My latest column is up at RealMoney. In it, I explain why I think the recent rally in semiconductor stocks should continue.

First, as I have mentioned before, the supply/demand balance remains favorable.

Second, pricing power appears to be improving, based on the most recent PPI report.

I think the names that will perform best are those whose gross margins are currently depressed, as improving margins would result in accelerating earnings power.

Disclosure: At time of publication, William Trent holds shares of SMH and MXIM, as well as put options against the shares of LRCX.

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).

This article is a reprint of my January 7, 2008 RealMoney column.

I have said in other articles that I think the semiconductor industry supply and demand fundamentals argue for positive stock performance out of the group. My general belief is that the semiconductor manufacturers like Intel (INTC - Annual Report) should do better than the semiconductor equipment manufacturers like Applied Materials (AMAT - Annual Report).

Although I think investors can profit from an ETF play like the Semiconductor HOLDRS (SMH) or the ProShares Ultra Semiconductors (USD - Annual Report), I figured it was about time for me to get more specific and try to pick some stocks I think are poised to do even better than the industry as a whole.

The clear winner, in my opinion, is MEMC Electronic Materials (WFR). MEMC is a leading manufacturer of silicon wafers for semiconductor devices and solar cells. Its customers include virtually all of the major semiconductor device manufacturers in the world.

MEMC is benefiting from a shortage of wafers, which has boosted its pricing power and profitability. According to DigiTimes, insufficient supply of polysilicon has spurred the price of silicon wafers so high that solar industry players are considering using scrap wafers that have been already been buried for years.

The tight supply has caused MEMC to drain most of its inventory. Days sales in Inventory (DSI) have plummeted from nearly 70 two years ago to less than 30 in the latest quarter.

Source: Zacks Research Wizard, William A. Trent

What’s more, the short supply is allowing MEMC to enter into highly favorable long-term supply contracts, with pre-determined pricing, on a take or pay basis, customer-advanced funds in the form of a capacity reservation deposit and equity participation in the customer’s business.

On the latest conference call, management said that not only their current capacity, but their planned capacity increases were largely spoken for.

Margins dipped slightly in the September quarter due in part to an incident that caused the company to lose well over a week’s worth of polysilicon production at its Pasadena, Texas polysilicon facility. Overall, though, the tight capacity has been contributing to rapid expansion in gross profit margin for the company.

Source: Zacks Research Wizard, William A. Trent

The increasing sales and margins, of course, are causing a steady increase in earnings estimates. Over the last 90 days 2008 EPS estimates have risen from $4.06 per share to $4.19 per share. The Zacks Rank, a measure of earnings revision momentum, is 2. This places MEMC among the top 20% of companies for earnings revision performance.

Of course, even the strongest fundamentals will do investors no good if the stock is overvalued. Fortunately, I don’t think this is the case for WFR.

Over the last 12 months, MEMC generated more than $600 million in free cash flow, giving it a 3.2% free cash flow yield based on the current $18.8 billion enterprise value. This just happens to be right in line with the current yield on 5-year Treasuries.

So why buy a risky investment like MEMC when risk-free Treasuries offer the same yield? Because Treasuries don’t offer growth, and MEMC offers tons of it. The consensus 5-year growth rate is 30%, but based on its return on equity MEMC has a sustainable growth rate of nearly 55% (which happens to be its growth rate over the past five years.)

Heck, even the lowest growth estimate is 13%. I’d take that in today’s market environment.

It’s true that by some measures the stock looks overvalued. For example, it has a price/book ratio of nearly 12x – well above the semiconductor industry average of 2x. A reduction in the valuation multiple would offset some portion of that growth benefit.

Since total return must equal growth plus the change in valuation, let’s assume that over the next five years MEMC grows at the 30% consensus rate but has its price/book shrink to the industry average of 2x. No problem. The growth still overwhelms the change in valuation, and the indicated annual return is 25%.

In my opinion, no other semiconductor player even offers close to that opportunity.

