The following is a reprint of my January 23, 2008 RealMoney column.

In October, I wrote a bullish article suggesting that Intel (INTC - Annual Report) had all its ducks in a row. Up until the earnings report this week, the stock was performing more or less in line with the S&P 500. Now, however, it is looking like a bad call.

In hopes of figuring out what went wrong with my thesis, I took a fresh look. I still think Intel is worth buying at these prices, but I would probably wait for a signal that momentum was returning to the name before starting a new position.

One mistake was in accepting what I realized were somewhat aggressive estimates. “According to the Semiconductor Industry Association, the year-over-year sales growth for the industry has ranged from 1.7% to 4.8% over the last six months. For the largest manufacturer to be growing at more than twice the overall industry rate seems somewhat aggressive at first glance,” I noted.

I thought that “since Intel and rival Advanced Micro Devices (AMD - Annual Report) were the first companies to over-order, the first to see the damage it did to their margins, and the first to announce cuts to planned expenditures, it should surprise nobody if they are the first to recover as well.” Compared to most semiconductor makers that was true, but not enough to justify a double-the-industry growth rate.

I also thought the worst would soon be over in semiconductor pricing trends, but things have managed to get worse in the meantime. That said, the industry’s capital spending discipline remains intact – data released yesterday showed that orders for semiconductor equipment were down more than originally reported in November and down 18% year/year in December. As demand gradually catches up to supply, pricing power will improve.

To my credit, I was correct about Intel and AMD seeing a recovery sooner than the overall industry. I noted that “margins for both AMD and Intel are lower than they have been at any time since the depths of the technology bust. A modest improvement from current levels would still leave them well below the normal range, if there is such a thing.” Intel’s margins improved from 52% in September to 58% in the December quarter.

I was also correct to point out improving inventory trends at Intel. Inventory levels declined $132 million sequentially and nearly $1 billion from the December 2006 quarter. Inventory reductions tend to put a damper on margins, so once the excesses are depleted margins should improve further. The inventory reductions also provide a significant (though temporary) boost to cash flow.

You didn’t think I’d write a whole article without coming around to cash flow, did you? But why not? Cash flow is probably the single best reason to consider owning Intel right now. Over the last 12 months, Intel’s free cash flow (cash from operations less capital expenditures) was $7.2 billion, for an effective free cash flow yield of more than 7% on the current enterprise value.

Intel has been letting this cash pile up on its balance sheet in cash and marketable securities that are probably yielding just three or four percent. To me it would be a no-brainer to buy the company’s stock and increase that yield to 7%. I suspect a $7 billion buyback announcement, to be executed promptly, would put some mojo back into the shares.

In the meantime, no matter how much of a value Intel seems to be, the momentum is clearly gone. I would probably want to wait for investors to start recognizing some of the value before jumping in here. Though I am not a technical analyst, measures such as the MACD signal or a close above the 50-day moving average would probably qualify. Alternatively, fundamental momentum in the form of positive earnings revisions could also count.

Another option would be to get paid for waiting by selling out-of-the-money put options. The July 17.50’s were selling for $1.25 at the time of writing. That would provide a 7% six-month return on the money at risk and an effective entry point of $16.25 if the option is exercised.

Disclosure: William Trent has a long position in SMH.

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.

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.

This article was originally published at RealMoney on October 10, 2007.

Intel Corp. (INTC - Annual Report) is scheduled to report earnings today, October 16. The consensus among sell side analysts is that the company will report sales of $9.6 billion (up 10% year/year) and earnings per share of $0.30. This puts the average analyst daringly close to the precise midpoint of the guidance Intel provided as its mid-quarter update.

According to the Semiconductor Industry Association (SIA), over the last six months the year/year sales growth for the overall semiconductor industry has ranged from 1.7% to 4.8%. For the largest manufacturer to be growing at more than twice the overall industry rate seems at first glance to be somewhat aggressive.

