Fears over global economic slowdown and rising interest rates have rattled investors and sparked a brutal selloff in North America and across the globe. The slide rippled across sectors, but as is frequently the case, technology was hit the hardest. The resultant weakness, though, helped temper frothy valuations and made some pockets of the sector, such as the semiconductor stocks and semiconductor manufacturing equipment makers, more attractive than others.
Companies making semiconductor products, which underpin the global technology revolution, are well positioned to benefit from the rapid growth of the Internet of Things, a market estimated to be worth US$4 to US$11 trillion by 2025.
Semiconductor industry stocks, which include suppliers of equipment to the global semiconductor business, started the year on a high note but appear to have got caught in the market downdraft lately. The PHLX Semiconductor Index (SOX), which was up more than 15% earlier this year, has given up all of its gains and is now down 1.5% for the year to date, as of Oct. 22, compared to more than 8% gains for the NASDAQ and over 3% rise in the S&P 500.
On the bright side, the ongoing softness has created an attractive opportunity for investors looking to play technology without having to pay the lofty premiums commanded by the blue-chip stocks. The following names are frontrunners of the semiconductor industry with robust competitive advantage, and they are trading at deep discounts to their Morningstar fair value estimates, representing value opportunities and sizeable upside potential.
| Microchip Technology Inc. | ||
| Ticker: | MCHP | |
| Current yield: | 2.17% | |
| Forward P/E: | 10.1 | |
| Price: | US$66.85 | |
| Fair value: | US$112 | |
| Value: | 40.3% discount | |
| Data as of Oct. 22, 2018 | ||
Microchip (MCHP) generates more than half of revenue from microcontrollers, or MCUs, which are semiconductors that act as the brains within a wide variety of common electronic devices.
"We view Microchip as one of the best-run firms within the chip space and especially like the firm's focus on higher-margin chip opportunities across a wide array of end markets," says a Morningstar equity report.
MCUs and analog chips aren't overly dependent on leading-edge designs, which helps keep capital investments relatively low. "These chips are selected based on performance rather than price, because they make up only a tiny portion of a product's overall cost," says Morningstar sector director Brian Colello. These chips have long product lives, and switching to a competing MCU could involve elaborate product redesigning, thus creating customer stickiness.
A leader in the 8-bit MCU segment, historically, the firm in recent years has been gaining ground in the more advanced 16- and 32-bit MCU market. The analog chip segment has also been growing steadily.
"Overall, we foresee healthy demand for Microchip's products going forward," says Colello. "As more and more electronic devices become 'smarter' and connected to the internet, Microchip's MCUs and analog chips stand to benefit."
The firm's sustainable competitive advantage, or wide moat, stems from proprietary chip designs, manufacturing expertise and switching costs, says Colello, who puts the stock's fair value at US$112.
Given Microchip's track record of stellar profitability, its leadership position in MCUs and the growth of its analog business, "it is more likely than not that Microchip will earn on excess capital over the next 20 years," forecasts Colello.
| Intel Corp. | ||
| Ticker: | INTC | |
| Current yield: | 2.66% | |
| Forward P/E: | 9.9 | |
| Price: | US$45.16 | |
| Fair value: | US$65 | |
| Value: | 30.5% discount | |
| Data as of Oct. 22, 2018 | ||
One of the world's largest chipmakers, Intel (INTC) designs and manufactures microprocessors and platform solutions for the global personal computer and data centre markets.
Intel's server processor business has benefited from the shift to the cloud. As the PC market declines, the semiconductor behemoth has been boosting its presence in Internet of Things, memory, artificial intelligence and automotives through strategic acquisitions including Altera, Mobileye, Nervana and Movidius.
"With the rise in interconnectivity of devices ranging from PCs to smartphones, Intel strives to provide the most powerful and energy-efficient silicon solution to any product ‘smart and connected'," says a Morningstar equity report.
Intel's data centre group benefits from the cloud computing trend. "Mobile devices have become the preferred device to perform computing tasks and access data via cloud infrastructures that require considerable server build-outs," says Morningstar equity analyst Abhinav Davuluri, who recently upped the stock's fair value from US$62 to US$65. "This development has provided strong tailwinds for Intel's lucrative server processor business."
