Two long-term bets on the struggling semiconductor industry

The strong demand environment in recent months has allowed several semiconductor companies to establish long-term preferred supplier and other special relationships with their customers. This has increased player awareness and stabilized revenue streams. However, industry supply is still constrained, which is a limiting factor. With the adoption of new technologies such as AI-ML, EVs, smart cities, and IoT, the growth prospects over the next 5-10 years are excellent.

While the long-term outlook is very positive, near-term concerns remain related to the Fed-engineered economic slowdown and supply problems. The most likely result is that customers become more vigilant and may order closer to consumption, resulting in less visibility. However, this should not be a deterrent given that some market segments remain surprisingly resilient. While we wait for a suitable entry point, there are some stocks worth keeping an eye on.

These will be stocks like Analog Devices and Microchip Technology.

About the industry

The electronic gadgets we use to accurately read our commands and record, store, retrieve, and process the information we send can be analog (allowing us to record and measure real-world information), digital (where available It works with semiconductor technology, regardless of whether it enables the processing of information. machine-readable language) or mixed-signal (allowing, among other things, analog-to-digital or digital-to-analog conversion). Most electronic gadgets, whether in consumer, industrial, automotive, medical, communications, or IoT markets, use a combination of these components.

The industry is cyclical and prices are elastic. Players typically serve multiple markets that offset individual seasonality or focus on specific core markets with highly differentiated technologies and relationships.

Main theme

this is probably It’s been a mixed year for semiconductor companies Offers analog and mixed signal chips. Some end markets will suffer. Here, PCs (business side is expected to rise moderately in the second half, consumer side is expected to remain weak) and smartphones (sluggish personal consumption due to inflation affecting disposable income, and leisure and travel etc. (due to rising propensity to consume). . However, other markets such as automotive, telecoms (especially his 5G), IoT, cloud, AI and industrial (including medical devices) are all expected to do well. Technological innovations such as the metaverse, digital health, EVs and other innovative transportation modes and sustainability considerations will also be drivers. China’s opening up is positive, but uncertainties related to dealing with China still remain.

industry is likely to Ongoing operational challenges. The main reason for this is the imbalance between supply and demand, which has led to an overstock of unconsumed DRAM and NAND chips, especially in the midst of weak demand for PCs and smartphones. This inventory imbalance also impacts the market as analog/mixed-signal chips are used in conjunction with these chips. Demand for data centers is on the rise in the long term, but is held back in the short term by rising costs, a slowing economy, and sustainability concerns. Meanwhile, chip shortages for the automotive market still persist (as some OEMs are cutting production as they want to eliminate inventory discrepancies first). The second half could be expected to be better than the first half. This is partly due to increased capacity and partly due to other factors such as the new upgrade cycle in his PC market due to the end of support for Windows 10.

A new problem that semiconductor companies are particularly exposed to is geopolitical tensions. Semiconductor supply chains are distributed around the world and must maintain international relationships to ensure uninterrupted operation. The Russo-Ukrainian war didn’t have much of an impact, but the deterioration in US-China relations is another story. If China really tries to take over Taiwan, as many experts predict, it could lead to a terrible war that would wreak havoc on the global economy, especially in the chip sector. This is because the top share of advanced node chips is produced on this island. Another geopolitical concern is the growing recognition among all major nations of the growing role of semiconductors in AI-driven electronic weapons and surveillance mechanisms. As the importance of semiconductors in defense increases, the need for land-based or near-land production is felt. This will lead to rebalancing the semiconductor supply chain based on much more strategic goals rather than in terms of cost reduction. So the government is trying to encourage companies to set up TSM in the US, which is a major supplier to the US, but the plan is to do this on a much larger scale. The CHIPS Act has the potential to solve the dilemma of increased costs resulting from US production and lower prices resulting from increased capacity. Meanwhile, the United States has ordered trade restrictions with China, another short-term headwind for players.

Sachs Industry Rankings Show Near-Term Weakness

Zacks Semiconductor – Analog and mixed industries are housed within the broader Zacks Computer and Technology sector. The Sachs industry rank is 188th, placing it in the bottom 25% of the 250 odd-numbered industries classified under Sachs.

A group’s Zacks Industry Rank is essentially the average of the Zacks Ranks of all member stocks, indicating a weaker near-term outlook. Our research shows that the top 50% of industries ranked by Sachs beat the bottom 50% by more than 2 to 1.

An industry’s position in the bottom 50% of industries ranked by Sachs is based on the revenue outlook of the constituent companies as a whole. Looking at revisions to total revenue forecasts over the past year, we see that despite some improvement in recent months, analyst opinion about the outlook for 2023 is still down from a year ago. The outlook for 2024 is weak. Overall, forecasts for 2023 are down 2.9% over the past year, and forecasts for 2024 are down 7.4%.

