The following is a reprint of my January 16, 2007 RealMoney column

In a volatile market, investors tend to gravitate toward companies and investments that provide stability. As crazy as this may sound, I think that stability can be found in a semiconductor company – namely, Taiwan Semiconductor (TSM). I think the table below shows just how stable.

Taiwan Semiconductor Cash Flow Generation ($U.S. Billions)

Sources: Taiwan Semiconductor, Yahoo! Finance, William A. Trent estimates

Taiwan Semi operates in an unsexy part of the semiconductor industry known as “foundries.” It sounds as exciting as a blacksmith shop, and that isn’t far from the truth. Foundries don’t design any of the products they manufacture. Instead, they make the chips that other companies design. Their expertise isn’t in technology so much as process and efficiency.

Because they don’t design the chips themselves, Taiwan Semiconductor and other foundries such as United Microelectronics (UMC) typically get lower gross margins. The design profits fall to their customers. TSM’s expertise in manufacturing and economies, however, are much needed by customers who are often too small to absorb the enormous costs of building a chip fabrication plant.

Such customers include many fabless semiconductor companies and systems companies such as Altera (ALTR), Broadcom (BRCM - Annual Report), Marvell (MRVL - Annual Report), nVidia (NVDA), Qualcomm (QCOM) and VIA Technology, as well as integrated device manufacturing companies such as Advanced Micro Devices (AMD - Annual Report), Analog Devices (ADI), Freescale, and Philips (PHG).

Many small customers have given the company a balanced sales base. By end market, 40-45% of sales are communications-related, about 30% are to the computer market, 15-20% go to consumer electronics and the rest serve the memory and industrial markets. In 2006, the largest customer represented 10% of company sales, and the top ten amounted to just over half of sales. The lack of concentrated exposure to any customer or end market is one of the reasons TSM can generate stable cash flows.

The largest customer related risk factor may be that three quarters of sales are to customers in North America, and thus may impact the company if there is a U.S. recession. However, the global end markets for technology suggest that the true end customer is more widely dispersed geographically.

As the cash flow table shows, it seems fairly safe to say TSM will generate about $2.5 billion in cash flow. In some years, such as 2006, the cash flow may be unusually high. But even the industry downturns in 2004 and 2007 did relatively little harm. Given that the current enterprise value for Taiwan Semi is about $42 billion, it is offering a free cash flow yield of just under 6%.

If I had $42 billion that I wanted to invest safely, I might choose between buying TSM outright or investing it all in 5-year U.S. Treasuries. The Treasuries are currently yielding about 3.0%, so I would get $1.25 billion in interest each year from my investment. If that were my choice, I think I would go with the $2.5 billion in cash flow offered by Taiwan Semi.

It’s true that as a small investor owning a portion of TSM I would not be able to access all of the free cash flow. There is some risk to the comparison, since I am hoping the company invests any cash they hold onto wisely. But the company does pay two thirds of the cash flow as a dividend. Unless things change, that is still a 4.0% yield taxed at 15% compared to a 3.0% yield taxed at my marginal income tax rate.

How Bad Can it Get?

As stable as it may appear, I also have to acknowledge that TSM’s cash flow is not guaranteed. However, I think 2007 probably marked a fundamental bottom for the semiconductor industry – or at any rate that things won’t get much worse.

Consider, for example, the pricing environment. The Bureau of Labor Statistics reported that semiconductor prices declined 16.9% in December compared to the year earlier. That number was a modest improvement over November’s decline, which was the worst on record. Even the depths of the Internet bust were better times for semiconductor pricing. The fact that the pricing environment is so extraordinarily bad suggests to me that it probably won’t get too much worse.

Year/Year Change in Semiconductor Prices (PPI Data)

Source: Bureau of Labor Statistics

Furthermore, as I have written in other columns, I think the turnaround in semiconductor fundamentals is within sight. Pricing is a function of supply and demand, and since March of 2007 demand (semiconductor revenues as reported by the Semiconductor Industry Association) has been growing at a faster rate than supply (bookings for new semiconductor equipment as reported by Semiconductor Equipment and Materials International).

I think the industry’s recent restraint in adding new capacity will soon become evident in stronger pricing even if there is an economic slowdown. If I am right, what already looks like a solid and stable cash flow level could soon look even better.

Disclosure: William Trent has a long position in SMH.

The following is a reprint of my January 8, 2008 RealMoney column.

In other articles, I have outlined the reasons why I think the semiconductor industry is poised for strong stock performance and why I think MEMC Electronic Materials (MEMC) is the best play on the sector.

