2 Semiconductor Stocks to Buy, 1 to Hold on Changing Macro Dynamics

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For most of last year, investors held out hope for a cyclical recovery in wireless and wireline CapEx with expectations of resurgence in China, LTE handset product cycles reinvigorating developed market capital spending and the insatiable growth in bandwidth consumption forcing network upgrades. Unfortunately, decelerating emerging market GDP and developed market carriers focus more on cash flow than subscriber acquisition acted to push out the investor-anticipated cyclical recovery driving relatively muted 2012 Telecom CapEx growth of 2.9% y/y (wireline +3.3% and wireless +2.6%). Further, the wireless/line supply chain saw less growth as the telecom equipment-to-CapEx ratio fell from ~36% to ~32%, driving equipment spend down 8% y/y.

While 2012 was largely disappointing, the market did see some “green-shoots” exiting the year –specifically AT&T (7% of global CapEx) guided annual CapEx up 13% from $18.8 billion in 2012 to $22.0 billion for 2013 to expand capacity for its LTE/U-verse networks. Further, T-Mobile recently indicated an approximate 25% increase in 2013 CapEx from $2.7 billion to $3.4 billion. Lastly, Cisco recently reported F1Q (Oct.) results with revenue +1.6% q/q versus expectations for +0.7%, providing yet another data point of stabilization to modest growth in the market

Tech experts know that Credit Suisse has a technology index by the name of Credit Suisse Technology Index (CSTI). It is interesting to note that Telecom Equipment was the worst performing sector of the CSTI from the beginning of the year through AT&T’s Analyst Day (11/7/12) – Telecom Equipment stocks were -8.7% versus the CSTI +10.8%. However, since AT&T’s Analyst Day on 11/7/12, telecom equipment stocks have increased 19.5%, well in excess of the CSTI, which has increased only 6.4% over the same time period.

While the Telecom CapEx outlook for 2013 continues to look muted, there seems to be some evidence of a modest mix shift towards equipment from ~32% in 2012 to 33 -34% in 2013, implying that the wireless/line equipment market could grow 2-5% in 2013. While 2-5% growth seems modest, it is a significant improvement from the 8% decline in 2012. Specific sub-segments leading growth should be wireline over wireless, optical networks, core routing, and enterprise WLAN.

Two Semis to Buy, One to hold

After having a brief overview of the wireline/less market, it is important to filter out those semiconductor players that are destined to make the maximum out of this trend.

Currently, both Xilinx (NASDAQ: XLNX) and Analog Devices (NASDAQ: ADI) are both at least partially underpinned by this more optimistic view, and they are also consistent with the holistic view that investors will be best served migrating from stocks levered to smartphone shipments to those more levered to usage models around increasing penetration of smartphones in the installed base. In addition, there is also a chance that the market might witness, an increase, albeit modest, in non-traditional network CapEx – heterogeneous networks, wifi-off loading and infrastructure around the “Internet of Things.” While these developments seem more of an evolutionary type rather than revolutionary, every little bit helps, and the market is specifically constructive on the 802.11 AC product cycle.

While the Street is clearly more constructive on the wireless/line supply chain in 2013 than it was in 2012, analysis suggests growth but not necessarily robust growth. This is the key reason why Xilinx is recommended as a buy but Altera Corp. (NASDAQ: ALTR) is recommended as a hold.

The brief discussion mentioned above leads us to reject the notion that wireless/wireline capital spending is significantly below the trend line, as well as the notion that wireless/line supply chain revenue is below trend.

Talking specifically, investors have underappreciated the dampening impact of three dynamics:

(1) Developed market carriers are less concerned with subscriber acquisition than they were several years back: Companies usually do not plan to fail – i.e. when acquiring subs was a priority, the carriers were spending above normalized levels in anticipation of taking market share. As subscriber acquisition strategy waned, it provided a cushion/downward pressure to capital spending budgets.

(2) Cellular Bandwidth Consumption is asymmetric and migrating subscribers from an ‘all you can eat’ to a tiered pricing plan could dramatically change bandwidth supply needs. The top 5% of all subs represent an outsized portion of bandwidth consumption. Changing the consumption pattern/price paid for just a small percentage of your subscriber base can dramatically change your bandwidth needs.

(3) China build out will be more linear: While the Street is bullish on an increase in China CapEx, especially in 2H13; it is important to stress here that the market is unlikely to return to levels seen in the 2008-2010 timeframe when China aggressively moved to 3G. We suspect that 3G will have a significantly longer life and LTE will be more linear in deployment.

Foolish Bottom Line

The crux of the discussion is that the market has underappreciated certain dynamics of the changing macro telecom environment which has led to a money-making opportunity for the semiconductor investors.

AnalystX has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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