By David Sterman
If you've ever invested in semiconductor and semiconductor-equipment stocks, then you've seen the dramatic ups and downs these shares can take. To make money with these chip stocks, you have to figure out the right time to buy (ahead of the next peak of the chip-spending cycle), and you need to cash-out before the cycle swings back down.
But because this is not always easy to identify, perhaps a saner approach is to focus on chip stocks that aren't quite as cyclical. I'm talking about chip makers that focus on the world outside of computers and telecom equipment, and instead target automobiles, industrial process-control systems, security networks and the like.
The time to look at these stocks has never been better. First, because an increasing number of items are being developed with chips embedded in them. Second, stock prices for the key players have rarely been this cheap.
The car of the future
Domestic appliances, lighting systems, clean-energy technologies and a range of other products are all getting "chip savvy." Let's take the automobile industry as an example. Today's cars already have vastly more computing power than 20 years ago. Airbags come with sensors, windshields can automatically detect raindrops, car stereos can adjust the volume when external noise intrudes in the interior, and phone calls can be routed through car speakers, for example. And chips make all of this possible.
In the years ahead, even more automotive technology will find a home in mainstream cars. We're just now seeing the adoption of cars that know to stay within a traffic lane, keep their distance from other cars, automatically stop when a pedestrian moves into traffic, toggle power between electric motors and traditional engines, and even anticipate an engine breakdown before it even occurs. This is going to be a real boon to the chip makers that supply the auto industry. And this is only the technology we know about right now. Extrapolate this trend into other industries such as domestic appliances or home energy systems, and you may get a sense the chip industry is in the midst of a mini-revolution.
And in this mini-revolution, three companies stand to benefit the most. They may not be as well-known as chip giants like Intel (NASDAQ:INTC), but their growth prospects are arguably even brighter. Here they are:.
1. Analog Devices (NASDAQ:ADI)
This company makes chips that go into cars, communications equipment and industrial equipment. It stands out as a top-industry performer. Heavy investments in research and development (R&D) (about $500 million a year), coupled with successful lean manufacturing processes have helped the company generate strong and rising margins. As a result, gross margins, which typically averaged about 60%, hit 67.2% in the fiscal third quarter (ended July) -- a company record.
The gross-margin strength is quickly turning into operating-margin strength. In the last industry cycle, Analog Devices generated 20% to 25% operating margins, but the metric could exceed 37% in the current fiscal year. These margin gains -- and the cash they produce -- are helping management to shrink the share count. Analog Devices has bought back 25% of its stock in the past five years, and another buyback plan is currently under way.
As a final thought, shares have traded between 11 and 34 times forward earnings in the past five years. Thanks to the current selloff, shares now trade for just 13 times projected fiscal (October) 2012 profits, which is near the bottom of that five-year range.
2. NXP Semiconductors (NASDAQ:NXPI)
This Netherlands-based company is the former chip division of electronics giant Phillips Electronics. NXP is a leading provider of mixed-signal (analog/digital) chips, which combine the ability to read a signal's strength (such as voltage), and determine whether the voltage is flowing or stopped (digital). Profit margins have been in line with the industry peer group (40% gross margins, 10% operating margins), but management is taking action to boost these figures by closing high-cost plants and increasing the amount of work that's outsourced to contract manufacturers.
This is all part of CEO Rick Clemmer's turnaround plan. He joined the company in 2009 as a turnaround specialist after fixing integrated circuit component company Agere Systems and selling it for $4 billion to LSI in 2007.
NXP Semiconductors was taken private in 2006 by Bain Capital, but it went public again in August 2010 at an initial public offering (IPO) price of $13 a share. By last winter, shares had already moved up to above $30, showing signs the stock had become a hot IPO. Almost a year later, it is now back down to roughly $17.
Investors are likely a bit spooked that the company's $4.5 billion debt load could prove troublesome if the economy really hits the skids. Cleamer says he intends to aggressively pay down a large part of this debt from the company's free cash flow during the next few years, which should help move the price to earnings (P/E) multiple back in line with industry peers (it currently stands at 7.9). Analysts at Sterne Agee figure margin gains and debt reductions could push the stock up roughly 70% to $29 within one year, or about 10.5 times their projected 2012 profit forecasts.
3. ON Semiconductor (ONNN)
This could be a great investment story for 2012 and 2013, since 2011 has proven to be year of growing pains. The company acquired a large mixed-signal chip division from Japanese electronics maker Sanyo last winter, but various crises in Asia have slowed down integration plans. Adding insult: recent flooding in Thailand has led to the temporary closure of a facility there as well.
Needless to say, the next quarter or two could still be messy, but the long-term outlook is quite bright for this chip maker. ON Semiconductor expects to boost margins at the acquired Sanyo facilities through various streamlining initiatives, so it should be posting better numbers in 2012 and beyond. Earnings per shares (EPS) is likely to grow from just under $1 this year to about $1.10, and then really surge to $1.30 in 2013, as all of the current turnaround steps get traction. Shares trade for just six times this view, and as the multiple expands, Citigroup predicts shares could rise from a current $8 to $17, while analysts at D.A. Davidson carry a $15 price target.
Risks to Consider: Although this group is not as deeply cyclical as many other semiconductor segments, it is still tied to the global economy. A major recession would surely dampen results.
In volatile times like this, it pays to focus on more consistent business models. Analog Devices has become the industry's leader in terms of cutting-edge products and strong profit margins. NXP Semiconductors is shaping up to be a solid debt deleveraging story and, as its balance sheet strengthens, the subpar earnings multiple is likely to expand and send the stock higher. ON Semiconductor has been quite noisy with its Asia-related challenges, but as the company overcomes them in 2012 and beyond, investors will find a very healthy -- and profitable -- company.
Investing in chip stocks can be tricky, but with these three stable stocks, investors will have their money in a place with enough downside protection and solid growth potential.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.