But I also realize that a bullish semiconductor outlook right now involves making a grab at that falling knife. Therefore, I thought I should also let people know which semiconductor stock looks most vulnerable to a downturn.

I think that stock is Microsemi (MSCC).

Microsemi is a leading designer, manufacturer and marketer of high performance analog and mixed-signal integrated circuits and high-reliability semiconductors. Its products manage and control or regulate power, protect against transient voltage spikes and transmit, receive and amplify signals.

Microsemi has held up fairly well, handily beating the performance of the Semiconductor HOLDRs (SMH) over the last year. This may be due largely to its strong end markets, which include defense, commercial aerospace, industrial/semicap, medical, mobile connectivity and notebooks, monitors and LCD televisions.

More Questions Than Answers

To me, however, the strong end markets only raise questions concerning Microsemi’s fundamental performance. For example, with such strong end markets, why did its cash from operations fall by more than half in the year ended September 30, 2007, compared with the prior year? Why is its inventory rising faster than sales, and why is its gross margin slipping?

I turned to the company’s latest 10K in hope of finding answers.

To begin with, the area is highly competitive. According to the 10K (emphasis added), “some of our current major competitors are Freescale Semiconductor, Inc., National Semiconductor Corp. (NSM), Texas Instruments, Inc. (TXN - Annual Report), Koninklijke Philips Electronics (PHG), ON Semiconductor Corp. (ONNN), Fairchild Semiconductor International, Inc. (FCS), Micrel Incorporated (MCRL), International Rectifier Corp. (IRF), Semtech Corp. (SMTC), Linear Technology Corp. (LLTC), Maxim Integrated Products, Inc. (MXIM), Skyworks Solutions, Inc. (SWKS), Diodes, Inc. (DIOD - Annual Report), Vishay Intertechnology, Inc. (VSH), O2Micro International, Ltd. (OIIM) and Monolithic Power Systems, Inc. (MPWR).” Gosh, I wouldn’t want them to leave anyone out.

Yet competition is just the third risk factor among a list that runs more than 12 pages.

The company notes the decline in net income related to non-cash acquisition related charges, restructuring charges and other factors. Yet non-cash charges don’t quite explain the decline in cash flow from operating activity. Furthermore, with “non-recurring” charges being reported in each of the last three years I’m going to go out on a limb and say investors can probably expect more of them in the future.

A Questionable Acquisition

According to the 10K, the company completed a merger with PowerDsine on January 9, 2007 and subsequently renamed PowerDsine Ltd., Microsemi Corp. - Analog Mixed Signal Group, Ltd. (”AMSGL”). Later, it notes that it “provided a valuation allowance of approximately $9,534,000 as of September 30, 2007 on all of our net deferred tax assets related to AMSGL as we have determined that it was more likely than not that the deferred tax assets would not be realized.”

Deferred tax assets are realized when the company earns taxable income in future periods. I’m not a big fan of acquiring companies that will “more likely than not” fail to earn taxable income in the future. This was one of the contributors to the decline in cash flow.

Microsemi’s gross margin weakened in the latest quarter (see chart.)

Source: Zacks Research Wizard, compiled by William A. Trent

I think there is additional margin risk stemming from burgeoning inventory levels.

Source: Zacks Research Wizard, compiled by William A. Trent

Since a large percentage of costs at semiconductor companies is fixed, producing more units results in a lower cost per unit and higher profit margins. But many of the additional units Microsemi is producing are going into inventory rather than the hands of customers.

At some point, Microsemi is going to have to sell that inventory (by producing less than customers demand.) That will reverse the positive effect on future gross margins.

Valuation Too High

All this would matter less if the stock looked cheap. But on the basis of free cash flow yield, which is my favored metric, Microsemi looks more expensive than most of its peers.

Free cash flow in 2007 was less than $4 million. On an enterprise value of $1.56 billion, that amounts to a free cash flow yield of just 0.25%. The cash flow would have to grow 150-fold just to bring the yield on par with that of Treasury bonds.

Even using the company’s best cash flow on record ($36.5 million in 2006) the yield is just 2.35% - nearly a percentage point below that of Treasuries. If I thought the company could return to the 2006 cash flow level, then grow at the forecast rate, I would be willing to consider an investment.

But given the rising inventory, unprofitable acquisition and potential for further declines in gross margin, I won’t be holding my breath.

Disclosures: William Trent is long Semiconductor HOLDRS (SMH) and Maxim Integrated Products (MXIM). He holds put options against shares of Lam Research (LRCX).

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William Trent currently owns put options against the shares of Lam Research (LRCX).