The wide moat firm is exploring new growth frontiers through bolt-on acquisitions and tie-ups. It's made a big thrust into the artificial intelligence (AI) market where it faces stiff competition from NVIDIA (NVDA) for specialized chips to accelerate AI-related workloads. "Intel has built a broad accelerator portfolio via the acquisition of Altera for FPGAs, Mobileye for computer vision chips used in cars, Nervana neural processors, and Movidius video processing units," says Davuluri, who says Intel will be a direct beneficiary of the AI accelerator chip market projected to be US$20 billion by 2021.
| Applied Materials Inc. | ||
| Ticker: | AMAT | |
| Current yield: | 1.75% | |
| Forward P/E: | 8.0 | |
| Price: | US$33.53 | |
| Fair value: | US$49 | |
| Value: | 31.6% discount | |
| Data as of Oct. 22, 2018 | ||
Regarded as the chip equipment industry's standard bearer, Applied Materials (AMAT) is one of the world's largest suppliers of semiconductor fabrication tools, providing engineering solutions to help make nearly every chip in the world.
The company has a broad product portfolio that offers customers the closest thing to a one-stop shop. "While competitors tend to specialize in a single core competency, Applied competes in almost every key equipment segment with the exception of photolithography," says a Morningstar report. "As a result, all major chipmakers develop strong relationships with Applied that span multiple process steps of their chip production."
As new manufacturing technologies replace old, semiconductor manufacturing is growing in complexity, thereby compelling chipmakers and equipment providers to collaborate. "We expect Applied to leverage existing relationships and insights into future customer technology needs to take advantage of the proliferating demand for state-of-the-art chips," says Davuluri, whose US$49 fair value for the stock implies significant upside potential.
Besides semiconductors, the firm is a leading supplier of manufacturing tools for flat-panel displays, including LCDs and OLEDs. The rising complexity of these displays in recent years has boosted demand for Applied's tools.
"The cyclical nature of the chip industry and the display market is a ubiquitous threat to equipment suppliers," cautions Davuluri. He adds, though, that thanks to an expansive product portfolio and large installed base, Applied will "comfortably weather business cycles" and "experience decent growth over the long term."
The company's robust competitive advantage is built on its equipment design expertise, strong R&D capabilities, and cost advantages. "These characteristics," says Davuluri, "have allowed it to become the top vendor in the semiconductor equipment market."
| KLA-Tencor Corp. | ||
| Ticker: | KLAC | |
| Current yield: | 2.95% | |
| Forward P/E: | 10.1 | |
| Price: | US$89.81 | |
| Fair value: | US$128 | |
| Value: | 29.8% discount | |
| Data as of Oct. 22, 2018 | ||
KLA-Tencor (KLAC) designs and manufactures yield-management and process-monitoring and control systems for the semiconductor industry.
The company dominates the process diagnostic and control segment of the semiconductor equipment industry. Its systems help lower production costs and maximize productivity for chipmakers by analyzing product and process quality at critical steps in the manufacture of circuits. "With a 50%-plus share in the process diagnostic and control (PDC) market and installed base of 20,000 tools, KLA-Tencor has built its leading technical expertise and extensive knowledge base into a wide economic moat," says a Morningstar report.
A large research and development allocation allows the firm to maintain its technological edge and puts it at the forefront of the PDC space, which helps form close relationships with customers. "KLA is well positioned for the long-term, as chipmakers will require more advanced PDC tools to go with fabrication technologies featuring smaller circuit sizes, new materials, and more process steps," says Davuluri, noting that the company's comprehensive portfolio and leading technical expertise enable its products to be in every major chip-manufacturing facility in the world.
KLA's PDC tools help customers improve semiconductor die yields, accelerate development and product ramps and ultimately maximize profitability.
Davuluri cautions that as a pure-play firm in the semiconductor equipment industry, the firm is not immune from cyclicality. However, the chip-gear maker has been able to command a premium for its specialized products, which "allows the firm to handle cyclical troughs fairly well for a company that operates in the chip equipment industry," says Davuluri, who recently raised the stock's fair value from US$125 to US$128, prompted by a stronger near-term outlook.
