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2 Long-Term Bets for Struggling Semiconductor Industry

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The strong demand environment of the last few months has allowed several semiconductor players to enter into long-term, preferred supplier or other special relationships with customers. This has improved visibility for players and stabilized revenue streams. However, the industry remains supply constrained, which is a limiting factor. Growth prospects over the next 5-10 years are excellent, because of the adoption of new technologies like AI-ML, EVs, smart cities, IoT, etc.
While the longer-term outlook is extremely bright, near-term concerns related to the Fed-engineered economic slowdown and supply challenges remain. The most likely result will be increased caution at customers, who could order closer to consumption, thus reducing visibility. But this should not be a deterrent considering that there are segments of the market that remain amazingly resilient. While we wait for a suitable entry point, there are a few stocks that could be worth keeping an eye on.
These would 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 throw at them run on semiconductor technology, whether analog (enabling the recording and measurement of real-world information), digital (processing information available in machine-readable language) or mixed signal (enabling conversion of analog signals to digital or digital to analog among other things). Most electronic gadgets use a combination of these components, whether in consumer, industrial, auto, medical, communications, or IoT and other markets.

The industry is cyclical and prices are elastic. Players usually serve multiple markets that offset their individual seasonality, or focus on certain core markets for which they have highly differentiated technology and relationships.

Major Themes

  • This is likely to be a mixed year for semiconductor companies offering analog and mixed signal chips. Some end markets will be sluggish. PCs (gradual uptick expected in the second half on the enterprise side and continued softness on the consumer side) and smartphones (weak consumer spending due to inflation affecting disposable income, as well as greater propensity to consume things like leisure and travel) stand out here. However, other markets like automotive, communications (especially 5G), IoT, cloud, AI, industrial (including medical devices) are all expected to do well. Technological innovation in the form of the metaverse, digital health, EVs and other innovative transportation and sustainability considerations are other drivers. China opening up is a positive, but uncertainties related to dealing with China remain.
  • The industry is likely to see continued operating challenges. Primary among these is the supply/demand imbalance that is leading to an inventory glut especially in DRAM and NAND chips that have not been consumed as PC and smartphone demand slumped. Since analog/mixed signal chips are used in combination with these chips, this inventory imbalance is also affecting the market. Data center demand is on a secular rise although tempered in the short term by increasing costs, a slowing economy and sustainability concerns. On the other hand, the shortage of chips for the automotive market remains (as some OEMs cut back production because they have an inventory mismatch that they want to clear first). The second half may be expected to be better than the first, partly because of increasing capacity and partly because of other factors such as the end of support for Windows 10 leading to another upgrade cycle in the PC market.
  • An emerging issue that semiconductor players are particularly exposed to is geopolitical tensions. The semiconductor supply chain is globally distributed, which means that international relations need to be maintained to ensure that work continues without disruption. While the Russia-Ukraine war didn’t have that much of an impact, the souring of relations between the U.S. and China is another story. If China really tries to take control of Taiwan as many experts expect it will, there could be a terrible war that will be highly disruptive of the global economy and especially of the chip sector. That’s because a leading share of advanced node chips are made on the island. Another geopolitical concern is the increasing awareness among all leading nations of the increasingly larger role that semiconductors are playing in AI-driven electronic weaponry and surveillance mechanisms. As the importance of semiconductors in defense grows, the need to onshore or near-shore production is being felt. This is leading to rebalancing of the semiconductor supply chain not with a cost-reduction perspective but with a far more strategic objective. So the government is trying to incentivize companies to build in the U.S. TSM, the main supplier to the U.S. is setting up in the country but the plan is to have this on a much larger scale. The CHIPS Act may help a difficult situation where increased capacity would depress prices while U.S. production would increase costs. In the meantime, the U.S. has ordered restrictions on trading with China, which is also a near-term headwind for players.

Zacks Industry Rank Indicates Near-Term Weakness

The Zacks Semiconductor – Analog and Mixed industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #188, which places it in the bottom 25% of the 250 odd Zacks-classified industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates weak near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the bottom 50% of Zacks-ranked industries is based on the earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions over the past year, we see that analyst opinion about the 2023 outlook remains down from a year ago although there has been some improvement in recent months. The outlook for 2024 has weakened. Overall, the 2023 estimates have dropped 2.9% over the past year, while 2024 estimates have dropped 7.4%.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Stock Market Performance Good

The Semiconductor – Analog and Mixed industry has traded at a premium to both the broader Zacks Computer and Technology sector and the S&P 500 starting from November. The broader sector was trailing both between November and March, but continued to improve thereafter.