However, the nadir in industry sales was in June, and the growth rate has been picking up steadily since then. Furthermore, the industry as a whole has been more disciplined about adding capacity. After more than a year of ordering more chip producing equipment than was needed to satisfy demand from customers, the last six months have seen orders for new equipment being placed at a far slower rate. In fact, sales of semiconductors in August grew 4.8%, while orders for new equipment saw a 19.4% decline year on year.

Since pricing is determined by supply and demand, when demand is growing at a faster rate than supply it should be good for pricing, margins and the stocks – subject to a lag between the time equipment is ordered and when it is installed. Last month, when the PPI data showed a poor pricing environment for semiconductors (see the chart of year/year price changes below) I said “I happen to believe the worst will soon be over for semiconductors.” The reason for my belief is that this year’s poor pricing environment stemmed from last year’s over-ordering of equipment, so this year’s thriftiness should start to improve pricing sometime soon.

Source: Bureau of Labor Statistics

Furthermore, since Intel and rival Advanced Micro Devices (AMD - Annual Report) were the first companies to over-order, the first to see the damage it did to their margins, and the first to announce cuts to planned expenditures, it should surprise nobody if they are the first to recover as well.

Finally, addressing the issue of whether the guidance is too aggressive, a look at the historical data suggests otherwise. Margins for both AMD and Intel are lower than they have been at any time since the depths of the technology bust. A modest improvement from current levels would still leave them well below the normal range, if there is such a thing.

Source: Zacks Research Wizard

Finally, I looked at inventory levels to see how supply and demand were trending at the company level. For Intel, at least, the inventory levels appear to be drifting back toward normal.

Source: Zacks Research Wizard

Stock performance following the report may come down to the December quarter guidance relative to expectations. There, too, however, the consensus appears beatable. Current estimates call for $10.4 billion in sales, which is just a 7.5% year/year rise. Given the acceleration in industry growth, that rate may well be in line with the overall industry rate despite the aforementioned justification for Intel to lead the group up.

With company inventory levels having peaked, margins potentially having troughed and overall industry health looking likely to improve, I believe Intel’s guidance is not aggressive, and may even be conservative.

Disclosure: William Trent has a long position in SMH.

AMD (AMD - Annual Report) reported financial results for the quarter ended June 30, 2007. AMD reported second quarter 2007 revenue of $1.378 billion, an operating loss of $457 million, and a net loss of $600 million, or $1.09 per share. This compared with analyst expectations of a loss of $0.85 on $1.26 billion in sales.

When I previewed earnings, I said its hard to see how it could get any worse, but if anyone can pull it off…. So let’s take a look at how they managed to do it.

The Good News

• Revenue was up 13% from last year
• Gross margins of 33% were up sequentially from 28%
• $130 million of their expenses were what they consider to be exclusion-worthy (although I wouldn’t give them credit for the $31 million in stock-based compensation.)

The Bad News

The bad news starts with gross margins. Although they were up sequentially, they were down from the near-record 57% the company reported in the year-ago quarter. One would expect the opposite when revenues rise in a capital-intensive industry. But looking back longer-term, it is last year that looks like the anomaly, not this one.

Moving on to operating expenses, AMD reported $461 million in gross profit, from which was deducted $475 million for research and development (uh-oh!), $365 million for marketing, general and administrative expenses and $78 million of acquisition related charges that were included in the $130 million non-recurring charges ($99 million by my accounting) noted above.

That leaves us with an operating loss of $457 million, or $358 million if you exclude the expenses management and I agree are non-recurring. That leads me to a couple of observations about AMD’s prospects:

• Even if AMD were to recover to last year’s near-record gross margin level they would have lost more than $33 million. How can their expenses be set at a level that is unprofitable in the best of times?
• If the chart above is correct and 33% is a more normal gross margin, at the current level of operating expenses they will need to increase revenue by nearly 80% just to break even.

The stock is in a relief rally because investors expected AMD’s margins to be creamed after Intel’s (INTC - Annual Report) results. I think if investors took a closer look the last thing they would feel is relief.

