NetLogic Microsystems Inc. (NETL)

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Post-CES, Semiconductor Stocks On A Tear
Rick Whittington,
01.10.11

The consensus is starting to recognize a semiconductor upturn, as innovation drives chip market.

Semiconductor stocks have been on a tear. After incurring a mid-course inventory correction that kicked off with Intel's PC slowing in mid-summer, stocks were hammered for a couple of weeks by fears of double-dip and a new recession. It turns out all was fine with the economy, and most shares have jumped to new recovery highs. The upturn started way before the crowd called it, with six full quarters of actual positive growth to date, preceded by an additional three to four months of increasing order rates. ISMs turned upward in early spring 2009, but so acidic was the financial and political environment few paid attention to the reliable lead indicators.

Today, finally--after much fretting and teeth gnashing--the consensus is beginning to recognize this new economic upturn's similarities with the prior globally synchronized expansion in 2002-2007. Sure, there are still worries about the European periphery, but key old member states (read: Germany) and new member states are thriving. New states are entering the common currency zone, despite its purported demise cast with global contagion, risky assets, emerging market decoupling, new depression and other market shibboleths. Worries over the rising price of oil could turn out to be as irrelevant as they were back in 2004-2005.

Instead of a diminished future, America faces a third year of strong overseas demand for its technologically advanced capital goods including--as the recent CES show made abundantly clear--electronics paraphernalia and chips. Industrial concerns were also a player at CES, notably in the form of automakers sporting cool user interfaces and using connectivity as key selling tools. Japan, South Korea and Taiwan were in view, but the stars were all American, as innovation reigned supreme and the world flocked to the United States' latest and greatest.

Even as China shows off advanced fighters and missiles, its economic dependence on imports is coming to the fore, with its latest trade figures showing a narrowing surplus even though its currency has only moved up modestly the past year. China's capital markets are also far less developed and even flimsy compared with the U.S. and the E.U.'s, all the silly rhetoric notwithstanding; its IPOs are already coming under deserved scrutiny for lack of transparency, code for hype. Beneath the headlines, China's per capita income remains only 10% of Japan's.

Thinking that a multiyear disaster lay ahead, Wall Street mavens fled the U.S. in 2008 and set up shop in front of what was promoted as an emerging markets path to unending riches. Yet while China's central bank correctly tightens in front of resource and capital goods reliance, the U.S. dollars chugs along in the face of Fed ease--mirroring a more diverse, entrepreneurial and dynamic economy. As America makes the long transition back toward greater manufacturing and industrial reliance, its consumer and retail sectors are showing great resilience, far from sign of a decaying or atrophy society the critics would sell.

Without any concrete sign of improving financials, market recognition of these many underlying positives is what's mostly behind the rally in chip stocks the past four months, most of which have trimmed guidance, with some even pointing to sharp near term declines. This is the way these stocks hit the cycle bottom two years ago, however, so many are obviously betting on a repeat lightning strike.

One worry is the bandwagon-jumping by those who missed in the past two years, as major firms have to get bullish now that the handwriting's on the wall and smaller entities seek a piece of the financing opportunities ahead. When underlying events warrant, there's nothing wrong with newfound optimism; what elicits concern is the price target game, without raising earnings estimates or fundamentally justifying the hikes. What's worse is when the target price goes up but ratings are maintained neutral or negative.

As earnings season approaches, I'm mindful that January through mid-April are typically strong months for chip bookings. If, as a number of companies have previously indicated, order rates got better as lead times shortened through the fall, then chip stocks will be just fine from here. Even if the December quarter reports are at, or even somewhat beneath, prior guidance, improving book-bill ratios should be enough to sustain the recent upward path. On the other hand, companies citing higher orders but still seeing down sequential sales (and earnings) for the upcoming March 2011 quarter will be penalized. For sure, end markets are so strong that the trend is up, but there's nothing like seeing the whites of their eyes.

Our favorites for the year ahead remain Altera, Linear Tech, Analog Devices, NetLogic, Broadcom and ASML. CES made it clear that the market is all about innovation, with new products pouring off drawing boards and old world items engineered to the fashion. I began this column twenty months ago with an emphasis on connectivity and mobility, highlighting smartphones both for their chip content and for the new broadband infrastructure necessary to support mobile Internet use. Security and quality of service throughout the network was the order of the day as these high performance devices swept the planet, tying together disparate economies and increasing productivity while kick-starting global industrial growth.

The aforementioned chip suppliers are obvious winners, but the world's leading photolithography maker, ASML, is probably less obvious and requires some additional explanation. With ASML already having ousted Canon from what had been a long-standing triumvirate responsible for supplying "steppers"--machines that lay out and print critical dimensions on the silicon wafers used to fabricate chips--the company's technical prowess is today also neutering Nikon. New generation steppers are required for the faster, more capable, and more power efficient chips that are driving most end market demand.

While this demand dictate has existed over the chip industry's near 50-year course, some of the cycles have been more focused on low-cost consumer applications, thus mitigating pricing power for the productive equipment. This was true in 2004-2007, when enterprise and communication infrastructure occupied a back seat following the 1996-2000 overbuilding. The irony of smartphones and iPads--consumer items of the Nth degree--is they are nearly always on a fast, wide-open Internet filled with viruses, hackers and other cyber risks.

Internet content increasingly dominated by full-feature video and demand for ultra-high-performance bandwidth means high chip demand up and down the line, necessitating tinier line widths and new-generation steppers. As ASML consolidates its competitive position and introduces both refinements to existing models as well as far more complex and capable new generation machines, its already rising selling prices are about to take a step function jump.

Compared with the roughly $25 million per machine price today, ASML will start shipping some items at a $50 million price point late next year, with technical extensions pushing that number to $60 million. This transition will go through this decade but it means a rising mix ASP over the course of the decade. Unit demand will ebb and flow with the chip cycles' many vagaries, including economic demand, internal manufacturing and supply chain. These are what are known in the trade as high-class problems.

http://www.forbes.com/2011/01/10/semiconductors-on-tear-chips-asml-intelligent-investing_2.html