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).

The Economic Calendar is quiet in the early part of this week but there are important reports at the end of the week. On Thursday is the Durable Goods report, for which the consensus estimates a 2.0% increase. On Friday is the Preliminary Estimate of 2Q GDP, which the consensus has pegged at 3.2%. That sounds a little high to me based on the economic data table I’ve been compiling.

EconomicData

The Earnings Calendar is as busy as it can get. Some of the names I’ll be watching:

Monday

• Altera (ALTR) - Xilinx (XLNX)  filed an awful report. Can Altera do any better? Consensus is $0.19 EPS on sales of $314 million.
• Hexcel (HXL) - This Small Cap Watch List (Track at Marketocracy) member was seeing rising estimates until last month, when they were cut from $0.20 to the current $0.17.
• Steel Dynamics (STLD - Annual Report) - The Mid Cap Watch List (Track at Marketocracy) member is expected to earn $1.04 on sales of $948 million.
• Texas Instruments (TXN - Annual Report) - expected to earn $0.42 on $3.45 billion in sales.

Tuesday

• CH Robinson (CHRW - Annual Report) - estimates have been rising and now stand at $0.47, but Landstar (LSTR - Annual Report) disappointed.
• CDW Corporation (CDWC) - stellar monthly sales reports have kept estimates rising. They now stand at $0.97.
• EMC Corporation (EMC - Annual Report) - The big news is still the VMWare IPO, but it is also a decent look at enterprise tech spend.
• Laboratory Corporation of America (LH) - The Mid Cap and Large Cap Watch List (Track at Marketocracy) member has been seeing positive earnings revisions and is now expected to earn $1.09 on $1.03 billion in revenue.
• Lexmark (LXK) preannounced and will probably offer poor guidance.
• Linear Technology (LLTC) - expected to earn $0.35 on $267 million in sales.
• Norsk Hydro (NHY) - The Large Cap Watch List (Track at Marketocracy) member has no analyst coverage right now.
• Plantronics (PLT) - my covered call position is now being cashed out so I’ve no skin in this one. But it is often volatile.
• United Parcel Services (UPS) is a great read on the health of the economy. Expectations are $1.03 on $12.23 billion in revenue.

Wednesday

• Arkansas Best (ABFS) - after Landstar’s (LSTR - Annual Report) weak quarter I’m expecting a poor showing. Estimates have come down to $0.67, but may not have come down enough.
• Colgate Palmolive (CL) - Large Cap Watch List (Track at Marketocracy) member unlikely to surprise much. Consensus is $0.83 on $3.31 billion.
• Corning (GLW - Annual Report) - is LCD supply/demand back in balance?
• Freeport McMoRan Copper & Gold (FCX - Annual Report) -Another Large Cap Watch List (Track at Marketocracy) member with dramatic positive earnings revisions, now standing at $2.71.
• Graco (GGG) is another Large Cap Watch List (Track at Marketocracy) member. Estimates have been coming down and are now at $0.61.
• MEMC Electronic Materials (WFR) - Is polysilicon supply catching up to demand for this Large Cap Watch List (Track at Marketocracy) member?
• Xerox (XRX) - can they make the numbers without asking investors to ignore a bunch of stuff? I don’t doubt they will earn $0.27 as expected but wonder how they’ll get there.

Thursday

• Federated Investors (FII) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.54.
• Ingram Micro (IM) is on the Small Cap Watch List (Track at Marketocracy) and expected to earn $0.36.
• KLA-Tencor (KLAC) - I know the semiconductor equipment fundamentals stink. I want to know how much and whether it is priced in.
• NII Holdings (NIHD) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.49.
• Western Digital (WDC) is on the Large Cap Watch List (Track at Marketocracy) and expected to earn $0.36.

Disclosure: William Trent has a long position in SMH.

In a press release yesterday, the Semiconductor Industry Association said:

According to iSuppli, an independent market analysis firm, excess semiconductor inventories are increasing, reflecting expectations of growing demand in the second half of the year.