According to Bloomberg.com:

Intel Corp., the world’s largest computer-chip maker, said second-quarter earnings rose 44 percent on its first sales increase in six periods. The stock dropped after the company’s profit margin trailed forecasts.Demand for memory chips used in mobile phones missed Intel’s estimates, dragging down profit margins, the company said.

Back in April, when they issued their guidance, I said the margin forecast was overly optimistic. The way I saw it, if they continued to produce flat out to reduce unit costs, the price war would be back with a vengeance and margins would go down. If they produced less in order to work down inventory, unit costs would be higher and margins would go down. Yet the company bizarrely expected margins to increase.

As I pointed out in my earnings preview, the margins will improve once they complete the memory JV. I was a little surprised that they did not account for that business as discontinued. After glancing at the accounting guidelines, I suspect they were not breaking it out as a separate segment before, and thus it is considered a product discontinuation rather than a business one.

The Economic Calendar is fairly active this week.

• PPI (Tuesday) - Look for my usual breakdown of the industries with pricing power
• Industrial Production (Tuesday) - Let’s see if businesses really are picking up steam
• CPI (Wednesday) - We know food costs more. What else does?
• Housing Starts (Wednesday) - Preview: They will be bad, and if not it will be bad news.
• Leading Indicators (Thursday)

The Earnings Calendar is going into overdrive this week. Some names I’ll be watching:

• Tata Consultancy Services (TCS)  - What will they say on Monday about rising wages and currencies?
• Intel (INTC - Annual Report) - (Tuesday) - Estimates seem low enough. Margins will improve ex Flash.
• Yahoo! (YHOO) - (Tuesday) - Low expectations likely justified but perhaps rewarded.
• American Standard (ASD) - (Wednesday) - They are on my Large Cap Watch List (Track at Marketocracy) and they are on the move. They’re picking up momentum and I suspect they will top estimates.
• Silgan Holdings (SLGN - Annual Report) - (Wednesday) - They are on my Small Cap Watch List (Track at Marketocracy) and have been blowing estimates out of the water. This one seems like another beater to me.
• Advanced Micro Devices (AMD - Annual Report) - (Thursday) - Hard to see how it could get any worse, but if anyone can pull it off…
• Landstar System (LSTR - Annual Report) - (Thursday) - This is one of my favorite companies and is on both the Small Cap Watch List (Track at Marketocracy) and the Mid Cap Watch List (Track at Marketocracy). They are trading a touch higher than I would like, though.
• Google (GOOG - Annual Report) - (Thursday) - Numbers are set up for them to beat them. If they don’t beat by enough, however, the stock could still suffer.
• Sandisk (SNDK - Annual Report) - (Thursday) - Who knows?
• SAP (SAP - Annual Report) - (Thursday) - Shouldn’t be much to trade on, but they might say something nasty about Oracle (ORCL - Annual Report) to make listening to their call worthwhile.
• Tempur-Pedic (TPX) - (Thursday) This one also graces both the Small Cap Watch List (Track at Marketocracy) and the Mid Cap Watch List (Track at Marketocracy). Estimates have been rising but they will probably still beat them.

Keep on your toes!

This post was featured at the Festival of Stocks.

Doug McIntyre at 24/7 Wall St. noted that Intel (INTC - Annual Report) And AMD (AMD - Annual Report) Both Claim Next Few Quarters Will Be Good:

Because the two companies represent virtually 100% of the processor market for PCs it would be hard for both companies to be right.

While Eric Savitz passed on Citigroup’s guess that Intel will consolidate share, the first question that came to my mind was whether it even matters, based on the inventory and gross margin studies I have been doing.

Starting with the actual inventory levels, measured in days sales on hand, Intel has 87.4 days while AMD has 67.8. While the company level inventory could mask trends going on in the channel (such as Hewlett Packard’s (HPQ - Annual Report) “strategic buys“) it does potentially indicate that AMD have less need to discount inventory in the near future, and potentially better margins.

