Is it Time for a Chip Market Turnaround?

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Microchip Technologies (NASDAQ: MCHP) recently released quarterly earnings. The company's CEO made the bold statement that, “ We believe the December quarter was the bottom of this cycle for Microchip...” If that's the case, Microchip could be a buy, but who else is worth looking at?

Cyclical

The chip business is notoriously cyclical, with the earnings and share prices of industry participants generally going up and down in an often volatile pattern. Generally speaking, this isn't an industry for the faint of heart.

Part of the reason for the industry's hot and cold performance comes from the fact that microchips are now found in just about everything. This makes the economy a huge factor in the demand for chips. Of course, the end customer isn't the chip manufacturer's customer, so there are usually at least two middle men to complicate supply and demand.

Since original equipment manufacturers aren't any better than retail stores at figuring out how many of what products to make, unexpected demand changes are common. Add to this the high fixed costs for chip companies, which have to have massive and expensive factories regardless of whether they make one chip or 2 million, and it becomes understandable how earnings could be so volatile. That said, leverage to the upside can be exciting when markets turn around.

This is the End

In a press release, Microchip Technologies' CEO recently opined, “...we are starting to see exceptionally strong bookings and expedite activity in our business driven by solid demand and a robust design win pipeline. We believe the December quarter was the bottom of this cycle for Microchip...”

There are two takeaways from this. First, this one company has been doing pretty well. That could make it worth looking at. However, based on the types of chips Microchip Technologies makes, it could be signaling an industry wide turn, as well.

In Everything From Remote Controls To Refrigerators

Spun off from General Instrument in 1989, Microchip Technologies is a leading supplier of microcontrollers (MCUs). These chips perform relatively simple tasks and are found in such household items as remote controls and refrigerators. Although commodity items, to some extent, contracts for these chips are often long-term in nature. A customer would have to make material changes in its products to accommodate other suppliers, making such changes infrequent.

This also helps to give the chips that Microchip sells long product lives and, thus, decent margins. Microchip Technologies has a solid business in the 8 bit space, but lags competitors in the more modern 16 bit and 32 bit areas. This isn't inherently a big thing today, but it is an issue for longer term growth. That said, the recently ended quarter witnessed record sales for these two chip categories. The long life cycles of the chips could allow the company ample time to build up these businesses over time.

The big problem facing the company of late was the economy. Indeed, since its products are in everyday consumer goods, it is indirectly affected by consumer spending: If end customers pull back, so do Microchip Technologies' customers. The company seems to believe that the low has been reached. This would be a good thing for this large chip player's results.

United Microelectronics Group (NYSE: UMC)

Founded in 1980, United Microelectronics claims to be Taiwan's first semiconductor company and the second largest microchip foundry in the world. As a pure foundry, the company does not design chips, it only makes them. This means that it foots the expense of owning and operating the factories that make semiconductors, leaving others to focus on research and development.

One of the keys to the company's success is ensuring that its factories are cutting edge, so it can keep up with changing customer needs. Today, it can support 28nm processes, mixed signal/RFCMOS, and “a wide range of specialty technologies”. The company has 10 manufacturing facilities.

At the end of the third quarter, management suggested that the close of 2012 would be relatively weak and it was. Worse, the company's outlook wasn't as positive as Microchip's view of the world. However, that could spell a buying opportunity for more aggressive investors. If the industry is starting to turn for one chip maker, the others are likely to follow soon enough.

United Microelectronics is a good company that is up against stiff competition from a larger rival, Taiwan Semiconductor (NYSE: TSM), which it has lagged for years. Still, with little to no debt and plenty of cash in the bank, the company is going to be a long-term survivor. When the chip market turns, United Microelectronics is set to benefit.

Taiwan Semiconductor (TSM)

Taiwan Semiconductor was founded in 1987. It claims to be the world's first dedicated semiconductor foundry. It is definitely the world's largest. The company does essentially the same thing as United Microelectronics. It has 14 facilities that it either owns or has agreements with throughout the world, including one each in China and the United States.

The company's results have been relatively weak of late, in line with its smaller competitor. Once again, however, if the chip market is making a turn, it would benefit Taiwan Semiconductor. That said, the chips these two companies make tend to be more complex than those made by Microchip Technologies, so it wouldn't be surprising for a turn to take longer to benefit these players.

An interesting note about Taiwan Semiconductor's business is that management is branching out into the currently hot fields of lighting and solar energy. While there are definitely synergies between chip making and these two industries, there is always a risk in moving into new areas. This is particularly true for a company that has benefited for so long from a singular focus.

STMicroelectronics NV (NYSE: STM)

STMicroelectronics is the largest chip maker in Europe. It is the result of the 1987 merger between SGS Microelettronica of Italy and Thomson Semiconducteurs of France, and operates in a vast array of chip categories, giving it a material level of diversification. The company's key markets include sense and power technologies, automotive products, and embedded-processing solutions.

A struggling joint venture, which the company has been working its way out of, and weak economic conditions in Europe have been material drags on STMicroelectronics' results of late. That said, the joint venture issue should be out of the way shortly, opening the company's options up materially, since it was effectively unable to compete for some business due to the partnership. This should help underpin longer-term performance.

The company's recently released earnings were predictably weak. However, its analog chip business appears to be doing reasonably well. This is the same segment that is driving performance at Microchip Technologies. Although STM's business is far more diverse, this bodes well for future results, particularly in combination with the partnership exit noted above.

Already Moving

The shares of some of the above companies have already started to move higher. That said, if the turnaround suggested by Microchip is coupled with a recovering world economy, there could be material room for some of these shares to run. The notable difference today from before the recession is the continued economic progress of China's citizens, which could result in a much larger end market for chips.

Yours,
 


Reuben Gregg Brewer 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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