An increase in inventory may be justified if sales are expected to grow at the same pace or greater. This could be due to seasonal factors, a new product launch, or merely wishful thinking on the part of the company building the inventory. I’m continuing my series on semiconductor inventory trends with a look at the sequential change in inventory between the last reported quarter and the previously reported quarter, and comparing that figure to the change in expected sales between the current quarter and the next quarter. I used Zacks Research Wizard to collect the data.

The metrics I used are imperfect at best, as the change in inventory in any two quarters will not necessarily correspond exactly to the expected sales growth over the subsequent two quarters. However, it should be useful as an indication of whether sales levels generally are expected to grow sufficiently to absorb the inventory.

Of 47 companies that passed the screen, I found that 20 of them have inventory growth within five percentage points of expected sales growth, which seems reasonable. I also found that there were more companies that have expected sales growth greater than past inventory growth than there were the opposite, but I would caution that semiconductor sales estimates have been coming down recently and the current data may be too optimistic.

The five companies for which inventory either declined or grew at a slower rate than expected sales growth by the widest margin were Silicon Labs SLAB, Silicon Image (SIMG), MEMC Electronic Materials (WFR), Applied Micro Circuits (AMCC) and Stats Chipp (STTS). In the case of Silcon Labs the change may be due in large part to the recent sale of its handset chip division, which accounted for half the company’s sales.

The five companies that had the largest increase in inventory, relative to expected sales growth, were Actions (ACTS), Cypress (CY), Monolithic Power (MPWR), Atheros (ATHR) and Linear Technology (LLTC).

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.

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 generally been critical of tech companies overinvesting. Sometimes our criticism is misconstrued as a criticism of innovation in genreral. For example, a commenter recently said:

I belong to the build it and they will come religion. If it were not for people like us new things will never get invented and new things will never be done because there does not exist a market for new things until they become old.

We are all for innovation and opening new markets, which is also why we are against overinvesting in existing markets. Too much capacity has largely commoditized the semiconductor business. That industry would do better by limiting its capacity growth, investing marginally in new opportunities, and returning the rest to shareholders so they can put the money to use in other exciting new areas. Industries mature, and when they do they need to recognize their maturity and act their age.

Credit Oracle (ORCL - Annual Report) for being among the first to recognize it - but in keeping with the general growth mindset rather than returning capital to their own shareholders they are returning it to the shareholders of companies they acquire. The end result is still less capital in the industry. Likewise, private equity buyouts and Linear’s (LLTC) recent partial self-LBO are beginning to do the same thing in the semiconductor space. Now, it is IBM’s turn to get religion.
IBM Board Approves 33 Percent Increase in Quarterly Cash Dividend:

The IBM board of directors today declared a regular quarterly cash dividend of $0.40 per common share, payable June 9, 2007 to stockholders of record May 10, 2007.

The board also authorized $15 billion in additional funds for use in the company’s stock repurchase program. This amount is in addition to approximately $1.4 billion for stock repurchase remaining at the end of March from a prior authorization.

For the record, IBM doesn’t have $15 billion in cash (although they aren’t all that far off either with more than $10 billion in cash and marketable securities.) Instead, the company says it will issue more debt to buy back the shares, much as Linear is doing.

IBM intends to borrow a large portion of the funds for this repurchase, and maintain increased financial leverage.  The company is confident in its ability to sustain strong cash flows and financial flexibility to continue to execute its current investment, dividend and acquisition strategies.

Technically speaking, using debt to repurchase shares is not reducing capital. Rather, it is shifting the mix of capital providers from equity holders to debtholders. But unlike equity debt has a maturity date, and is generally more likely than equity to be retired. In the long run, the desired capital reduction should be accomplished.

Disclosure: William Trent has a long position in SMH.

We have generally been critical of tech companies overinvesting. Sometimes our criticism is misconstrued as a criticism of innovation in genreral. For example, a commenter recently said:

I belong to the build it and they will come religion. If it were not for people like us new things will never get invented and new things will never be done because there does not exist a market for new things until they become old.

