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.

It is hard to write about Qualcomm (QCOM) without some mention of the enemies it has made over the years. The company’s success, as well as the ire of its competitors, has stemmed from its strong patent portfolio – from which it has extracted hefty (some say unfair) royalties.

With the stock down about 20% on the heels of the current dispute, I thought it a timely time to wrap up what some of the interested parties have been saying. I’ll start with Nokia (NOK).

Rick Simonson

And Tim, in terms of the impact on royalties in the quarter, when you look at our WCDMA royalty provisions, it had some positive impact on the gross margin, but there are far many more important drivers for the sequential gross margin improvement in Q2.

The success of the total product portfolio and particularly driven by having very desirable hit products in every part of the range, high end, low end, midrange, a little bit of the slightly moderated price competition that Olli-Pekka just mentioned would be the second thing that I would call out. Our favorable product mix with M and ES growing faster than MP, thirdly. And fourth, the overall good cost management.

In other words, the benefit that we got in the COGS. Those four things far swamp the very small incremental benefit from the gross margin related to our total WCDMA royalty provisions. In other words, we would be writing the exact same story of this quarter without even that small incremental benefit.

Tim Long – Banc of America Securities

So we can assume that provision is lower than what was actually was being paid previous percentage rate but it’s lower than what was being paid previously?

Rick Simonson

Well, again as we talked before, we necessarily have to be somewhere in between there because we feel strongly in our position that the rates under the old agreement with the one party, QUALCOMM are not correct and we wouldn’t be spending the time on this debate if in fact we felt that we were accruing at the same rate. But it is, to repeat as we said before, somewhere in between those two.

(Excerpt from full NOK conference call transcript)

Next up is Broadcom (BRCM - Annual Report).

Finally, as we stated numerous times in the past, we stand ready to negotiate with QUALCOMM or any other market participant to seek a commercial solution as we’ve done today with Verizon.

With respect to Broadcom’s current litigation proceeding against QUALCOMM things are going very well. Our goals remain simple and two-fold. One is to gain proper recognition of the value of our IP, and the second is to achieve a level of competitive playing field.

At this time QUALCOMM has been found to infringe four of our patents, three of them willfully in two different forms. We also have additional patents that have not yet been addressed to trial. Please note that QUALCOMM has either lost or dropped all claims against Broadcom. There has not been any movement in our discussions with QUALCOMM, as it appears that they have bet their future and end customers’ upcoming product launches on their political lobbying skills.

(Excerpt from full BRCM conference call transcript)

The patent issues also affect Qualcomm’s customers such as Sprint Nextel (S - Annual Report).

We continue to explore our options to ensure our customers have the latest handsets. We continue to import handsets with the technology solution designed by Qualcomm. Qualcomm believes this workaround does not fall within the ITC order. We’ve been testing the solution for several months and there are no impacts on the customer experience.

We are also considering a number of other alternative resolutions to this dispute, including encouraging the two parties to reach resolution.

(Excerpt from full S conference call transcript)

As noted above, Verizon (VZ - Annual Report) also uses the technology but has come to a commercial deal with Broadcom. So what does Qualcomm have to say about all this?

Obviously, we are disappointed with the rulings on behalf of Broadcom both in the Santa Ana case and in front of the ITC. We continue to believe that the rulings are wrong and are pursuing all avenues to reverse and to mitigate the effects of these rulings, including working with our partners who may obtain a license from Broadcom. We’ve been unable to come to agreement ourselves with Broadcom because they’ve insisted that a comprehensive settlement includes the ability for it’s customers to obtain royalty free rights through significant portions of our patent portfolio which would have a material impact on our licensing business. This business is funded on R&D and innovations that we have transferred to are approximately 140 licensees. We remain committed to defend our business model and the benefits they provide to wireless industry. Unfortunately given the threat of injunctions against certain of our products, the next few months represent a crucial litigation time-frame and we can’t predict the outcomes at this time….
With respect to the Nokia arbitration, we have now arrived at a process for selecting arbitrators and that process is underway and we expect to have the arbitration panel in place in fairly short order. And then once the panel is in place we think that the procedure will start moving forward, subsequently the panel will set a schedule and of course we will be pushing for a pretty aggressive schedule. I suspect Nokia will be pushing for ‘08 schedule and we won’t know what kind of schedule we get obviously until the arbitrators order, but that would be the next step.

(Excerpt from full QCOM conference call transcript)

Supposedly it was Sun Tzu who counseled “keep your friends close and your enemies closer.” Qualcomm currently seems fairly far from both.

Update: The original post contained a data error.
In the interest of digging deeper into the semiconductor oversupply issues, this post will begin 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.