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

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

My December 4, 2007 RealMoney article:

Recent data points are shaking my confidence in the near-term outlook for semiconductor stocks.

After being bearish for more than a year I had turned cautiously bullish earlier this year because it looked like potential supply (which I measure as orders for new semiconductor equipment) was coming back in line with demand (which I measure as the year/year change in semiconductor revenues. Unfortunately, the latest data show this trend weakening faster than I thought it would.

On Monday, the Semiconductor Industry Association (SIA) released their sales report for October, saying worldwide semiconductor sales rose to $23.1 billion, an increase of 5 percent over the $22 billion reported in October 2006 and 2 percent higher than the $22.6 billion reported in September of this year.

That 5.0% sales increase year/year was a slight decline from the 5.8% year/year growth reported a month ago but was still the second-best growth reported since January. Taken alone, I wouldn’t consider this report troubling in terms of the supply/demand balance as it shows stable if not slightly improving demand trends.

However, on November 15 Semiconductor Equipment and Materials International (SEMI) released their October book/bill report for semiconductor equipment orders and sales. The bookings figure was flat with the final September 2007 level of $1.24 billion and 16 percent less than the $1.47 billion in orders posted in October 2006.

The fact that demand growth (up 5%) was greater than supply growth (down 16%) is generally supportive of positive performance for semiconductor stocks. The performance of the SOX index during the last five periods in which such conditions prevailed is presented below.

Sources: SIA, SEMI, William A. Trent

In each of the periods other than 2001/2002 the excess demand growth relative to supply resulted in positive returns for the SOX. Unfortunately, the current period to date most resembles 2001/2002. That similarity is also noticeable when looking at the size of the relative peaks and troughs in supply/demand balance.

Sources: SIA, SEMI, William A. Trent

As the chart illustrates, there is typically a fair degree of symmetry between subsequent peaks and troughs, which is only natural because over time one would expect balanced supply and demand.

That 2001 peak in excess demand, however, occurred quickly and was shallow relative to the long, drawn-out period of excess supply that preceded it. So far in 2007, the chart is looking very similar. If the relationship continues to hold, it could be some time before semiconductor stocks again experience the normal cyclical upswing.

There are still some reasons for cautious optimism. For one thing, the semiconductor industry data are sometimes subject to large revisions. With that in mind, I’m not going to get too hung up on the data released in a given month.

Furthermore, recent forecasts have continued to show a cautious approach to adding capacity. Gartner Dataquest forecast that 2008 capital investments by the four largest foundries will decline 9.6% year-on-year. The largest foundries are Taiwan Semiconductor (TSM), United Microelectronics (UMC), Chartered Semiconductor (CHRT) and Semiconductor Manufacturing International (SMI).

Also, according to a Friedman Billings Ramsey analyst, capital spending in the DRAM sector is expected to fall by more than 30 percent in 2008. Leading players in this market include Samsung (SSNLF), Qimonda (QI), Hynix (HXSCF), and Micron (MU - Annual Report).

Together foundries and DRAM have been responsible for a good deal of the total capex and their caution ahead increases the chances of supply and demand returning to balance.

However, given the current state of the economy and the seasonal factors that should have helped demand in October and November, I’m glad I have my long position in the Semiconductor HOLDRS (SMH) offset by a put option on equipment maker LAM Research (LRCX).

In general, I favor the semiconductor makers like Intel (INTC - Annual Report) over the equipment makers like Applied Materials (AMAT - Annual Report) or KLA-Tencor, due to the fact that more capex cuts will be needed to restore the supply/demand balance.

Disclosure: William Trent is long SMH and holds put options against LAM Research (LRCX)

Note: Be sure to use real time stock quotes and pick the right stocks for your portfolio.

Disclosure: William Trent has a long position in SMH.

Originally published at RealMoney on September 19, 2007.

Tony Crescenzi says the latest PPI report should be tossed because the benign headline reading will almost certainly be reversed in the months ahead owing to the surge in energy costs that has occurred of late. I say not so fast! If prices are rising, that means some companies out there are likely to see better profits. Before tossing out the report, I’m betting we can figure out who a few of them will be.

