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).

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.

A reader complained yesterday that we have been too negative. While we aren’t going to go crazy and have a whole positivity day, we will take the time to outline the bull case for the industry on which we have been most negative: semiconductors.

1. The bad news is known. When we started harping about oversupply, it was the farthest thing from anyone’s mind. Like Heisenberg’s uncertainty principle, the act of observation can alter the experiment.
2. The market is ignoring the fundamentals. Related to point 1, the market knows about the bad fundamentals and doesn’t care. Often this means that the bad news is sufficiently well known to be priced in. This is of course the weakest reason, as the market ignored the fundamentals in 2000 as well.
3. Demand may be ready to pick up. Double-digit growth from a tech distributor for the first time in a long time should not be ignored. The Vista hoopla has passed, now the nuts and bolts work may be beginning.
4. Supply and demand will soon realign. For the first time since 2005, orders for new equipment grew at a slower rate than semiconductor end demand. The longer this situation continues, the healthier it will be for future industry sales, pricing and profit margins.
5. The game has changed. Forget private equity buyers. For the first time a semiconductor management team decided it was more important to take capital out of the industry than to add more. This is a sea change in semiconductor management-think, and the strong positive reaction from investors ensures that the wave will continue to build.

There. That wasn’t so hard, was it? Stay tuned for our five reasons NOT to buy semiconductor stocks today.

Disclosure: William Trent has a long position in SMH.

We have been talking about oversupply of semiconductors for some time. Now, in the last two weeks two research firms have cut forecasts according to Semiconductor Fabtech:

IC Insights has drastically cut its semiconductor growth projections for 2007 citing severe pricing pressures in the NAND flash memory market as well as the continued decline in microprocessor prices. However, the market research firm has added that a major DRAM price collapse has also started and will also affect market growth this year. As a result, the firm has lowered its forecast to 2 percent growth compared to its previous forecast of 7 percent growth for 2007.Only two weeks ago, Semico Research lowered its semiconductor forecast for the second time this year citing poor prices even though unit demand remained strong, and now projects only 1.8 percent growth for 2007. In March, Semico had projected growth of 5.8 percent compared to a projection at the beginning of the year that the semiconductor industry would grow by 7 percent.

While everyone plays catchup we will refer you back to our October 2006 comments, which have not needed any revisions:

The chart below shows the year/year growth rate in semiconductor sales for each month going back to 1998. Data is courtesy of the Semiconductor Industry Association (SIA).

This tells us a few things:

• The semiconductor sales growth rate has been more consistent since 2005 (in the mid-high single digits.)
• The forecast calls for that to essentially continue for two more years.
• The chart tells us that is pretty dadgum unlikely.

Sales growth is likely to be either much higher or much lower than 8.6% next year. The million dollar question (or however much you may have at stake - for us it’s more like a couple thousand) is which direction. We’re betting it is lower.

For one thing, this is the longest the semi industry has ever gone without a year/year decline. By itself that doesn’t mean much - due to the fabless/foundry model and general tech industry maturity sales growth should be less volatile.

However, when you combine low volatility in sales growth with huge orders for new manufacturing equipment you end up with oversupply. Oversupply in a cyclical industry means sharper than normal price reductions. If the prices fall faster than unit demand rises - you get a decline in sales.

The other reason we expect semiconductor sales to be less than the industry predicts next year is summed up in the following chart, which tracks the total sales (rather than growth) over the preceding twelve months. There has been a definite change in the overall growth rate, going back to about 1995 or 1996, depending on where you want to draw the lines. For simplicity, we’ll just use the last 10 years (September 1996 - August 2006). Over that time frame, the average growth rate has been 6.3%. However, it is easy to see that that rate is toward the top of the new range (the trendline represents resistance in this case.)

So, given overcapacity, volatility and resistance we think 8.6% growth in 2007 is on the optimistic side. Perhaps even the wildly optimistic side.

We’ll have to wait and see how much of a shakeup there is in 2007 before we’d be willing to comment on 2008.

Disclosure: William Trent has a long position in SMH.

When Semiconductor Equipment and Materials International (SEMI), the industry trade organization for semiconductor equipment makers, reported the January book to bill ratio for chip equipment, we were concerned.

Unfortunately, just when it looked as if things might be set to turn the semiconductor companies re-accelerated their pace of equipment orders over the last two months.

Until orders for semiconductor equipment start growing at less than the roughly 10% growth in demand for semis, there will continue to be the brutal pricing environment we have seen recently. The decent guidance and calling of bottoms are pipe dreams.

But now it appears there could be another reason for the datapoint we found so strange. According to Reuters.com:

Global sales of microchip-making equipment in February rose 16.6 percent from a year earlier on demand for tools to make and process silicon wafers, an industry group in Japan said on Friday.Sales of gear used to make semiconductors rose to $2.72 billion in February, the Semiconductor Equipment Association of Japan (SEAJ) said.