Today 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.

The higher the inventory levels, the more likely the company will need to reduce prices, reduce production or take a write-off, all of which would reduce gross profit margin. This first pass looks merely at inventory levels and does not consider strategy or other factors. For example, a fabless company would likely own less inventory than a company that produces chips at its own facilities. In a later post I will consider the trends in inventory (although the historic data I provide below gives some of it away) to determine the companies for which inventory levels are higher than the historic norm for that particular company.

The five companies with the highest levels of inventory relative to their recent sales levels are: Microsemi (MSCC), Lattice (LSCC), Analog Devices (ADI), Micrel (MCRL) and Intersil (ISIL).

The five with the lowest levels of inventory relative to recent sales are: Amkor Tech (AMKR); Smart Modular (SMOD), Large Cap Watch List (Track at Marketocracy) member MEMC Electronics (WFR); Actions (ACTS) and Sirf Technology (SIRF).

The complete list follows.

Disclosure: William Trent has a long position in SMH.

After yesterday’s Agere (AGR) preannouncement, we decided to update our research on semiconductor industry fundamentals. This has been made easier since we received a complimentary trial of Zacks Research Wizard.

We first note that days inventory on hand at 39 semiconductor companies listed on public markets in the U.S. improved slightly in the December quarter. This improvement is in line with normal seasonality, as the holiday season is typically marked by strong sales of consumer electronics and the inventory moves away from the manufacturer toward the end user. On a year/year basis to more accurately reflect the seasonality, the days inventory on hand rose.

What the chart doesn’t show is what happened to inventory in the channel. For the uninitiated, the “channel” is everything between manufacturer and end user. For semiconductors, the channel includes distributors, the manufacturers that put the chips into end products such as cel phones or computers, and distributors, wholesalers and retailers of the end products. Given the increasing evidence of slowing consumer demand, the channel inventory could be particularly significant right now (remember Agere’s warning was due to channel inventory corrections.)

Next we turn to capacity utilization, which has clearly started to fall. Excess capacity means the potential for even more inventory to be produced, which tends to put downward pressure on prices. Since the majority of semiconductor manufacturing costs are fixed, low utilization means lower profits – either because prices have to be reduced or because the per-unit costs are higher when production is cut.

Next we turn to orders for new semiconductor equipment, which when installed will increase capacity still further (thus lowering utilization still further.)  The new equipment orders continue to rise at a much faster rate than the end demand for semiconductors.

So there you have it – on an industry-wide basis things are bad and appear likely to get worse. We’ll finish things off with a list of the companies whose days inventory grew year/year:

Disclosure: William Trent has a long position in SMH.

Last week, when National Semiconductor (NSM), Xilinx (XLNX) and Broadcom (BRCM - Annual Report) all reduced their outlook, we noted the wireless industry connection between the companies and asked “Who’s next?” It turns out we didn’t have to wait long to find out. TI cuts fourth-quarter financial outlook | Reuters.com

The company, which makes everything from calculators to chips for flat-screen televisions, said it now expects earnings from continuing operations of 37 cents to 40 cents a share compared with its earlier target of 40 cents to 46 cents.It said it now expects revenue of $3.35 billion to $3.5 billion for the quarter. In October it had forecast fourth-quarter revenue of $3.46 billion to $3.75 billion.

When we commented on the misses last week, a commenter asked “which stocks will go up/down.. any ideas?”

So, in case the wireless link wasn’t enough we hereby list a few wireless supply chain companies with a forward P/E ratio of 20 or higher:

Powerwave (PWAV) (35)

Research in Motion (RIMM) (29)

Silicon Laboratories SLAB (27)

Cree (CREE) (26)

You’ll have to do your own research to determine whether any of these are worth acting on, but it should provide a good starting point. If you can think of any others, feel free to add them in the comment section.

Given the sales weakness in the wireless semiconductor chain, you might wonder whether inventory is also piling up at Broadcom (BRCM - Annual Report). Broadcom says Q4 inventories almost “ideal” | Reuters.com

Wireless chip company Broadcom Corp. (BRCM - Annual Report) expects to finish its fourth quarter with inventories near an ideal level, Chief Executive Scott McGregor said on Thursday.”We still believe we’re on track for Q4, to close out Q4 with inventories approximating an ideal level for us. So we’re very comfortable with that,” McGregor told an investment conference.

Notice he didn’t say anything about Q1. The market shared our skepticism, sending the stock down 2.5% yesterday and another 1.5% after hours in the wake of the National Semiconductor (NSM) and Xilinx (XLNX) warnings.

Disclosure: William Trent has a long position in SMH.