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The Semiconductor Industry is one of the more cyclical sectors in the Value Line universe. Indeed, during times of economic prosperity, the chip sector thrives, thanks to increased spending on the corporate and consumer sides. However, during economic downturns revenues come under pressure, as corporate information technology budgets are pared and consumers hold off on purchasing the latest gadgets.

We can best describe the industry as a growth venue. True, the sector is not as high-flying as it once was, but it does still exhibit better-than-average expansion characteristics. Competition is intense, with product innovation, fueled by aggressive research & development (R&D), paving the way for increased profitability. Below, we discuss other ways companies try to gain a competitive advantage.

Revenue Enhancement

Increasing sales is important to chip companies. This is because higher sales allows for improved fixed cost absorption. Product innovation is also important, since consumers crave the newest offerings. Consumer discretionary items, such as cellular phones, digital televisions, and portable music players, are upgraded regularly, giving customers many options to choose from. Technological innovation results in intense pressure to bring interesting products to the marketplace in a timely manner. Additionally, consumers tend to buy advanced new products long before the old ones are dysfunctional. This is not the case in most industries. For instance, many consumers keep their refrigerators until they go on the blink, but they will upgrade their cell-phones every two years or so.

Many semiconductor companies also supply silicon to the corporate market. This generally involves long-term, definitive contracts. Innovation is a key factor here, as well. During prosperous economic times, corporations upgrade their networks and replace equipment. The book-to-bill ratio is a crucial metric for investors to keep an eye on in this market. If a semiconductor company's book-to-bill ratio is above 1.0 this implies that operations are in expansion mode; in other words, orders received exceed orders billed. During economic downturns, however, many corporations curtail their information technology budgets, hurting demand for silicon. One of the more cyclical end-markets is Telecommunications Services. This sector is heavily dependent on the amount of product in the distribution channel. Telecom managements must accurately gauge customer demand, according to economic times and a product's popularity, so as not to build excess inventory, which can take some time to work down.

Operating Margins

There are many ways in which semiconductor companies may increase their profits. For one, they can increase revenues as a means to widen the operating margin. However, in some instances, especially if a specific end-market is mature, the potential for revenue expansion is limited. Under such circumstances, managements need to focus on other profit-building methods, cutting costs, for example. Cost control often entails personnel reduction, facilities consolidation, and productivity-enhancement measures.

Manufacturing is, of course, a major cost-control area for a semiconductor company. Implementing production improvement methodologies is a key means to lowering the breakeven point. Chipmakers have historically increased the size of the “wafers” they use. This allows for the placement of more transistors on each wafer, cutting costs.

Die shrink is another important manufacturing enhancement method. This is an architectural change to the fabrication process that simplifies electronic devices, providing common platforms with increased performance. More specific, semiconductor manufacturers shrink the size of the chips they create—going from a 45-nanometer to a 32-nanometer production process, for example. This allows for more chips to be created from a single wafer. Further scale downs seem likely, as process technology continues to advance.

Balance Sheet Considerations

Cash is king for chip companies, particularly during difficult economic times. When the economy has soured, profits fall, and thus it is imperative to have a good amount of cash on the ledger to survive. One term that is often referred to by managements and investors during such a scenario is the "cash-burn rate". The term considers how much cash a company uses to maintain normal operations from one quarter to the next. A fast-dwindling cash balance may be a red flag.

Aside from funding every-day operations, cash also is essential to product development. Most semiconductor companies don't pay dividends because they believe the funds are better put to use investing in operations. The rationale is that shareholders will enjoy greater overall returns in the long run. It's good practice to regularly monitor a company's R&D outlays (as a percentage of sales). Consistent spending is crucial in turning out a steady stream of attractive products and staying competitive.

In this industry, debt ratios vary widely from time to time and company to company. Most notably, chip designers are usually much less leveraged than manufacturers of transistors. Also, at times, some companies may take on heavier debt burdens when they see an opportunity to capture additional business and earn a higher return.

Conclusion

The Semiconductor Industry is inherently more volatile than many other sectors under our review. Members of the group constantly have to deal with the effects of the broader economic cycle, ever-shortening product lifecycles, and persistent peer competition. Still, investors willing to wager on the ups and downs of the business cycle may find semiconductor stocks an interesting group.