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Semiconductor Companies Form a Wide Industry: Where Should You Invest?

Although many believe that semiconductors and chips are exactly the same, they are not. Within the semiconductor industry, there are diverse branches, from LED manufacturers to cutting-edge chip designers. In this article I will take a look at two companies within the industry (not the most famous, but relatively well known): Altera Corp. (ALTR) and Cree Inc. (CREE). By looking into their fundamentals and prospects, I will try to elucidate which one stands as the best investment option for long-term stockholders.

The Programmable Future

Altera is a leading supplier of programmable semiconductors and related products, and the second-largest designer of programmable logic devices (PLDs) by market share. What makes these chips unique is their capability of being programmed, unlike regular chips, which means that their circuitries can be customized by electronics manufacturers for specific applications.

However, larger and more costly, PLDs are used in electronics that don't have the necessary volume to absorb the up-front costs of creating an application-specific integrated circuit (ASIC). This trend should only accentuate going forward, as the up-front costs of developing cutting-edge ASICs have been rising substantially and are expected to continue to do so. As a consequence, the volume needed to make ASICs cost-effective is much larger. Therefore, new opportunities emerge for PLDs, which have been taking market share from ASICs and are expected to drive growth at Altera over the upcoming years.

Holding almost 40% of the market share (Gartner), and with its customers facing high switching costs (since engineers tend to be trained and experienced in programming PLDs from a specific vendor) Altera´s business looks quite moated.

Another advantage that Altera has over its industry peers is its asset-light model. The company is fabless, meaning that it purchases silicon wafers from Taiwan Semiconductor Manufacturing Company (TSM), an independent wafer foundry, which are then assembled by independent Asian subcontractors. Furthermore, “some observers believe that Altera's products, which bridge the gap between PLDs and ASICs (so-called "structured ASICs"), are superior to Xilinx's [the market share leader] offering” (Morningstar).

Finally, Intel (INTC) has agreed to manufacture chips for Altera using its 14 nanometer trigate transistor technology. This should help Altera achieve a smooth transition to 14 nanometer FPGA production. As the agreement requires Intel to consider Altera as the prime consumer of its 14 nanometer FPGAs, Xilinx will probably have to look elsewhere to match its competitor´s offering.

Trading at 24 times its earnings, just around the industry average, while offering industry leading margins and decent returns and debt levels, this looks like a stock to add to your long-term portfolios. To make the deal even sweeter, Altera yields 1.61% of the current stock price in the form of dividends.

And a Not-So-Luminous Future

Cree is a leading developer and manufacturer of light-emitting diode (LED) chips, components and lighting solutions that allow its users to reduce their energy usage and therefore, its costs. Although analysts tend to like this company, I consider it to be a less attractive option than Altera.

Even in a context of increasing demand, new regulation and decreasing production costs and sales prices, where top and bottom-lines should grow, the company´s profitability seems extremely tied to the cyclicality of the market. Only holding scale-related advantages (no technological edge) to set it apart from its rivals, Cree doesn’t seem like the safest of investments for the long-term.

Opposite to Altera, Cree has no economic moat around its business. With few barriers to entry and many options to LEDs in the lighting market, the company´s future profitability looks quite unpredictable. In addition, several big companies like Samsung Electronics Co. (SMSD) and LG Electronics (LGLD) have also entered the LED industry, increasing competition and generating overcapacity. For instance, Wal-Mart (WMT), the retail behemoth, now offers a six-pack of LED bulbs for less than $9.00, versus Cree´s $75 for a six-pack. Although Cree´s bulbs save a little bit more energy, the price difference is certainly unjustified.

Also, “the Chinese government has subsidized the purchase of LED tools, which has enabled many small Chinese startups to ramp up chip production and could lead to a new wave of competition for Cree in the years ahead” (Morningstar).

Although recent results look decent and the stock price fell almost 17% on Wednesday, shares still look overvalued at more than $60 each. Trading at 100 times its earnings while offering razor thin margins and returns, and a lack of dividends, Cree looks substantially less alluring for investors than Altera.

(Semi)Conductors to Success

Overall, Altera looks like the best option here analyzed. Offering compelling growth prospects, plenty of expansion opportunities, a fair valuation and even yielding dividends, this is a stock to buy and hold as demand for PLDs continues to increase at the expense of ASICs. If Meryl Witmer and Ray Dalio bought the company´s stock over the last quarter, why shouldn´t you?

Cree´s case is different. Although short-term disappointments have beat up the stock price and long-term projections remain encouraging (as Cree is a leader in a growing industry), valuation still looks unjustified to me. However, keeping a close eye on the company doesn´t seem like a bad idea, as several long-term investments that the management made could start paying off in a couple of years.

Disclosure: Damian Illia holds no position in any stocks mentioned.

About the author:

Damian Illia
A fundamental analyst at Lonetreeanalytics.com constantly looking for value and income investments.

Visit Damian Illia's Website


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