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3 Solid Buys from the Semiconductor Industry

The strong demand environment of the last few months has allowed several semiconductor players to enter into long-term, preferred supplier or other special relationships with customers. This has improved visibility for players and stabilized revenue streams. However, the industry remains supply constrained, which is a limiting factor. Growth prospects over the next 5-10 years are excellent, because of the adoption of new technologies like AI-ML, EVs, smart cities, IoT, etc.
While the longer-term outlook is extremely bright, near-term concerns related to the Fed-engineered economic slowdown and supply challenges remain. The most likely result will be increased caution at customers, who could order closer to consumption, thus reducing visibility. But this should not be a deterrent considering that there are segments of the market that remain amazingly resilient. 
Our current picks are Analog Devices (ADI), Microchip Technology (MCHP) and Silicon Laboratories (SLAB).

About the Industry

This industry includes mostly semiconductor chip manufacturers like Intel Corporation (INTC).

Major Themes for the Industry

  • This is likely to be a mixed year for semiconductor companies offering analog and mixed signal chips. Some end markets will be sluggish. PCs (gradual uptick expected in the second half on the enterprise side and continued softness on the consumer side) and smartphones (weak consumer spending due to inflation affecting disposable income, as well as greater propensity to consume things like leisure and travel) stand out here. However, other markets like automotive, communications (especially 5G), IoT, cloud, AI, industrial (including medical devices) are all expected to do well. Technological innovation in the form of the metaverse, digital health, EVs and other innovative transportation and sustainability considerations are other drivers. China opening up is a positive, but uncertainties related to dealing with China remain.

  • The industry is likely to see continued operating challenges. Primary among these is the supply/demand imbalance that is leading to an inventory glut especially in DRAM and NAND chips that have not been consumed as PC and smartphone demand slumped. Data center demand has also dropped off sharper than expected as leading tech players absorbed the reduction in advertising demand. On the other hand, the shortage of chips for the automotive market remains. The situation is expected to gradually improve as we get into the second half partly because some of the demand is expected to come back, partly because of increasing capacity and partly because of other factors such as the end of support for Windows 10 leading to another upgrade cycle in the PC market.

  • An emerging issue that semiconductor players are particularly exposed to is geopolitical tensions. The semiconductor supply chain is globally distributed, which means that international relations need to be maintained to ensure that work continues without disruption. While the Russia-Ukraine war didn’t have that much of an impact, the souring of relations between the U.S. and China is another story. If China really tries to take control of Taiwan as many experts expect it will, there could be a terrible war that will be highly disruptive of the global economy and especially of the chip sector. That’s because a leading share of advanced node chips are made on the island. Another geopolitical concern is the increasing awareness among all leading nations of the increasingly larger role that semiconductors are playing in AI-driven electronic weaponry and surveillance mechanisms. As semiconductors become important in defense, the need to onshore or near-shore production is being felt. This is leading to rebalancing of the semiconductor supply chain not with a cost-reduction perspective but with a far more strategic objective. So the government is trying to incentivize companies to build in the U.S. TSM, the main supplier to the U.S. is setting up in the country but the plan is to have this on a much larger scale. The CHIPS Act may help a difficult situation where increased capacity would depress prices while U.S. production would increase costs. In the meantime, the U.S. has ordered restrictions on trading with China, which is also a near-term headwind for players.

Zacks Industry Rank Indicates Relatively Strong Prospects

The Zacks Semiconductor – Analog and Mixed industry is housed within the broader Zacks Computer and Technology sector. It carries a Zacks Industry Rank #57, which places it in the top 23% of the 250 odd Zacks-classified industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates relatively strong near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s positioning in the top 50% of Zacks-ranked industries is based on the earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions over the past year, it appears that analyst opinion about the 2023 outlook has improved while that for 2024 has weakened slightly: 2023 estimates have risen 5.9% over the past year, while 2024 estimates have dropped 3.7%.

Before we present a few stocks that you may want to consider for your portfolio, let’s take a look at the industry’s recent stock-market performance and valuation picture.

Stock Market Performance Is Attractive

The Semiconductor – Analog and Mixed industry has traded at a premium to the S&P 500 through most of the past year and starting from November it has pulled way ahead as the S&P essentially flatlined. The broader Zacks Computer and Technology Sector has trailed the S&P 500 since April.

Overall, the industry gained 13.1% over the past year while the broader sector lost 14.1% and the S&P 500 lost 11.0%.

