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 valuations are supportive.
Our current picks are Analog Devices, MACOM Technology and Microchip.
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 Driving the Industry
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Most companies in this industry are positioned for strong growth this year followed by
difficult comps and weaker demand
in the next. It is the net effect of these companies being still somewhat behind schedule in delivering to the post-pandemic rush in demand. This in turn is because of supply chain disruption (which continues for most), driven by the pandemic, geopolitical tensions and the more recent COVID shutdowns in China. Supply constraints also impact profitability as it may be necessary to idle capacity despite demand being out there. Going into 2023, some segments are seeing orders slow down or get rescheduled, which along with the slight uptick in cancellations, points to increasing caution at customers. But many of these companies have long term agreements stretching well into 2023, which means that any softness could take longer to show up in the results.
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The increasing use of electronics in vehicles, airplanes and defense equipment; increased factory automation; greater penetration of smartphones, tablets, notebooks, PCs and all manner of personal computing and other personal devices and smart household appliances; communications infrastructure moving to 5G; greater reliance on cloud infrastructure; the advent of artificial intelligence (AI), the Internet of Things (IoT), more advanced medical devices, EVs, self-driving cars etc continue to
expand the addressable market for semiconductor chips
. The constantly expanding addressable market makes this a very attractive industry for long-term investment. This is particularly true because the industry is capacity constrained based on today’s level of digitization, but this digitization is expected to increase manifold over the next decade because of the adoption of AI, EV and other emerging technologies. Additionally, the breadth of markets and applications ensure that even if some segments (like consumer/computing) see demand pullbacks, emerging areas like AI, EV, IoT, etc. balance them out.
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The
post-pandemic hybrid model
, where more people move out of their homes more often but not all the time, is leading to an expansion of the overall electronic footprint of the consumer/computing segment. Near-term challenges here are related to strong uptake in the last couple of years. But there are other opportunities, including the metaverse and consumer devices incorporating newer technologies to enable more experiences. The number of semiconductors per device and their complexities also continue to increase, thus supporting demand.
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The adoption of
5G communications technology
, enabling 10X the data rate as 4G, is another boost to analog-mixed signal sales both in base stations and end devices. Because of the multiple input (MI) and multiple output (MO) streams the technology enables in base stations, demand for sensors and power management analog including envelope tracking chips (to manage excess power flow and thus reduce heating), as well as gallium nitride (GaN) materials are increasing. Moreover, since 5G is only involved in short range signals, it is not totally replacing 4G but supplementing it, thus adding to component demand.
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Industry consolidation
is important because the cost and complications of making chips rises in an environment where the adoption of semiconductors in devices of varying value requires prices to decline. Acquisitions are also driven by the need to expand R&D capabilities and to acquire key talent.
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U.S. government officials worry that none of the most advanced chips are currently manufactured in the country. This is considered to be a
national security concern
given that semiconductors are playing an increasingly larger role in AI-driven electronic weaponry and surveillance mechanisms. 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. How exactly this situation will play out for the industry is unknown. Increasing capacity would depress prices. And U.S. production would increase cost. So much depends on the government’s contribution (perhaps through the CHIPS Act). 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 Uncertain Prospects
The Zacks
Semiconductor – Analog and Mixed
industry is housed within the broader Zacks
Computer and Technology
sector. It carries a Zacks Industry Rank #204, which places it in the bottom 18% of more than 250 Zacks-classified industries.
The group’s
Zacks Industry Rank
, which is basically the average of the Zacks Rank of all the member stocks, indicates uncertain 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.
However, despite the industry’s positioning in the bottom 50% of Zacks-ranked industries, the earnings outlook for the constituent companies in aggregate, is positive. Looking at the aggregate earnings estimate revisions over the past year. it appears that analyst opinion has significantly improved: 2022 estimates have risen 26.9% over the past year, while 2023 estimates have risen 2.9%.
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 Attractive
Since April, the Zacks Semiconductor – Analog and Mixed industry has traded at a premium to the broader Zacks Computer and Technology Sector. It has however traded at a slight discount to the S&P 500 though much of this period.
Overall, the industry lost 17.1% of its value over the past year while the broader sector lost 34.9% and the S&P 500 lost 18.1%.
One-Year Price Performance
Image Source: Zacks Investment Research
Industry’s Current Valuation
On the basis of forward 12-month price-to-earnings (P/E) ratio, the industry is trading at a 16.34X multiple, which is a discount to both the S&P 500’s 17.48X and the broader computer and technology sector’s 20.67X. At the current level, it is also trading below its median level of 16.70X over the past year.
The industry has traded between its lowest point of 13.80X and highest point of 24.11X over the past year.
Forward 12 Month Price-to-Earnings (P/E) Ratio
Image Source: Zacks Investment Research
3 Stocks To Hold for the Long-Term
Analog Devices, Inc.
ADI
: A fabless semiconductor company, 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.
Management is optimistic about near-term strength based on stabilizing orders, a strong backlog and continued design win momentum. Additionally, the increased scale and diversification, flexibility of its manufacturing model, and strengthening brand value are expected to help it navigate the economic downturn. This strength has allowed it to generate all-time high fourth-quarter revenues in the industrial, automotive and communications markets, as well as relatively modest growth in consumer. Analog Devices pays a regular dividend, and it increased the payout on a per share basis by over 10%.
The company beat October quarter estimates by 5.8% and in the last 60 days, the 2023 estimates for this Zacks Rank #3 (Hold) company increased 28 cents (2.9%). The 2024 estimate increased 22 cents (2.2%).
The shares are down 7.4% over the past year.
Price and Consensus: ADI
Image Source: Zacks Investment Research
MACOM Technology
MTSI
: The company designs and manufactures analog semiconductor solutions for use in wireless and wireline applications across the radio frequency (RF), microwave, millimeter wave, and lightwave spectrum in the United States, China, Taiwan, Japan, Singapore, Thailand, South Korea, Australia, Malaysia, and internationally data center, industrial & defense and telecom markets.
The company is seeing particular strength in telecom, data center and defense markets. 5G deployments and increased adoption of the cloud are drivers for MACOM and management is optimistic about share gains in 2023.
MACOM topped the Zacks Consensus earnings estimate by 1.3% in the last quarter. Its 2023 (ending September) EPS estimate has dropped a penny in the last 60 days while the 2024 estimate increased a couple of cents.
Shares of this Zacks Rank #3 stock are down 9.6% over the past year.
Price and Consensus: MTSI
Image Source: Zacks Investment Research
Microchip Technology Inc.
MCHP
: 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.
Microchip’s demand far outpaces its ability to supply. It is a good thing that more than 50% of its backlog is non-cancellable under its Preferred Supply Program (PSP). Other than the fact that it greatly improves visibility, it also helps in the current environment where the company is seeing supply constraints. This is also stretching out lead times and forcing the company to idle capacity, which hurts its profitability.
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 bought back a substantial number of shares and earlier this year, the board announced a 37.8% increase in the dividend.Therefore management continues to return value to shareholders.
Microchip beat estimates by 1.4% in the last quarter. The Zacks Consensus Estimate for 2022 has increased 24 cents (4.2%) in the last 60 days. The 2023 estimate increased 6 cents (1.0%) during the same period.
#3 ranked Microchip’s shares are down 11.5% over the past year.
Price and Consensus: MCHP
Image Source: Zacks Investment Research
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