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.

North American-based manufacturers of semiconductor equipment posted $1.23 billion in orders in February 2008 (three-month average basis) and a book-to-bill ratio of 0.93 according to the February 2008 Book-to-Bill Report published today by SEMI.

The three-month average of worldwide bookings in February 2008 was $1.23 billion. The bookings figure is about eight percent greater than the final January 2008 level of $1.14 billion, but 12 percent less than the $1.40 billion in orders posted in February 2007.

With semiconductor sales essentially running flat, I was able to take solace in the fact that the steeper declines in semiconductor equipment orders were a signal that excess capacity was being soaked up. In fact, semiconductor sales have now likely outstripped orders for new manufacturing equipment for each of the last 12 months.

Unfortunately it hasn’t yet helped semiconductor manufacturers. The SOX index has lost a quarter of its value over that same time period.

If semiconductor manufacturers want to get their stocks’ mojo back, the last thing they should be doing is ordering more capacity in the face of an economic slowdown.

Disclosure: At time of publication, William Trent owns shares of Maxim (MXIM) and the Semiconductor HOLDRS (SMH). He holds put options against the shares of LAM Research (LRCX).

Disclosure: William Trent has a long position in SMH.

The Semiconductor Industry Association released the January semiconductor sales report today.

Worldwide sales of semiconductors in January were $21.5 billion, a nominal increase of 0.03 percent from January 2007, the Semiconductor Industry Association (SIA) reported today. Sales declined by 3.6 percent from December 2007 when the industry reported sales of $22.3 billion. SIA said the sequential decline in sales was in line with traditional seasonal patterns for the industry.

“Virtually all product lines and all geographic markets experienced slightly lower sales in January,” said SIA President George Scalise.

The good news, as I see it, is that orders for semiconductor manufacturing equipment were down 22.3% in January.  Less equipment means less capacity, and even the same amount of sales generation will soak up the excess and improve the pricing environment.

The semiconductor sales growth has exceeded semi equipment order growth since March 2007, so it is now likely to start showing up in the fundamentals. Yes, a general economic slowdown will make it harder for semi pricing to improve. But as long as the supply continues to grow at a slower rate, the semi cycle will return regardless of what happens in the business cycle.

Disclosure: William Trent is long SMH and MXIM, and has written put options against shares of LRCX.

Disclosure: William Trent has a long position in SMH.

According to Semiconductor Equipment and Materials International (SEMI):

North American-based manufacturers of semiconductor equipment posted $1.12 billion in orders in January 2008 (three-month average basis) and a book-to-bill ratio of 0.89 according to the January 2008 Book-to-Bill Report published today by SEMI. A book-to-bill of 0.89 means that $89 worth of orders were received for every $100 of product billed for the month.The three-month average of worldwide bookings in January 2008 was $1.12 billion. The bookings figure is about three percent less than the final December 2007 level of $1.16 billion and 22 percent less than the $1.45 billion in orders posted in January 2007.

22.3%, to be exact. To me, this is good news for semiconductor manufacturers, because the demand for chips is still growing - barely. With equipment installations going down, the oversupply that currently exists will soon be absorbed, recession or no.

Disclosure: Long SMH, MXIM; wrote put options against 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).

Note: If you want to find great mutual funds
make sure to check smartmoney.com.

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).

Note: Get the best financial advice on the net and invest your money wisely!

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

My long-term orientation doesn’t typically fare so well in short term stock picking contests. Nonetheless, I have decided to enter the blogger face-off over at SINLetter. You can check in to see which of us are making the best picks between now and the end of March.

My picks were long SMH, short Diebold (DBD) and long CSG Systems (CSGS).

The following is a reprint of my December 27, 2007 RealMoney column

Recently I expressed concern that there may be more pain ahead for semiconductor manufacturers. The concern was based on recent sales reports from the semiconductor equipment industry and from the semiconductor equipment industry.

I have noticed that semiconductor stocks tend to perform best when the growth for chips exceeds the order growth for chip equipment. This is simple supply and demand stuff - when the chip sales are growing faster than equipment sales, it indicates demand is growing faster than supply. That means tighter capacity and less pricing pressure over the coming months, which is generally good for profits and by extension the stock prices. The reverse is true when orders for equipment are growing faster than chip sales.

Based on the October data, the equipment orders declined 24.7% year/year in September but only 16% in October. My fear was that the orders were not being cut as much as they had been in recent cycles, and therefore that the up-cycle I have been expecting would be cut short.

I did, however, note some cause for cautious optimism - in particular that the semiconductor industry data are sometimes subject to large revisions. And, lo and behold, the October equipment orders were revised down sharply.

Based on the updated report, equipment orders declined 19.9% in October and 19.4% in November. These data are much more supportive of my original thesis that the next year was likely to be a good one for semiconductor stocks.

Better yet, Gartner Group expects all major segments of capital spending to decline in 2008. Worldwide semiconductor equipment spending is now expected to total $40.3 billion in 2008, a 9.9 percent decrease from 2007 spending of $44.8 billion. (Source: Fabtech).

I don’t always believe reports from the industry analysts, because they are often wrong. I like to use the supply/demand model as a gut-check, allowing me to reconcile the unknown (analyst estimates) with what is known (current leading indicators.) In this particular case, I think Gartner is going to be close to the mark.

So what is the upside for investors? I have charted the performance of the SOX index over the last five “excess demand” cycles - with each one beginning the month after semiconductor sales begin to grow at a faster rate than semiconductor equipment orders. I use a one-month delay because the Semiconductor Industry Association reports monthly sales on a one-month lag, so the chart shows the performance starting at the time the data become available.

From the start of the excess demand cycle to the first month of excess supply, semiconductor stocks did very well in three out of four instances - and the bad time was likely a by-product of the Internet bust. (That explanation is also supported by the fact that the periods of excess supply were bad times for the SOX in three out of the last four instances, with the Internet boom being the one exception.)

Sources: Semiconductor Industry Association, Semiconductor Equipment and Materials International, Yahoo!Finance, compiled by William A. Trent

The current period is much more “normal” than boom/bust for tech. Therefore, I think the normal outcomes are likely to prevail.

But perhaps more enticing is that so far in this cycle the SOX is down nearly 16%. Similar (though slightly worse) interim declines happened in two of the previous cycles, and in both cases were followed by rallies of more than 50% over the following six months.

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

Disclosure: William Trent owns shares in the SMH and in Maxim Integrated Circuits (MXIM) and put options on LAM Research (LRCX)

Note: Always read the fine print when signing up for low interest credit cards to avoid hidden costs!

Disclosure: William Trent has a long position in SMH.

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.

For the second consecutive month, worldwide sales of semiconductors rose sharply in September, the Semiconductor Industry Association (SIA) reported. Global microchip sales in September were $22.6 billion, an increase of 5.9 percent from September 2006 when sales were $21.3 billion.

5.9% probably doesn’t sound like stellar growth, and it isn’t much special. However, compared to the growth in industry capacity it is strong. And since price is a function of both supply and demand, sales growth that exceeds capacity growth should ultimately have a positive impact on pricing.

Disclosure: William Trent holds long positions in the Semiconductor Holdrs (SMH) and put options related to shares of Lam Research (LRCX).

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