Weak Outlook for Semiconductors, so Are These Multiples Justified?
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It has been a rough year for semiconductors. From natural disasters that disrupt supply chains to weak demand that diminishes labor productivity, investors should be focused on the downside catalysts. Despite this weak environment, the market surprisingly has assessed both strong and vulnerable producers alike with high multiples. Is this in any way warranted? Below, I review several stocks with this question in mind.
Texas Instruments (NASDAQ:TXN): A Giant Falls
At a respective 20.2x and 17.3x past and forward earnings, TI is an expensive broad line semiconductor producer. Analysts are very cognizant of this premium and, accordingly, have a reserved outlook. 23 of 33 reporting analysts rate the stock a "hold" or worse, one of which calls it a "sell." This is despite a strong 16.5% return on invested capital and industry leading ROE.
There are several reasons why analysts steer investors away from this company. First, the stock has rallied 20.2% from the lows; in fact, news should have taken the stock in the opposite direction. Management recently guided for weak industrial, computing, telecom, and infrastructure. One of the only two fields that management cited a healthy outlook for, e-readers, actually faces a weak future environment. IHS iSuppli has estimated e-reader shipments to decline 36% in 2012 to 14.9 million units. This erosion is attributed to soaring tablet sales, and, unfortunately, it is not being offset by momentum elsewhere. Management's main concern is lean inventories, which threaten margins in an uncertain environment. Wireless sales are expected to underperform yet again next quarter.
All of this falls within the conext of management deciding to lay off 5% of its workers (or 1,700 jobs) and focus more on OMAP processors on long-lasting embedded applications. TI estimates it will save $450 million per year as a result of the layoffs. While the move may be good in the short-term, the downscaling is indicative of weakening underlying fundamentals. It should be no surprise that the company is exiting a large portion of its wireless connectivity market, which will register a $200 million loss in 4Q12.
Riskier investments are said to outperform their safer peers, so let's take a look at two highly volatile alternatives: Analog and Maxim. Unlike TI, these companies do not have the scale and thus lack the resiliency to weather a poor industrial environment for long. At 25.1x past earnings, however, Maxim looks expensive despite the vulnerability. Analog Devices isn't much cheaper at 19.8x and is really playing with fire in light of the low single-digit EPS growth that is forecasted over the next five years.
There are several reasons why you should be hesitant about buying these volatile investments. Analog Devices guided for a 6-12% q-o-q decline in revenue, which is worse than the 2% drop expected and evidences further market deterioration. Inventory adjustments remain an ongoing problem for both producers and have caused internal guidance to go down. It should not be surprising then that Analog Devices has taken steps similar to TI by cutting production and, in the process, eroding margins (costs are spread over less goods). In the fourth quarter, Analog saw gross margins erode by 180 basis points q-o-q to 63.8%, and it is expected to continue to fall.
A look at Maxim can give you an indication of the overall risk/reward for these two companies. Assuming Maxim grows EPS by a rate of 13.5%, 2016 EPS will come out to $3. At a multiple of 16x, this translates to a future stock value of $48. Discounting backwards by 10% yields a present value that is roughly in line with the present value. The absence of any margin of safety makes this a stock to be avoided, especially since multiples are quite high for the risk involved.
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