The Bureau of Labor Statistics, which prepares the PPI report, provides detailed information on an industry basis. The problem is figuring out how to find it on their web site. Starting at the PPI home page, I scroll down to the headline that says “Get Detailed PPI Statistics” then click on Industry Data. You can then pick out which industries you want to see (I pick ‘em all) and click “Retrieve Data.” Then I select “More Formatting Options” and click on the boxes for 12-month percent change, all years, and include graphs. Once I hit “retrieve data” again I have what I’m looking for - graphs that make it easy to tell which industries are gaining or losing their pricing power.

First up is the fruit and vegetable canning industry. At 5.3% year/year inflation, pricing is clearly better than normal. It is down from a recent peak but still looks to be generally in a rising trend.

Possible plays on this industry include can makers such as Ball Corp. (BLL), Crown Holdings CCK - Annual Report), or Silgan (SLGN - Annual Report). Or you can go to the food processors such as Campbell Soup (CPB), Del Monte (DLM - Annual Report), Hain Celestial (HAIN), or HJ Heinz (HNZ).

Looking better still are industrial valves, up 9.3% year/year against tough comparisons.

Some of the industrial valve makers include Flowserve (FLS), Crane (CR) and Curtiss Wright (CW - Annual Report).

But enough with boring “old” industries. How about tech? It is seldom that tech prices actually increase, but sometimes they decline at a slower than usual pace, which can provide a similar opportunity. That may be the case right now with computer storage devices.

Last month’s 2.9% decline from last year was the smallest price drop on record for this industry, and the ongoing consolidation may help the trend continue. Plenty of ways to play this one, including Brocade (BRCD), EMC (EMC - Annual Report), Iomega (IOM), Hutchinson (HTCH), Quantum (QTM), Sandisk (SNDK - Annual Report), Seagate (STX - Annual Report), and Western Digital (WDC).

By contrast, semiconductors are experiencing the worst pricing on record.

That could be the signal for a contrarian play (I happen to think the worst will soon be over for semiconductors) or possibly just an excuse to avoid the group for a while.

The PPI clued me in to the opportunity in railroads a year before Buffett bought in. I hestitate to bet against him, but it looks like the industry’s price increases have ground to a halt.

If you have the guts, I’d count this as bad news for Burlington Northern (BNI), CSX Corp. (CSX), Norfolk Southern (NSC), and Union Pacific (UNP).

Finally, Wired Telecommunications saw pricing decline for years after the 1996 Telecom Act, but recent consolidation is allowing them to raise prices again.

Winners here would be CenturyTel (CTL), AT&T (T - Annual Report), Verizon (VZ - Annual Report) and Embarq (EQ).

By my count, that is 26 potential stock tips, all courtesy of the U.S. government. I’ll take that over tossing the report any day.

Disclosure: Long Semiconductor HOLDRs (SMH).

According to the Semiconductor Industry Association, worldwide sales of semiconductors increased in July, growing to $20.6 billion, an increase of 2.2 percent over July 2006. This is pretty much in line with the average year/year growth so far in 2007. This is the predictable result of excess semiconductor equipment orders in 2006.

Well, semiconductor equipment orders were down 17% in July. That means that semiconductor demand growth is nearly 20 percentage points higher than expected growth in supply. On average, those conditions have led to strong returns for the SOX index. Subscribers can download my model for more information.

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Disclosure: William Trent has a long position in SMH.

North American-based manufacturers of semiconductor equipment posted $1.44 billion in orders in July 2007 (three-month average basis) and a book-to-bill ratio of 0.84 according to the July 2007 Book-to-Bill Report published by trade organization Semiconductor Equipment and Materials International (SEMI). A book-to-bill of 0.84 means that $84 worth of orders were received for every $100 of product billed for the month. According to Solid State Technology Magazine:

The real story is bookings (orders), which slumped more than 10% M-M in July and about 17% Y-Y to $1.44 billion — the biggest monthly decline since Oct. 2006, and biggest Y-Y dropoff since late 2005. It’s also the first month of double-digit declines both M-M and Y-Y since January 2005. “Orders have slowed from the strong levels observed in the first part of this year,” noted Stanley Myers, president/CEO of SEMI, in a statement.