The group also restated sales figures for January, saying sales rose 17.2 percent year-on-year to $3.49 billion, instead of a previously stated rise of 34.5 percent to $4.01 billion.

A member of Semiconductor Equipment and Materials International, a California-based industry group, had given the wrong sales numbers, the SEAJ said in a statement.

Then SEMI reported adjusted figures. Here is what the numbers looked like in February as originally reported:

And here is the new and improved data:

The March numbers will be reported Thursday. Given that the supply/demand imbalance is the main contributor to our bearishness, a continuation in this trend would mean we are much closer to adopting a neutral/bullish outlook for semis. We can’t wait for Thursday’s release to find out.

Disclosure: William Trent has a long position in SMH.

Having given you our take on the semiconductor sales data yesterday, We had to laugh when we saw this article from Tech Trader Daily - Semis: Feb Sales Data Look Weak; Are We Nearing A Bottom?

The Street this morning agrees on the obvious conclusion of the latest SIA data: it was weak. “Weak February results,” “shipments weaker than typical,” “weakness in both units and pricing,” “data appears generally weak,” “weaker than normal seasonality,” said analysts this morning at J.P. Morgan, Wedbush Morgan, Robert W. Baird, Lehman Brothers and UBS, respectively.But there is also a growing consensus that we are at or near a bottom in semi fundamentals, and that a recovery is just around the corner; it is a theory tied to the notion that the recent inventory correction in the sector is nearly completed.

Oh, really? Here’s a chart we’d like the analysts Eric quoted to look at, which is a total semiconductor sales on a trailing 12-month basis since 1995, based on data from the Semiconductor Industry Association:

So, Christopher Danely, analyst at J.P. Morgan, Craig Berger, of Wedbush Morgan, Lehman’s Tim Luke, and Uche Orji, of UBS: Can you tell me why this looks like a bottom to you?

Disclosure: William Trent has a long position in SMH.

The Semiconductor Industry Association released global semiconductor sales data for the month of February, 2007, and it did not look good.

Worldwide sales of semiconductors of $20.09 billion in February were 6.5 percent lower than January when sales were $21.48 billion, the Semiconductor Industry Association (SIA) reported today. February sales increased by 4.2 percent from the $19.28 billion recorded in February 2006.“While seasonality clearly contributed to the 6.5 percent decline in worldwide chip sales month-on-month, declining unit shipments and lower average selling prices (ASPs) in several key market segments were a factor,” said SIA President George Scalise. “Both unit shipments and total sales of microprocessors and DSP chips experienced sequential declines in February. Unit shipments of NAND flash increased sequentially while total sales saw a double-digit decline, indicating very competitive market conditions.”

It reminds us of something we said in February:  Although end demand for semiconductors has experienced fairly steady growth, excess supply has sometimes caused inventory to grow to unsustainable levels. For example, “by 2000 most of the capacity was in place, churning out chips. Since end demand was growing at a slower pace, inventory built up. The falloff in 2001 wasn’t so much a drop in demand, but the fact that the demand could be filled from that existing inventory.” We even backed it up with this chart:

We followed up last week, saying “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.” It sounds very similar to what Scalise described in today’s SIA press release:

“Year-on-year, we see evidence of the fiercely competitive market conditions – across the board unit sales in key products increased, while ASPs declined. Unit sales of microprocessors were up almost 8 percent while ASPs declined 15 percent, and NAND flash units grew by over 40 percent while experiencing a nearly 50 percent drop in ASPs. These products tend to be indicators of conditions in important end markets such as personal computers and consumer devices,” Scalise continued. “Personal computers and consumer products now account for approximately 60 percent of semiconductor sales. Both competitive conditions and product mix issues appear to be affecting revenues of these key components.”

SIA noted that overall capacity utilization declined from 88.9 percent in the third quarter of 2006 to 86.8 percent in the fourth quarter. Most of the decline was in foundry utilization, which fell from 91.5 percent in the third quarter to 80.9 percent in the fourth quarter. The reduction in capacity utilization in the fourth quarter addressed inventory builds in the semiconductor supply chain and selected end markets which are expected to show growth consistent with GDP performance in key world markets in the coming months.

The problem for us is, we don’t see the reduction in capacity utilization as having “addressed inventory builds.” Rather, we see it as the logical conclusion of excess capacity expansion that has built up now for more than a year:

At the time, we said:

The good thing about the downward revision, and also the decline in February, is that it restores some balance to at least the trend in equipment orders relative to end demand for semiconductors. Although supply (chip equipment orders) is still growing much faster than the roughly 10% growth in semiconductor demand, at least the rate at which the capacity is growing is starting to slow down again. Furthermore, the billings (which represent what is actually installed rather than orders, which may prove too optimistic) have been running at a slower rate than orders. The 22% growth of installed equipment is still well higher than what is needed, but has less far to fall.

