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Fishing for Chip Stocks

"There is no shortage of good growth in all end markets," says Tom Smith, who follows semiconductors for Standard & Poor's Equity Research. New gadgets, particularly in consumer products and medical devices, require a single design on a chip, and there's a premium price for the design, Smith explains. "We use more chips in cars, refrigerators, and a lot of things people don't think of."

Overall, based on a moderate growth environment, Smith has a neutral outlook for the chip industry for the next 12 months (see BW Online, 12/5/05, "Stocks Marching to an iPod Beat"). The good news is demand is pretty good, chip inventories are low, and capacity utilization in the industry is a little bit tight -- at 90.1% as of the third quarter of 2005, he says.

EXPENSING OPTIONS. For the chip industry overall, Smith looks for 9% sales growth in 2006. Among the variety of chips, programmable logic makers might see 11% growth, while DRAM makers are expected to lag the group, he says.

However, valuations may be a little tougher to sift through. Smith points out that semiconductor companies are trading below their recent historical average for price-to-sales, which is generally a positive sign. Still, he sees "a more blurred outlook" for valuations based on price-to-earnings, partly because the multiples could be hurt by the greater transparency of stock-options expenses.

"Depending on how one calculates your earnings for your price-to-earnings ratios, you might develop a wide range of what might be an appropriate p-e," he explains. "So valuing on p-e is more challenging this year than it has in the past."

TOP OF THE HEAP. With that in mind, Smith favors companies that clearly have positive earnings and a positive trend based on earnings including stock options, he says. His two favorite stocks are Marvell Technology (MRVL) and Altera (ALTR) -- which are both ranked 5 STARS, or strong buy. He also likes Analog Devices (ADI), Intel (INTC), Nvidia (NVDA), Xilinx (XLNX), Microchip Technology (MCHP), and Texas Instruments (TXN) -- which sport a 4-STARS, or buy, recommendation.

Smith recently spoke with BW Online's Karyn McCormack about what sets Marvell and Altera apart from the rest. Edited excerpts from his remarks follow:

Note: Tom Smith is an S&P Equity Research analyst. He has no ownership interest in or affiliation with any of the companies on which he writes research. All of the views expressed here accurately reflect the analyst's personal views regarding any and all of the subject securities or issuers. No part of the analyst's compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed.

Marvell Technology

Marvell makes a variety of chips for communications -- high-performance analog, mixed signal, and digital signal processing chips for broadband and wireless communications. They have come up with some niche products that are allowing them to grow revenue faster than the group and most peers for a number of quarters now, and we think that this can continue, as long as the industry growth holds up, at least through 2006.

We're looking for revenues to grow 43% in fiscal year 2006 (ending January). Looking ahead to fiscal 2007, we're [projecting] 35% revenue growth. This is clearly higher than most of its peers.

Marvell's chips are used in a lot of larger communications equipment that consumers wouldn't see. They have a history of serving the storage market. Then they grew to serve the high-speed communications market -- basically the broadband markets.

CUTTING EDGE. They have some risk from a limited customer base -- three customers accounted for 42% of revenue in fiscal year 2005, but as long as they're seen as the preferred solution for these communications boxes, then they should be able do pretty well.

Like many semiconductor makers, they have a limited amount of long term debt, which is a plus. The story on Marvell is, we're betting that they maintain a design edge and can stay ahead of the competition in chips for communications equipment.


It's one of the two main producers of programmable logic chips, which is a type of semiconductor whereby the customer can do the final configurations on the circuit design at the customer's shop, which creates a lot of flexibility.

For revenues, we're looking for 14% growth in 2006 and 13% in 2007. That makes it 5% faster than the industry and 3% to 4% faster than logic makers generally.

The programmable-chip category has grown faster than the overall semi market by a clear margin, by 6 to 7 percentage points, and we predict that will be the case again in 2006. Altera and Xilinx both went through something of a revenue miss and a hiccup, and in Altera's case an inconsistent gross margin trend, back in September-October. Both stocks fell in that period, but we view them as strong companies that will come back. To some extent, they have come back, but we think they will do well in the moderate growth environment we see ahead.

SPEED PREMIUM. Back in 2000, programmable chips were known to be used in sophisticated communications equipment and some computer and storage and other kinds of industrial areas. But over the past five years, they've come to be used in a wider variety of industrial applications and certainly a wider variety of consumer applications. As the chips get smaller, lighter, faster, and all that, they've become more affordable for more kinds of gadgets and equipment.

Programmables carry a higher margin -- it's a more expensive kind of chip than an application-specific chip, partly because of the customization and the ease of use of the software that allows the customer to reconfigure the chips. You pay a premium, and you want these chips because it can give you an edge in speed to market.

If you're designing something, and you want to get it out of the factory, you would much rather pull the programmable logic chip off the shelf and program it yourself in a day or two or week, rather than calling an application-specific chip company, having them make a prototype, test it, and then deliver it 14 weeks later. So in any kind of product line, there's speed to market advantage with programmables.

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