Make that an understatement. Finally, the industry is coming around to the notion that the downturn is more than a short-term blip. Not that I mind - the more people understand there is a cyclical downturn the sooner the stocks can move past it.

Just to double check and make sure that the downturn is indeed well recognized, I skimmed through some recent semiconductor equipment earnings conference calls.

Applied Materials (AMAT - Annual Report) recognizes it.

Steven O’Rourke - Deutsche Bank

Thank you. Good afternoon. A couple of questions. First, I hate to beat a dead horse but are the foundries telling you anything different now than they told you three months ago?

Michael R. Splinter

Well, if you look at our revenue in Q3, we had an up-tick in foundry orders that we delivered in the quarter, had some good turns business, and so we — three months ago we kind of expected that trend to continue throughout the year and it’s not. And so yes, there is a fairly substantial difference between now and May.

(Excerpt from full AMAT conference call transcript)

Lam Research (LRCX) does not.

We expect that foundry shipments for Lam will be weak in the September quarter as a function of the pull-ins to June and we expect that shipments in foundry will strengthen in the December quarter. Shipments for Logic, Flash other and MPU are expected to be flat in the second half compared with the first half.

(Excerpt from full LRCX conference call transcript)

KLA Tencor (KLAC) is still thinking it is a seasonal issue. Note to KLAC: year/year comparisons are not affected by seasonality.

Our September outlook is a little complex this year, as we have a number of factors impacting our results, largely related to recent acquisitions. Jeff will give you more of the details. Given that, our bookings outlook for September is down 15%, with a range of plus or minus 10%. This is on par with the typical seasonality we experience in September.

(Excerpt from full KLAC conference call transcript)

Unfortunately, it doesn’t sound like the downturn is as well-understood as I was hoping.

Subscribers can download my spreadsheets.

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Disclosure: William Trent owns put options against the shares of Lam Research (LRCX) and is short put options against shares in the Semiconductor HOLDRS (SMH).

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

Last week I pointed out that demand for semiconductors has now exceeded orders for new capacity for four consecutive months. To me, that suggests that the existing overcapacity will be filled up within a few months. And tight capacity usually makes for a good time to own stocks.

To shed further light on that observation, I went back and updated my semiconductor supply and demand spreadsheet, separating out the periods when demand exceeded supply and charting the progress of the SOX index during those periods. Because there is a lag period before the Semiconductor Industry Association reports the data (June’s results were reported in early August) I use the subsequent monthly closing price for the SOX (in this case July) for my starting point. I also map the returns until the month after the excess demand situation no longer exists, since there is no way of telling the “last” month of one cycle until the next one has started.

During the last four cycles, owning the SOX during periods such as this one has produced returns ranging from a high of nearly 73% (2003) to a low of -10% (2001-02). Cumulatively, a long-only strategy of owning the SOX during such periods and avoiding it at all other times would have produced cumulative returns of 188%, compared to just 92% that would have been earned by a buy-and-hold strategy starting in April 1998.

What’s more, there have been relatively few periods during which this strategy would be underwater. That’s not to say that losses aren’t possible - in fact during two of the four cycles there were losses of 25% or so at some point. But those periods were relatively short term. I have taken exposure by selling put options, so if such a decline does occur I will be holding the index (in this case the SMH).

Statisticians and quantitative analysts will find much to criticize about this strategy, which is simplistic and based on a limited number of observations. Then again, many of those same analysts are the fellows that designed the complex highly leveraged derivative strategies that are blowing up right now. For me, I prefer a simple model that intuition tells me ought to work and which has, in fact, tended to work most of the time.

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Disclosure: William Trent has a long position in SMH.