Moving along to the trends in inventory management, compared to the year-ago levels Intel’s DSI have risen 12% compared to a 13% decline for AMD. However, on a sequential basis both companies are moving closer to even with last year. That is to say, the trends are toward mean reversion. Since the picture is mixed I hesitate to draw conclusions regarding margins from this comparison.
Comparing the amount each company produces to the amount it sells, I found that AMD has been producing significantly more than it is selling for the last four quarters, while Intel’s production has been in line with demand for the last three quarters. This contrasts with the actual DSI study, and checking back to the original data it looks to me like the smoothing process (I calculated DSI as the 4-quarter sum of COGS using the 5-quarter average of Inventory) masked the more recent inventory build. Therefore, on balance the data indicate that AMD has more risk to future margins than Intel.

Interestingly, AMD has already seen a far more significant margin decline (see charts).

Since I don’t have access to gross margin estimates, it is hard to tell whether the potential margin pressure is factored in to current estimates. Estimates have been falling for both companies over the last 90 days, and far more so for AMD, suggesting that at least some of the differential is expected. However, the estimates also imply improving margins for both companies in the September quarter compared with the June quarter, in part due to higher expected sales leading up to the seasonally strong part of the year.

If Citigroup is right about AMD’s product delays I would argue that it does matter, and that there is even more risk to AMD’s margins than is currently reflected in estimates.

Update: The original post contained a data error.
In the interest of digging deeper into the semiconductor oversupply issues, this post continues a series of data gathering on important ratios for companies in the industry. Hopefully the process will provide insight toward the companies better (or worse) positioned to take advantage of the next upturn or weather the downturn.

Yesterday I used Zacks Research Wizard to get the recent Cost of Goods Sold (COGS) and Inventory levels for semiconductor industry participants over the last several quarters. I made some modest limitations on the share volume and market cap, but still ended up with more than 50 names. I used trailing twelve month COGS and the average of the last five quarters (for a beginning, ending and average) of inventory to calculate Days Sales in Inventory.

Higher inventory levels relative to sales indicates a greater likelihood that the company will need to reduce prices, reduce production or take a write-off, all of which would reduce gross profit margin. In this post I compare the current DSI to the DSI in the same quarter one year ago. This should mitigate any seasonal effects, such as ramping inventory ahead of holiday sales, that might distort sequential comparisons.

The companies with the biggest increase in DSI may have the most trouble in the event of an industry downdraft. Even if semiconductor sales remain strong they will need demand to catch up with their current capacity and may not see as much benefit as other manufacturers. The five companies with the largest year/year DSI increase are Silicon Labs SLAB, Applied Micro (AMCC), Zoran (ZRAN), Monolithic Power (MPWR) and Triquint (TQNT).

The companies with the greatest reduction in DSI, by contrast, may be poised for margin expansion as they replenish inventory levels and ramp up production to meet demand. The five companies with the biggest decrease in DSI are Large Cap Watch List (Track at Marketocracy) member MEMC Electronics (WFR), Advanced Micro Devices (AMD - Annual Report), Atheros (ATHR), Conexant (CNXT) and Intersil (ISIL).

The complete list follows.

DSI As Percentage of DSI One Year Ago:

Disclosure: William Trent has a long position in SMH.

Lest you think we were going soft, we hereby balance our earlier enthusiasm for semi stocks with our more customary caution. The five reasons to avoid semiconductor stocks right now include:

1. The fundamentals will get worse before they get better. While supply indications grew slower than demand in April, the turn followed 16 months of too much capacity being ordered. As that capacity comes on line, the inventory situation will worsen and margins will get hit more. It is not at all certain that estimates reflect this.
2. It is May. Sure, sell in May and go away is a cliche. Things often become cliches for a reason.
3. Demand? What demand?
4. Valuations are too high because investors are hoping for more premium buyouts. They will happen, but not to every name in the sector.
5. The last bear may no longer be standing.

Food for thought.

Disclosure: William Trent has a long position in SMH.