Unfortunately, today’s release also blows a hole in any hopes we had that slowing orders would restore balance. Since we measure the imbalance as the differential between dollar capacity growth and dollar sales growth, the slowdown in semi demand to 4% year/year from “roughly 10%” means that February’s decline in chip orders did not improve the potential supply imbalance. Things have farther to fall than we thought.

Disclosure: William Trent has a long position in SMH.

TI sees 2007 global cellphone unit sales up 20 pct | Technology | Technology | Reuters.co.uk

Global sales of mobile phones are expected to grow to between 1.1 billion and 1.2 billion units in 2007, up as much as 20 percent from about 1 billion units sold last year, a Texas Instruments (TXN.N: Quote, Profile , Research) official said on Friday. “We are optimistic on the growth momentum of low-price mobile phones,” Terry Cheng, the president of Texas Instruments Inc. (TI) Asia, told Reuters on the sidelines of a seminar in Taipei. TI is the world’s biggest cellphone chip maker.”The company has shipped large amounts of chips for low-price mobile phones since November and December last year, which will help boost our business significantly this year,” he said.

Um… shipments in November and December boosted last year’s business. You aren’t allowed to count them twice. And as to market growth, they seem way too high.

In October Merrill Lynch forecast about 950 million units for 2006 and less than 10% growth in 2007. That takes you to maybe 1.05 billion. That was also in line with an industry forecaster’s predictions.

At least we’ll give credit to TI for going out on a limb.

We have written several articles about Silicon Laboratories SLAB. Although we like the company and its technology, it has often been richly priced.  We have also written several articles disparaging the constant “who will be the next buyout candidate” festival that has overtaken semiconductor analysts desperate for reasons to get people to buy the stocks. Finally, however, we have found one we kinda-sorta buy into.
The Austin (TX) American-Statesman asks if whether a Chip maker shake-up is on the horizon? More »

Disclosure: William Trent has a long position in SMH.

Last month we were surprised to hear some cautionary words out of Semiconductor Industry Association President and chief cheerleader George Scalise. At the time, we said it could either be a positive contrary indicator or a sign things were really bad. Whatever the case, it seems to have passed. According to the association’s latest press release:

The Semiconductor Industry Association (SIA) today reported that global sales of semiconductors reached $22.7 billion in November, an increase of 11.3 percent from the $20.4 billion in November 2005. Sales increased by 3.1 percent from the $22.0 billion reported in October. The November sales figure was the fifth-consecutive month of record sales. For the first 11 months of 2006, worldwide semiconductor sales totaled $225.1 billion, an increase of 9.4 percent from the like period of 2005 when sales were $205.7 billion.Consumer applications continued to drive demand of microchip sales in November. According to the Consumer Electronics Association (CEA), unit sales of consumer electronic products such as flat-panel displays and digital cameras were ahead of forecasts in the holiday season and resulted in strong revenue growth despite some erosion in the average selling price for some products. The CEA reported that November unit sales of digital cameras in the U.S. market were up 30 percent over November 2005 and up over 40 percent for the first 11 months of 2006. Semiconductor product lines that showed strong sequential growth included DSPs (digital signal processors), up 12.3 percent; DRAMs (dynamic random-access memories) up 6.8 percent; NAND flash up 6.3 percent; and microprocessors, up 4.3 percent.

“Despite some signs of slower economic growth in the fourth quarter, consumer purchases of electronic products remained strong and again drove semiconductor sales to record levels,” said SIA President George Scalise. “The latest Conference Board survey of consumer confidence reflected increasing optimism. An improving job market and indications of healthy economic growth going forward should contribute to stronger demand for semiconductor products which are increasingly driven by consumer electronic purchases.

“Inventories are in line with current demand in most major product segments, and there are even signs of tight supplies in some memory products,” Scalise continued. “Global sales of semiconductors for the first 11 months of 2006 are in line with the SIA forecast of 9.4 percent growth for the year. 2007 is shaping up to be another good year for the industry with a forecast of 10 percent growth over 2006,” Scalise concluded.

We have been warning about inventories for some time, and now even the mainstream media is picking up on the theme (which may be yet another contrary indicator.)  Still, George Scalise saying inventories are tight doesn’t change the fact that semiconductor companies continue to order equipment at a faster pace than their customers order semiconductors (see chart).

As that equipment gets installed, Scalise won’t be able to wish away the semiconductors produced, and most of them will go into inventory.

Disclosure: William Trent has a long position in SMH.