While macro trends continue to be uncertain, a curious thing is happening: consumers are continuing to demand innovation in smartphones, tablets, and PCs. I believe that this demand has actually been driven by supply. Consumer tech manufacturers are not the only the beneficiaries of this resiliency - semiconductors are more indirectly supported by end market demand. While some producers, like Taiwan Semiconductor Manufacturing Company Ltd. (TSM), look expensive, others, like Intel Corporation (INTC) and Broadcom Corporation (BRCM), look meaningful undervalued. Below, I review the fundamentals of each company.
According to data from FINVIZ.com, Taiwan Semiconductor trades at a respective 15.8x and 13x past and forward earnings and is currently rated a 3.1 out of 5 where 5 is a "sell". The dividend yield of 3.6% is compelling, but the fundamentals don't look strong enough to outperform peers.
Lowering expectations amidst signs of another inventory correction, management gave in-line third quarter guidance. Sales contraction will thus be particularly pronounced in 4Q12 and 1Q13. Management further reduced outlook for 28nm, which it expects to represent one-fifth of the business by 4Q12. Some have expressed that slowing demand in smartphones is structural and unlikely to change in the near term. I disagree and believe any of weak demand in this end market will be supported by rising innovation in companies like Apple (AAPL). In fact, the company stated for the first time ever that it would set aside more fabs for a sole customer, Apple, after years of multi-customer strategy.
More concerning is capex, which has seen an unfettered rise. Once ROE peaks this year and starts to fall, investors will start focusing more on the free cash flow pressure. This is particularly disconcerting as margins start to decline with rising competition. Intel, the global leader in the sector, may start to corner Taiwan Semiconductor's specific market and add to the woes. Accordingly, I believe the sidelines is the best place to be for now.
Intel is one of my favorite stocks on the Street. It trades at just a respective 11x and 10.2x past and forward earnings with a strong dividend yield of 3.5%. Analysts are not too bullish on the stock and only rate it around a "hold", but I find it particularly strange their very predictions suggest considerable upside.
If Intel grows EPS 10.7% annually over the next half decade, as it is expected to, the future stock would be worth $52 by 2016 at a 15x multiple. Discounting backwards by 9% yields a present value of $33.80. Put differently, there is more than a 30% margin of safety that the stock will double in value.
Despite a relatively cautious outlook, Intel released strong second quarter results with market share gains and solid free cash flow generation. Revenue grew north of 5% sequentially as better-than-expected momentum in DCG and PCG offset weaker NAND markets. Design wins across handsets and tablets with 20 more Intel tablets expected (largely from Windows 8) continue to to solidify the company's role in the market.
Going forward, penetration in MPUs, DCG, and non-core Mobility, Embedded, and NAND markets continue to represent meaningful catalysts to shareholder value. Demand has been so strong, as evidenced by the 140 design wins across a variety of platforms, that management expects a strong ramp in 2H12. Investors are encouraged to buy now before the upside is more evidently seen.
Broadcom is the most preferred stock on the Street with a "buy" rating, according to data sourced from FINVIZ.com. It trades at 10.8x forward earnings, but lacks a competitive dividend yield. After growing EPS by a breathtaking 20.6% annual rate over the past 5 years during a tough market, Broadcom is forecast for 15.5% annual growth over the next 5 years. I believe the company will meet this goal and consistently become more generous with the dividend yield to reduce downside.
Management's dedication to R&D remains a compelling reason to continue to buy for many current shareholders. In the past, this R&D has resulted in superior chips that holds more memory than peers and is, by comparison, more cost-effective. New design wins in the mobile and wireless markets will thus be substantial in the future, as manufacturers continue to reduce the size of their goods. By acquiring NetLogic, Broadcom also showcased to the market that is not resting on their laurels, but exploring multiple markets at once.
Bolt-on acquisitions have, however, constrained how much free cash flow is returned to shareholders. Design wins with Samsung and Nokia are, moreover, challenged by competition. With that said, I like the company's position in SOCs at set-top boxes. This is a major catalyst and beneficiary of Google's (GOOG) and Apple's developments in television. When combined with the company's leading role in mobile connectivity, Broadcom has synergisitc diversification across the increasingly connected tech world.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: We seek IR business from all of the firms in our coverage, but research covered in this note is independent and for prospective clients. The distributor of this research report, Gould Partners, manages Takeover Analyst and is not a licensed investment adviser or broker dealer. Investors are cautioned to perform their own due diligence.