We are all for innovation and opening new markets, which is also why we are against overinvesting in existing markets. Too much capacity has largely commoditized the semiconductor business. That industry would do better by limiting its capacity growth, investing marginally in new opportunities, and returning the rest to shareholders so they can put the money to use in other exciting new areas. Industries mature, and when they do they need to recognize their maturity and act their age.

Credit Oracle (ORCL - Annual Report) for being among the first to recognize it - but in keeping with the general growth mindset rather than returning capital to their own shareholders they are returning it to the shareholders of companies they acquire. The end result is still less capital in the industry. Likewise, private equity buyouts and Linear’s (LLTC) recent partial self-LBO are beginning to do the same thing in the semiconductor space. Now, it is IBM’s turn to get religion.
IBM Board Approves 33 Percent Increase in Quarterly Cash Dividend:

The IBM board of directors today declared a regular quarterly cash dividend of $0.40 per common share, payable June 9, 2007 to stockholders of record May 10, 2007.

The board also authorized $15 billion in additional funds for use in the company’s stock repurchase program. This amount is in addition to approximately $1.4 billion for stock repurchase remaining at the end of March from a prior authorization.

For the record, IBM doesn’t have $15 billion in cash (although they aren’t all that far off either with more than $10 billion in cash and marketable securities.) Instead, the company says it will issue more debt to buy back the shares, much as Linear is doing.

IBM intends to borrow a large portion of the funds for this repurchase, and maintain increased financial leverage.  The company is confident in its ability to sustain strong cash flows and financial flexibility to continue to execute its current investment, dividend and acquisition strategies.

Technically speaking, using debt to repurchase shares is not reducing capital. Rather, it is shifting the mix of capital providers from equity holders to debtholders. But unlike equity debt has a maturity date, and is generally more likely than equity to be retired. In the long run, the desired capital reduction should be accomplished.

Disclosure: William Trent has a long position in SMH.

We’ve been harsh critics of the semiconductor industry’s “build it and they will come” attitude, noting that a significant slowdown in industry growth began in the mid-90’s (before the tech bubble).

Software is in the same boat, but companies have been much more rational about how to deal with it. While they still introduce new products and features, Microsoft (MSFT - Annual Report) is returning wads of cash to shareholders and Oracle (ORCL - Annual Report) is using its cash for acquisitions. Both strategies take capital out of the industry and thus allow existing returns to be spread over a smaller capital base. Presto! Returns on capital improve.

Although some semiconductor firms, such as Linear Technology (LLTC), appear to have gotten the message others will change their ways only by force. Case in point: microprocessors.

Intel certainly isn’t going to let up any time soon.

Today’s product leadership is built around our 65 nanometer technologies and we are well along the path to introduce products based upon 45 nanometer technology later this year. To that end, we’ve announced the use of breakthrough materials in our 45 nanometer process that will allow us to introduce faster and more power-efficient microprocessors to pack more features into smaller die.

(Excerpt from full INTC conference call transcript)

With $8 billion more cash than debt, Intel can sustain irrational levels of investment for an extended period. By contrast, Advanced Micro Devices (AMD - Annual Report) is running a little low on cash. Not surprisingly, they are getting supply/demand religion:

Among the efforts already underway are: reducing 2007 CapEx spending by approximately $500 million, largely by slowing the rate of the fab 38 conversion; we are reassessing our overall staffing plans, specifically we are going to limit ourselves solely to critical hires, and to the extent that we add resources, we will focus primarily on doing so in lower cost geographies.

(Excerpt from full AMD conference call transcript)

Intel put a spin on the damage they have done, saying:

Gross margins for the quarter was better than we expected and we can report excellent results over the last year in cutting spending, which is $0.5 billion lower than the first quarter of 2006.

Looking beyond the transitional second quarter, we see an improving second half as the distinctive products and process technologies catered date. We expect gross margins to improve significantly in the second half with a percentage in lower 50’s range and we have raised our forecast for the full year….

