3 Semiconductor Stocks to Consider Buying

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

If you are bullish on tech industries, it makes sense to back semiconductors, which directly supply the end markets. However, there are a few headwinds in terms of demand that you should keep in mind. Below, I explain what TI (NASDAQ: TXN) and Analog (NASDAQ: ADI) are doing to hedge against this uncertainty.

"A weak demand environment" for Texas Instrument

Texas Instruments is a global leader in manufacturing semiconductors. The company has been performing fairly well in the industry, and has been an attractive investment in terms of returning cash to shareholders through share repurchases. This is despite operational challenges.

Rich Templeton, the company’s CEO, has said that the company is operating in “a weak demand environment.” At the same time, the CEO has been quick to note that despite the unfavorable economic situation, the company was still committed to bring attractive returns to shareholders. He noted that free cash flow grew by 20% to $3 billion for the 2012 fiscal year. 90% of the free cash flow was then used in share repurchase programs as well as dividend payments.

The company's strong cash flow was realized principally from the company’s analog and embedded processing segment. This segment has high margins, low capital needs, and solid growth.

However, from a financial standpoint, the company is in a weak position compared to peers. Long-term debt to equity stands at 38.2 versus an 18.7 industry average. The current ratio stands at 2.6 versus a 3.4 industry average. At the same time, the price-to-book value of 3.5 is on the higher side of the industry.

Reasons to be optimist about Analog

Analog Devices is a global leader in analog semiconductor technology. Like TI, Analog Devices has taken several steps to mitigate risk for investors. In 2012, a total of $505 million in cash flow was used to repurchase shares and pay a divided.

Going forward, however, the company faces several headwinds. In 2013, management expects revenue to fall by 6%-12% and the gross margin to erode by around 180 basis points. Despite this weak outlook, investors are still cheery. This can be seen in how the stock has soared to its 52-week high after rising 33% from the lows. 

There are several reasons to be optimistic. First, the company is in a terrific financial position. The current ratio stands at 9.7. Second, return on invested capital currently stands at a healthy 13.8%, which is around 500 basis points greater than the industry average. Third, risk is relatively limited for this semiconductor producer, as evidenced by the beta of 1.07 -- some peers have much greater volatility. With a dividend yield of 3%, Analog lacks much risk despite the macro headwind.

Xilinx: Reduced risk opportunity

For even less risk, consider adding Xilinx (NASDAQ: XLNX) to your semiconductor portfolio. This company has been a consistent winner over the past 4+ years -- through good times and bad. It has had similar EPS growth over the past 5 years, and is forecasted for relative acceleration over the next 5 years. Its margins are 700 basis points greater than the industry average, which makes Xilinx less vulnerable to shortages and surpluses.

Xilinx also has a very clean balance sheet. There is no long-term debt, and the quick ratio is healthy at 1.5. More than 15% of the market capitalization is represented by just cash alone. Despite industry-wide uncertainty, EPS has beaten expectations in all of the last 5 quarters. Beta, a measure of volatility, is roughly in-line with the market. 

Conclusion

Semiconductors are a risky market with frequent supply and demand changes. However, risk can be reduced by investing in Xilinx and Analog. TI is in worse financial shape and operationally struggling, yet it trades at roughly the same PE multiple. For this reason, I recommend avoiding TI and investing in its peers.

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David Gould 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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