3 Leading Semiconductor Stocks to Watch

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

Semiconductors, chips, and processors. In this industry you have got to be really big in order to actually succeed. With the decline of the PC and the rise of smartphones and tablets, the scenario is somehow reorganizing. We will look into some of the main companies in the sector -- Intel (NASDAQ: INTC), ARM Holdings (NASDAQ: ARMH), and Taiwan Semiconductor Manufacturing (NYSE: TSM) -- in order to analyze how they will perform in the future given the changing circumstances.

A big cap leader to keep an eye on

In a sector which has been performing flatly, Intel has been underperforming its peers since April 2012. Although many believe that recovery is not bound to occur, others still trust the company to be indispensable for the sector’s production.

One way or another, the stock should be considered as its dividend yield of 3.87% is considerably above the 2.2% industry average and higher than the yields offered by 160 -- or 98% -- of the 164 companies in the semiconductor segment. Something similar can be said about the 10.3x P/E ratio, way below the 22.35 industry median. All these elements combined would provide great value for investment.

Another positive point for Intel is its expanding operating margin, currently among the highest in the industry at 27.4% while the sector´s median is at 2.15%. Comparable is the situation of other metrics such as net margin, return on equity, return on asset etc., all of which are significantly above the industry´s median values.

Some of the company´s characteristics, like its vertical integration (unique in the sector), its best-in-class fabrication process and results, and its impressive R&D spending, make Intel a stock worth noting.

Despite the encouraging signs, some investors are worried about the decay of the PC market and about Intel´s capability of penetrating and dominating the smartphone market. Also Zacks´ #3 Hold rank and Barrons’ Hold consensus place the company below many other investment options with greater expected growth.

ARM Holdings is an emerging leader

As mentioned previously, some companies in the sector offer better growth prospects and higher expected returns than Intel. This is ARM’s case: with a projected EPS increase of 29% in 2013, it ranks as a #2-Buy for Zacks’ analysts, while The Wall Street Journal’s consensus is overweight on the stock.

Nevertheless, the market seems to have already acknowledged this as the stock trades at $46.33, its highest price in 13 years and 85.6 times its EPS, 24x P/S, and 11.3x P/B, higher values than 98% of its 164 peers.

Despite the valuation, which certainly reflects a significant amount of optimism regarding future profits, ARM is an attractive investment because of its promising outlook. The company reported a 29% increase in revenue in the first quarter, and another 21% in revenue growth is expected in the second quarter.

Important development and margin expansion opportunities arise from increasing sales in the smartphone and tablet processor market, which provide higher royalty earnings over each processor than the PC market. Morningstar analysts estimate an annual revenue CAGR of 18% over the next five years for this company.

Some other financials also look encouraging, as operating margin has been expanding for over four years, reaching an impressive 36.1%. This margin is not only wider than the ones offered by 99% of the 164 companies in the industry, way above the 2.15% sector median, but also the highest in the firm’s history. Same can be said about the remaining profitability and growth ratios, as ARM ranks higher than 99% of its 164 peers in net margin, return on equity, return on assets, return on capital and revenue, EBITDA, and EPS growth ratios (see table below).

<img alt="" src="http://g.fool.com/editorial/images/35784/armh_holdigns_large.png" />

Notwithstanding the fact that ARM has solid financials and growth prospects, Morningstar analysts assure that the company’s dominance is “locked up just yet” as the stock price assumes the bullish scenario in which ARM surpasses Intel (or at least takes an important share of its customers) in the mobile, PC, and server market.

An emerging market play

Also, among Intel´s competition, Taiwan Semiconductor, the world’s largest contract chip foundry with almost half of the market share (Gartner), is a buy as well. For Zacks, it's a #2-Buy rank, same as for most of Barron´s analysts; The Wall Street Journal consensus suggests an overweight rating on the stock.

Since individual chipmakers cannot afford the manufacturing and only dedicate to design, growing foundry demands have driven TSMC´s profit. Although competition in the segment is also increasing due to low entry barriers, the company focuses on the cutting-edge and high-tech part of the segment, in which most of its peers can’t compete.

This makes Taiwan Semiconductor the most profitable firm in the industry, with over $16 billion in revenue (ttm) and more than $5.5 billion in net income (ttm). Profitability and growth ratios beat 99% of competing firms as well.

The chipmaker´s high exposure to the mobile phone market and growing demand has pushed up its earnings 18% in Q1 to $1.3 billion. It has also been reported that TSMC is manufacturing the chips designed by Apple for its new iPhones and iPads.

However, some risks should be taken into account. For starters, the semiconductor business requires huge capital investments in order to meet the increasing demand, which makes it extremely susceptible to demand cycles. Taiwan Semiconductor is not an exception to this trend, as its financial results have tended to follow the oscillations in the broader foundry industry. In addition, increased competition, especially from GlobalFoundries, a spin-off from Advanced Micro Devices, and Samsung threaten Taiwan Semiconductor´s market dominance.

Conclusion

The significant growth in the mobile tech sector has opened up a new set of opportunities for chipmakers. Although Intel might be the best-known company among the above, ARM Holdings and, especially, Taiwan Semiconductor Manufacturing look interesting avenues for investment.


Victor Selva has no position in any stocks mentioned. The Motley Fool recommends Intel. The Motley Fool owns shares of Intel. 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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