Gross margin dollars were $4.4 billion, $378 million lower than the fourth quarter. Gross margin percentage of 50.1% was above the midpoint of our forecast and 0.5% higher than the fourth quarter.

(Excerpt from full INTC conference call transcript)

The raised guidance is to 51% gross margins - plus or minus a few points. In 2005 Intel’s margins were 60%. 10 percentage points of margin were lost because they kept building capacity that wasn’t needed - why do they continue? To hear them tell it, it is because the margins will improve once they ramp up on the new technology.

Chris Caso - Friedman, Billings Ramsey

Hi thank you. I wonder if you can give some detail on what impact we might expect from the introduction of the 45 nanometer product in the second half, specifically on gross margin impact, you talked about 25% smaller die size, do you expect that have any material effect on gross margins this year and if not maybe you can talk a little bit about what we might expect in the 2008?

Andy Bryant

When you start a new process you typically have a little bit of variation, and it comes with it because you have the start-up cost that you’re dealing with now. Then before the product gets called you have the pre-quality reserves and then you’re quick valuing at a point in time. So, when we get into the Q2, I will give a better forecast of when those products may qualify and when you might start to see the inventory being valued and the costing marginal effect. So, I guess, I am telling you, I am not going to give you many specifics about that. Yes, we think the cost envelope for those products can be very competitive, we feel pretty good about where those are headed.

(Excerpt from full INTC conference call transcript)

The thing is, investors can only hear that so many times before they stop believing it. Here is what Bryant said in the Q2 2006 conference call:

Andy Bryant

Thanks, Paul. The second quarter was the time for facing the challenges of the market, while moving ahead with plans to improve our products and capabilities. Competition, market softness, a product mix shift in customer inventory levels entering the quarter, were among the challenges.

In growth and servers, chipsets for mobile computers and communications infrastructure were among the bright spots.

While we have trimmed the outlook for gross margin for the year, we continue to tackle the cost structure with reductions in capital spending, R&D, and headcount. We have also reduced our level of cash and the number of shares outstanding.

As Paul stated, we made excellent progress in pushing forward with new products to support a stronger second half.

(Excerpt from full INTC Q2 2006 conference call transcript)

The second half came and went. Just as we expect the second half of this year to come and go without the relentless investment in new technology paying off. We just hope it doesn’t take a liquidity crisis before Intel finally comes to its senses.

Disclosure: William Trent has a long position in SMH.

Our preview of earnings for Advanced Micro Devices (AMD - Annual Report) - Expected to lose $0.46 on $1.34 billion in sales this quarter and $0.36 on $1.35 billion next. Given how disastrous the current outlook is, we may be getting near the bottom for estimates. Valuation, however, remains questionable. We hate negative P/E multiples.
Like many prognostications, we didn’t call things exactly right. AMD Reports First Quarter Results:

AMD (AMD - Annual Report) today reported financial results for the quarter ended March 31, 2007. AMD reported first quarter 2007 revenue of $1.233 billion, an operating loss of $504 million, and a net loss of $611 million, or $1.11 per share. These results include ATI acquisition-related and integration charges of $113 million, or $0.21 per share, and employee stock-based compensation expense of $28 million, or $0.05 per share.

Maybe now we’re closer to a bottom.

First quarter 2007 gross margin was 31 percent, excluding stock-based compensation expense and acquisition-related charges, compared to 40 percent in the fourth quarter of 2006 and 59 percent in the first quarter of 2006. The decrease from the prior quarter was largely due to significantly lower microprocessor unit shipments, lower microprocessor average selling prices (ASPs), and the inclusion of the former ATI operations, which generally have lower-margin products, for the entire quarter.

Selling fewer items at lower prices is seldom a recipe for success. Guidance, meanwhile, was cryptic:

In the seasonally down second quarter, AMD expects revenue to be flat to slightly up.

