Tech

Leila Abboud is a Bloomberg Gadfly columnist covering technology. She previously worked for Reuters and the Wall Street Journal.

Tim Culpan is a technology columnist for Bloomberg Gadfly. He previously covered technology for Bloomberg News.

Semiconductor companies have a reputation for being volatile, capital intensive and brutally cyclical. The sector's in one of its periodic slumps, with revenue expected to fall again for the second year in a row because of weak demand in China, a dearth of hit products from Apple and Sony, and the fading appeal of desktop computers.

So why is the Philadelphia Stock Exchange Semiconductor Index -- home to Texas Instruments, Intel, Broadcom, and Taiwanese foundry operator TSMC -- trading at levels not seen since late 2000? It's risen 20 percent this year versus a 6.7 percent gain in the S&P 500 index, and is on an eight-week winning streak.

Sure, analysts predict top-line growth will come back soon. Yet the rate will pale next to historic ones. Analysts at Bryan Garnier see a return to 0.6 percent average revenue increases for the next three years, compared to an average of about 9 percent between 1986 and 2015.

Some of the stock gains can be ascribed to the fact that forward 12-month earnings expectations are rising, even as actual earnings are falling, something not seen since 2009 after the financial crisis.

SOX it to Me
While average earnings among members of the SOX Index have fallen, analysts have raised estimates for the coming year. This divergence hasn't been seen since 2009 after the financial crisis.
Source: Bloomberg

Yet even taking that into account, investors appear to have bid up the sector beyond what sell-side analysts predict for next year. Price-to-earnings ratios are near their highest in three years:

Chips Ahoy
Valuations among members of the Philadelphia Stock Exchange Semiconductor Index are approaching a three-year high as investors drive up prices
Source: Bloomberg

Of course, the chief reason for the euphoria is deals, and the prospect of more of them. The chip sector has been consolidating rapidly since early 2015 with $92.6 billion of deals completed, and $84.3 billion pending, according to Bloomberg data. The frenzy means investors are probably ascribing takeover premiums to potential targets, such as Maxim Integrated with a $11.7 billion market value and Microsemi at $4 billion.

But M&A isn't the only reason for the frothiness. Demand for chips used in cars, gaming, and video is growing rapidly even as smartphones and PCs struggle. This benefits chipmakers carving out specializations such as Nvidia, Infineon and NXP. Bryan Garnier reckons automotive chips will grow 6.8 percent on average from 2015 to 2018, and industrial chips by 7.5 percent.

And despite the lofty P/E ratios, there may still be some value around. Neil Campling at Northern Trust Securities urges a focus on returns on invested capital. Using that measure, some chipmakers such as Texas Instruments come out well. It delivered a 20.7 percent cash return on invested capital on average in the past three years:

Texas Hold 'Em
Chip maker Texas Instruments isn't beloved by analysts, who mostly have hold ratings on the shares, but it has a track record of solid cash generation
Source: Northern Trust Securities
Cash return on invested capital is a metric used by Northern Trust. It's similar to ROIC but uses cash instead of profit

Finally, with the much-ballyhooed "Internet of Things" apparently around the corner, we'll need lots of chips to connect all those intelligent fridges and robocars. Investors are right to look forward to a silicon-infused future. But with the index on a tear, picking winners is getting harder.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Leila Abboud in Paris at labboud@bloomberg.net
Tim Culpan in Taipei at tculpan1@bloomberg.net

To contact the editor responsible for this story:
James Boxell at jboxell@bloomberg.net