Overall, the industry gained 7.5% over the past year while the broader sector gained 9.2% and the S&P 500 2.8%.

One-Year Price Performance

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Industry's Current Valuation

The industry's valuation is inexpensive. On the basis of forward 12-month price-to-earnings (P/E) ratio, the industry is trading at a 16.94X multiple, which is a discount to both the S&P 500’s 18.48X and the broader computer and technology sector’s 23.70X. At the current level, it is however trading at a slight premium to its median level of 16.70X over the past year.

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

Forward 12 Month Price-to-Earnings (P/E) Ratio

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2 Stocks to Hold for the Long-Term

Analog Devices, Inc. (ADI - Free Report) : Analog Devices is an original equipment manufacturer of semiconductor devices, specifically, analog, mixed signal and digital signal processing (DSP) integrated circuits for industrial, consumer, communications and automotive customers. Other than manufacturing at its facilities in the U.S., Ireland and Southeast Asia, it also outsources some production to outside foundries, mainly Taiwan Semiconductor Manufacturing Company for front-end processing and third-party subcontractors for back-end operations.

Analog Devices’ strength in the more resilient industrial (over 50% revenue share) and automotive markets is proving to be helpful in the difficult operating climate we are seeing today. However, as the economy softens further in the second half of the year, demand in these markets is expected to moderate. Edge computing (emerging applications include Industry 4.0, Smart Energy Systems, Electric Vehicles, Advanced Connectivity and Immersive Consumer) and ubiquitous connectivity are secular drivers however, as they are shifting ever-increasing amounts of data processing to the Intelligent Edge. The edge is where the semiconductor content per dollar of capex continues to increase, and that is where ADI is focused.

As far as operations are concerned, the company has been growing output both internally and at its foundry partners, which has led to continued reduction in lead times. Bookings remain lower than sales, which increases the risk of the company missing guidance. But while this is bringing down the backlog, at the current levels the backlog still represents nearly a year’s sales.

Analog Devices beat April quarter estimates by 2.9%. In the last 30 days, the 2023 and 2024 estimates of this Zacks Rank #3 (Hold) company have been stable.

The shares are up 6.7% over the past year.

Price and Consensus: ADI

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Microchip Technology Incorporated (MCHP - Free Report) : Microchip Technology Incorporated operates in the Americas, Europe and Asia. It develops, manufactures and sells smart, connected and secure embedded control solutions such as general purpose 8-bit, 16-bit and 32-bit microcontrollers; 32-bit embedded microprocessors; and specialized microcontrollers for automotive, industrial, computing, communications, lighting, power supplies, motor control, human machine interface, security, wired connectivity and wireless connectivity applications.

The near-term outlook for Microchip isn’t great. With fears of a slowing economy looming, customers are looking to push out orders, which the company has been to help them with their inventory positions. This situation is expected to continue in the current quarter, with a corresponding negative impact on sales. Additionally, with such a sizeable backlog, new orders have slowed down, further deteriorating the outlook. However, since Microchip mainly produces at trailing edge facilities which have been in short supply in the last two years, management expects that there isn’t a lot of inventory buildup at customers. At the same time, with supply constraints easing, its lead times continue to improve and the company intends to bring lead times down to 26 weeks by the end of the year.

The long-term outlook is excellent however. More than 50% of its backlog is non-cancellable under its Preferred Supply Program (PSP), which is great for stability and visibility. Management has also been focused on total system solutions and higher growth megatrends, which has translated into increased design wins and share gains, positioning it for strong growth once the economic situation turns.

Investors would also be interested to know that its strong cash flows have enabled the company to pay down a substantial portion of its debt over the last few years and also pay a consistent dividend. The company recently announced a 38.8% increase in the dividend with plans to return 100% of free cash flow to shareholders by the March 2025 quarter. 

Microchip beat estimates by 0.7% in the last quarter. The Zacks Consensus Estimate for 2023 has increased 5 cents (0.8%) in the last 30 days. The 2024 estimate increased 17 cents (2.7%) during the same period.

#2 ranked Microchip’s shares are up 8.2% over the past year.

Price and Consensus: MCHP

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