Well, consensus was correct about the “flat to slightly up” part. The only thing is, it is off the $1.233 billion base rather than the $1.34 that had been expected.

As to the questionable valuation, AMD took a page from Linear Technology’s (LLTC) book and dangled the prospect of huge share purchases in front of investors, according to TheStreet.com.

Executives said the company was evaluating various “asset-light” options, which involve outsourcing portions of chip fabrication to third parties instead of building multibillion-dollar facilities, and noted that the company was not averse to seeking shelter from the rigors of the public markets through a private-equity deal.

We think investors are reading too much into this in the wake of the Linear-inspired giddiness. Linear actually had the cash to do half its buyback and tons of cash flow with which to finance the remainder. AMD, by contrast, is running out of cash - which is why it needs capital in the first place, public or private.

Turning to the more mundane task of sifting through the mess that is AMD’s financial statements, inventories managed to grow 15% sequentially and have now nearly tripled on a year/year basis. They can cover 106 days worth of sales with what they now have on hand, but remember - the value of the inventory on hand declines almost daily. “Deferred income on shipments to distributors,” also known as “channel inventory,” would cover another 20 days. Forget “asset light” - AMD shouldn’t need to spend another dime on capacity for some time.

AMD shed nearly $400 million of cash during the quarter, to end with less than $1.2 billion. A couple more quarters like this and they’ll be looking for subprime lenders rather than private equity buyers.

Linear Technology Reports Lower Revenue and Net Income From the Third Quarter of the Previous Fiscal Year and Announces Plans for a $3.0 Billion Accelerated Stock Repurchase Transaction: Financial News - Yahoo! Finance

Linear Technology Corporation (LLTC), a leading, independent manufacturer of high performance linear integrated circuits, today announced that revenue for its quarterly period ended April 1, 2007, was $255.0 million, a decrease of 9% or $23.9 million from revenue of $278.9 million for the third quarter of the previous fiscal year. Net income computed in accordance with U.S. Generally Accepted Accounting Principles (GAAP) for the third quarter of fiscal year 2007 of $98.6 million or $0.32 diluted earnings per share decreased 11% or $12.0 million from net income of $110.6 million or $0.35 diluted earnings per share for the third quarter of the previous fiscal year.

As we noted in our preview, Consensus wanted $0.32 on $254 million this quarter and $0.34 on $263 million next. So while the current earnings came in pretty much in line, the estimates for next quarter are at the lower end of management’s guidance:

In summary, we currently expect revenue to increase 3% to 6% with operating margins up similarly.

That would put revenue in the $263-$270 range, with earnings pretty much on target. Furthermore, inventory levels continued to creep up, adding $5 million (10%) sequentially and $13 million (30%) year/year compared to the respective sales growth figures of negative 4.5% sequentially and negative 9% year/year. That is, for lack of a better word, horrible.
So operationally we were not very impressed with the report. However, it wasn’t the operations that sent the stock up 10% in after-hours trading. In part investors were likely expecting worse from semiconductor stocks this quarter. We know we were. But most importantly, the company announced plans to buy back $3 billion worth of its own stock:

The Company also announced its plans to enter into an accelerated stock repurchase transaction, subject to market and other conditions, pursuant to which it will repurchase approximately $3 billion of its shares of common stock. The Company intends to finance such repurchase with existing cash and the proceeds of a $1.7 billion convertible note offering. The accelerated stock repurchase transaction would be conditioned on the closing of the convertible note offering.

We’ve talked about the smoke-and-mirrors nature of these buybacks funded by convertible note issues in previous posts. We don’t have the details on this one, but note that the buyback could reduce the current share count by nearly 30%. While the added interest expense and foregone interest on cash balances will affect that somewhat, we estimate roughly a 15-20% gain in EPS based on the following back-of-the-envelope calculation using estimated FY 2007 earnings:

Even allowing for some smoke and mirrors, that is quite an improvement to EPS. Certainly enough for investors to overlook some operational issues that were already fairly well-known anyway.

Disclosure: William Trent has a long position in SMH.