Before we dive into some of the stocks to consider in your portfolio, let’s take a look at the big picture of recent stock market performance and valuations for the industry.

Stock market performance is good

Semiconductors – analog and mixed industries have traded at a premium to both the broader Sachs computer and technology sector and the S&P 500 since November. The broader sector saw him set back from November to March, but continued to improve after that.

Overall, the industry is up 7.5% over the past year, with the broader sector up 9.2% and the S&P 500 up 2.8%.

1 year price performance

Image Source: Sachs Investment Research

Industry Current Rating

The industry has a low reputation. Based on the price-to-earnings ratio (PER) over the next 12 months, the industry is trading at 16.94 times his. That’s a discount to his 18.48x for the S&P 500 and 23.70x for the broader computer and technology sector. . However, at current levels, it is trading at a slight premium to the median of 16.70x over the past year.

The industry has traded at multiples between 13.80x and 18.56x over the past year.

Futures 12-Month Price Earnings Ratio (PER)

Image Source: Sachs Investment Research

2 Stocks to hold for the long term

Analog Devices, Inc. (ADI): Analog Devices is an original equipment manufacturer of semiconductor devices, especially analog, mixed-signal and digital signal processing (DSP) integrated circuits for industrial, consumer, communications and automotive customers. In addition to manufacturing at our own facilities in the United States, Ireland, and Southeast Asia, we outsource some production to external foundries, mainly Taiwan Semiconductor Manufacturing Co., Ltd. for front-end processing, and third-party subcontractors for back-end operations. I’m here.

ADI’s strengths in more resilient industrial markets (over 50% revenue share) and automotive markets are proving useful in the challenging operating environment we face today. However, demand in these markets is expected to slow as the economy slows further in the second half of the year. However, edge computing (emerging applications include Industry 4.0, smart energy systems, electric vehicles, advanced connectivity, and immersive consumers) and ubiquitous connectivity are enabling intelligent It’s a long-term impetus because we’re moving to the edge. It’s the edge where semiconductor content per dollar of capital spending continues to rise, and ADI is focused there.

As far as operations are concerned, the company has increased production both internally and with its foundry partners, which has led to continued reductions in lead times. Bookings remain below sales, increasing the risk that businesses will miss guidance. However, although this is reducing the backlog, at current levels the backlog is still roughly equivalent to a year’s worth of sales.

Analog Devices beat its forecast for the April quarter by 2.9%. Over the past 30 days, his 2023 and his 2024 forecasts for this Zacks ranked 3rd (hold) company have remained stable.

The stock has risen 6.7% over the past year.

Price and Consensus: ADI

Image Source: Sachs Investment Research

Microchip Technology, Inc. (MCHP): Microchip Technology Incorporated has operations in the Americas, Europe and Asia. The company develops, manufactures and markets smart, connected and secure embedded control solutions including general purpose 8-bit, 16-bit and 32-bit microcontrollers. 32-bit embedded microprocessor. Also included are specialty microcontrollers for automotive, industrial, computing, communications, lighting, power, motor control, human machine interface, security, wired and wireless connectivity applications.

The near-term outlook for microchips is not good. As fears of an economic slowdown loom large, the company has helped customers stock up on orders as they try to delay orders. This situation is expected to continue in the current quarter, with a corresponding negative impact on sales. In addition, such a large order backlog has slowed new orders and made the outlook even worse. However, management expects customer inventories to build up less as Microchip manufactures primarily in state-of-the-art facilities that have been in short supply over the past two years. At the same time, lead times continue to improve as supply constraints ease, with the company planning to reduce lead times to 26 weeks by the end of the year.

But the long-term outlook is great. Over 50% of his backlog is irrevocable based on the Priority Supply Program (PSP), which is excellent in terms of stability and visibility. Management is also focused on total system solutions and higher growth megatrends, which will lead to successful designs and increased share, poised for strong growth should economic conditions improve. .

Investors will also be interested in how the company’s strong cash flow has allowed it to pay off a substantial portion of its debt and pay a steady dividend over the past few years. The company recently announced a 38.8% dividend increase on a plan to return 100% of free cash flow to shareholders by the March 2025 quarter.

Microchips outperformed expectations by 0.7% last quarter. The Zacks Consensus forecast for 2023 is up 5 cents (0.8%) over the past 30 days. Forecasts for 2024 show an increase of 17 cents (2.7%) over the same period.

Shares of No. 2 Microchip are up 8.2% over the past year.

Price and Consensus: MCHP