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Is It Time to Change the Chip? A Look at Two Semiconductor Companies
Posted by: Damian Illia (IP Logged)
Date: October 4, 2013 05:06PM

The tech industry is the second largest exporting industry in the U.S. But in the recent time, low-cost substitutes have shifted production to others countries like China or Taiwan. The industry is capital-intensive and requires investments to advance in technology and reduce manufacturing costs, changing its exposure from volatile markets to others more stable. The S&P Semiconductors sub-industry index increased 14.7% year to date. So let's take a look at two companies in the semiconductor and see which one is doing better and becoming the better invest in this highly cyclical semiconductor industry.

Texas Instruments (TXN) designs and manufactures semiconductors and is one of the largest suppliers of analog and Digital Signal Processing (DPS) integrated circuits. Considering the sales reported in 2012, the three main products segments were analog (55% of revenue), embedded processing (15%) and wireless (11%).

The company's plan is to compete in several industries, increasing differentiation in its business and gaining exposure to many end markets and customers. The objective is to transform to a predominantly analog-based company basically because this segment make the highest margins for the firm. So the company´s focus is the analog chip business and consequently reduce the wireless segment which is a lower-margin one. Also, the company´s strategy is starting to integrate more functionality into single devices, increasing exposure to longer life-cycle products (industrial and automotive markets will be the key) and minimizing costs because analog products require less replacement than manufacturing digital products.

In terms of valuation, the stock sells at a trailing P/E of 22.2x, trading at a discount compared to the industry average of 23.1x, representing a discount of 3.9%, and a premium compared to the S&P 500 average of 19.37. Analysts’ expectations imply a forward P/E of 17.99. At that P/E it seems cheaper compared to the industry average. For the second quarter fiscal year 2013, gross profit margin remains unchanged when compared to the same period a year ago and second-quarter earnings missed the Zacks Consensus Estimate.

One Step Forward

Although the stock has done pretty well, investors can have another option of investing in the tech sector with Linear Technology Corporation (LLTC) because there is no other semiconductor company that can be able to match the company's profitability. Linear Technology offers thousands of analog products to original equipment manufacturers. The company´s plan is to specialize in market segments that require high-performance analog with focus on industrial and automotive products. Customers base decisions on quality and Linear´s chip are considered to be products that have long life and superior technology. This is considered in prices and makes attractive margins to the company.

The industrial market represents a great opportunity for growth because most industrial customers buy analog expertise and the company shows ability to retain talent people. With respect to the auto market, is expected to boost its sales this year, leaving in the past the natural disaster that damage the Japan's economy.

Multiples are very similar to the ones that show Texas. Its P/E multiple, on a trailing-12 month basis, is 22.2 and the forward P/E multiple is 16.93. A company characteristic is its commitment to return cash to investors in the form of dividends. The current dividend yield is 2.6%, which is quite good to protect the purchasing power, especially considering the consistency of track-record dividends payments since 1992.

Finally, I always like to see the evolution of one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity. The ROE is considered high; It stood at 41.4% and is higher than 99% of the companies in the industry. It is very important to understand this metric before investing in a high-growth company.

Final Comment

Despite the effects of the economic crises, that impact the computing and consumer market through the lower spending of consumers and the credit crisis that affected the automotive and industrial markets, both companies should benefit from an improved in the global economy. In the long term, growth in semiconductors is highly correlated to global GDP. According to World Semiconductor Trade Statistics data, it is expected that semiconductor sales growth reach 4.5% in 2013, following the 3.2% decline in 2012.

In my point of view, the increased differentiation that makes Linear in its business and lower-cost strategy should generate higher margins and drive earnings high, making it the most attractive choice. Hedge fund gurus like Joel Greenblatt, Steven Cohen and Ray Dalio added this stock to their portfolios. I would advise fundamental investors to consider this attractive option for their portfolios as well.

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

Guru Discussed: Joel Greenblatt: Current Portfolio, Stock Picks
Ray Dalio: Current Portfolio, Stock Picks
Stocks Discussed: TXN, LLTC,
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