equipment Industries