One-Year Price Performance

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Industry's Current Valuation

On the basis of forward 12-month price-to-earnings (P/E) ratio, the industry is trading at a 17.12X multiple, which is a discount to both the S&P 500’s 17.33X and the broader computer and technology sector’s 21.22X. At the current level, it is however trading at a premium to its median level of 16.70X over the past year.

The industry has traded between a 13.80X and 18.74X multiple over the past year.

Forward 12 Month Price-to-Earnings (P/E) Ratio

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3 Stocks to Hold for the Long-Term

Analog Devices, Inc. (ADI): Analog Devices is an original equipment manufacturer of semiconductor devices, specifically, analog, mixed signal and digital signal processing (DSP) integrated circuits for industrial, consumer, communications and automotive customers. Other than manufacturing at its facilities in the U.S., Ireland and Southeast Asia, it also outsources some production to outside foundries, mainly Taiwan Semiconductor Manufacturing Company for front-end processing and third-party subcontractors for back-end operations.

Analog Devices’ strength in the more resilient industrial (over 50% revenue share) and automotive markets is proving to be helpful in the difficult operating climate we are seeing today. Demand in these markets, particularly for automation and electrification are currently driving its business. These along with pervasive sensing, AI-driven edge computing and ubiquitous connectivity that are enabling new capabilities, applications and markets at the Intelligent Edge are secular drivers.

As far as operations are concerned, the company has been growing its output both internally and at its foundry partners, which has allowed it to lower lead times. However, it still has a significant backlog, which would translate into a year’s revenue at the current level.

Shipments are expected to increase through the year, bringing the backlog back to normal levels. The company recently raised its quarterly dividend by 13%, making it the fifth consecutive double-digit increase, and the 19th straight year of dividend increase.

The company beat January quarter estimates by 6.2% and in the last 30 days, the 2023 estimates for this Zacks Rank #2 (Buy) company dropped a couple of cents The 2024 estimate increased by 90 cents (9.0%).

The shares are up 25.3% over the past year.

Price and Consensus: ADI

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Microchip Technology Inc. (MCHP): Microchip Technology Incorporated operates in the Americas, Europe and Asia. It develops, manufactures and sells smart, connected and secure embedded control solutions such as general purpose 8-bit, 16-bit, and 32-bit microcontrollers; 32-bit embedded microprocessors; and specialized microcontrollers for automotive, industrial, computing, communications, lighting, power supplies, motor control, human machine interface, security, wired connectivity and wireless connectivity applications.

Microchip’s demand far outpaces its ability to supply. It is a good thing that more than 50% of its backlog is non-cancellable under its Preferred Supply Program (PSP). Other than the fact that it greatly improves visibility, it also helps in the current environment where supply constraints are only now beginning to ease up.

Management is currently focused on bringing down its backlog while maintaining the quality of new orders. As supply continues to improve and lead times come down, profitability will also improve. However, China’s imposing and then suddenly raising its lockdown has resulted in inventory gluts that are an overhang on Microchip’s business.

Investors would be interested to know that its strong cash flows have enabled the company to pay down a substantial portion of its debt over the last few years and also pay a consistent dividend. The company recently announced a 41.5% increase in the quarterly dividend. Therefore management continues to return value to shareholders.

Microchip beat estimates by 0.7% in the last quarter. The Zacks Consensus Estimate for 2023 has increased 7 cents (1.2%) in the last 60 days. The 2024 estimate increased 35 cents (6.0%) during the same period.

#2 ranked Microchip’s shares are up 19.3% over the past year.

Price and Consensus: MCHP

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Silicon Laboratories Inc. (SLAB): Silicon Laboratories is a fabless semiconductor company offering wireless microcontrollers and sensor products primarily in the U.S., China and Taiwan. Its products are used in various Internet of Things (IoT) applications, including connected home and security, industrial automation and control, smart metering, smart lighting, commercial building automation, consumer electronics, asset tracking and medical instrumentation.

Silicon Laboratories is seeing solid momentum in its business, which has allowed it to double its organic revenue in two years  and increase its design wins by 120%. Management continues to see significant opportunity and expects the design win momentum to continue, further building its leadership position in IoT, despite the macroeconomic uncertainties.

Silicon Laboratories topped the Zacks Consensus earnings estimate by 35.1% in the last quarter. Its 2023 EPS estimate has jumped a dollar (25.3%) in the last 60 days while the 2024 estimate increased 49 cents (9.0%).

Shares of this Zacks Rank #2 stock are up 26.2% over the past year.

Price and Consensus: SLAB

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