My latest column is up at RealMoney. In it, I explain why I think the recent rally in semiconductor stocks should continue.

First, as I have mentioned before, the supply/demand balance remains favorable.

Second, pricing power appears to be improving, based on the most recent PPI report.

I think the names that will perform best are those whose gross margins are currently depressed, as improving margins would result in accelerating earnings power.

Disclosure: At time of publication, William Trent holds shares of SMH and MXIM, as well as put options against the shares of LRCX.

Disclosure: William Trent has a long position in SMH.

My latest RealMoney column is up, on Omnivision (OVTI). You can get the full story at their site, but in summary:

OmniVision derives 70%-80% of sales are derived from the camera cell phone market. Recent trends in the handset market suggest there could be some bumps in the road ahead. Handsets have been selling like hotcakes, but recent cooling signs have emerged.

In a tougher handset market, I’d also expect a tougher pricing environment for OmniVision and its peers. Competitors in the market for CMOS image sensors include MagnaChip, Micron (MU - Annual Report) , Samsung, Sony (SNE - Annual Report) , ST Microelectronics (STM) and Toshiba. The company also faces competition from the makers of CCD chips, which have typically represented the higher-end products.

Still, I like the recent trend in OmniVision and the potential for expanded interest among value investors in coming months. With appropriate protection (such as tight trading stops), it might be worth taking a risk in the name.

Alternatively, the April $17.50 puts are $0.80 as I write this. Writing the puts would offer either a 4.5% five-week yield on the money risked, or a more attractive entry point of $16.70 should the options be exercised.

Disclosure: At time of publication, William Trent has no financial position in the companies mentioned.

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)

Disclosure: William Trent has a long position in SMH.

Last year the companies in the memory segment of the semiconductor industry were working flat out in anticipation of rising demand on the heels of Microsoft’s Windows Vista release. At one point last year they accounted for a significant portion of the investments in new semiconductor equipment as well. With the memory situation now more generally recognized as a glut and more rational investment plans being put into place, some memory prices are actually rising. I decided to take a look at the recent conference calls for some of the most exposed companies to see if there is anything noteworthy to report.

STMicroelectronics (STM) is the third-largest supplier of NOR flash memory and is combining its memory business with that of Intel (INTC - Annual Report) into a joint venture to be known as Numonyx. Flash was not their strongest segment, partly due to temporary customer issues.

Carlo Ferro

Good afternoon, everybody. This is not frankly a particular quarter for pricing pressure on flash when including both NOR and NAND. We’re used to this kind of pressure, which is in the mid-single-digit range. What maybe is somehow peculiar, has been somehow peculiar is that the price pressure on NOR has been somehow higher than price pressure on NAND.

Carlo Bozotti

Yes, but the major issue in Q2 on flash was volume and specifically in the wireless and of course a specific customer where our presence is very important and I think that the major issue that we had was the lack of volume at this customer, or at that customer.

(Excerpt from full STM conference call transcript)

Nokia (NOK) is the largest customer for STMicroelectronics, accounting for about 20% of sales. Last week Nokia announced they would be sending even more business to STM, and STM shares rose on the announcement. I think STM has generally been making the right moves.

SanDisk (SNDK - Annual Report) is one of the world’s largest suppliers of flash-based data storage products for the consumer, mobile communications, and industrial markets. SanDisk is hopeful the industry has hit bottom for this cycle.

The second quarter started under very difficult market conditions but improved markedly as the quarter progressed. April and May were characterized by excess supply, but July is coming to balance and during the distinct possibility the demand for high capacity flash products may outstrip industry wide supply in the second half of this year.

(Excerpt from full SNDK conference call transcript)

Micron (MU - Annual Report) did not sound quite as confident – call it cautious optimism. Micron is a leading manufacturer of both DRAM and flash memory.

The major factors affecting this quarter’s results were, one: significant growth in industry memory supply, which caused average selling price erosion across DRAM and NAND memory; two: noteworthy cost per megabit reductions achieved by the company for its DRAM and NAND devices, which could not keep pace with ASP declines, and three: progress made on reductions and overhead expenditures….
Despite the demand strength and encouraging signs pointing to stronger demand in the second half of the calendar year, the memory business in particular has been under profitability pressure due to persistent oversupply. Moving forward, I am optimistic about a more favorable supply/demand balance as we see the impacts of memory content expansion, new end product introductions, seasonal demand upticks, and a slowing industry-wide output growth rate.

(Excerpt from full MU conference call transcript)

Finally, I turn to one of the companies most at risk should capital spending subside – Lam Research (LRCX). They sound optimistic, but I’m not so sure.

We expect that foundry shipments for Lam will be weak in the September quarter as a function of the pull-ins to June and we expect that shipments in foundry will strengthen in the December quarter. Shipments for Logic, Flash other and MPU are expected to be flat in the second half compared with the first half.

Turning to 2008, as we discussed at our Analyst Meeting last week, we believe that 50% CapEx intensity and memory is not sustainable existing 2007, and in fact the rated capacity additions has already begun to slow. The depth and duration of this reduction in capacity additions will be dictated by the actual demand environment as we go forward in the next 6 to 12 months.

Demand trends to watch here included adoption rates of major products such Vista and the iPhone, as well as, the overall demand for the broad range of other semiconductor intensive consumer digital electronic products.

As we move into 2008 it will also be important to watch the conversion of 200 millimeter memory production to 300 millimeter as memory manufactures ability to generate acceptable profits of 200 millimeter will force additional production to move to 300 millimeter.

Based on current industry dynamics, our very early assessment for calendar year 2008 is that overall wafer side equipment spending is likely to be flattish with memory spending to be down potentially 10% to 15%, and an expectation that foundry logic/other and MPU spending will increase sufficiently to offset the decline in memory spending.

(Excerpt from full LRCX conference call transcript)

Lam got 73% of its revenue from the sale of equipment to memory chip makers in the last quarter. If three quarters of the business declines 10% to 15%, for the overall business to remain flat the remainder would have to grow from 27% to 39%. Semiconductor sales growth has averaged high single-digit, and most forecasts I have seen for semi equipment over the next two years are in that range as well. I think the guidance is too optimistic.

Disclosure: William Trent owns put options against shares of Lam Research (LRCX) and has a short position in put options related to the Semiconductor HOLDRS (SMH) ETF.

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

For semiconductor manufacturers, production is represented by the semiconductors sold (COGS) and any change in inventory. Since the business has high operating leverage, producing more chips in any given period means each chip costs less. This in turn tends to boost gross margin when production levels are high.

The problem arises when the company is producing more than it can sell, which is what made me bearish on semiconductors over the last year.  By comparing production to sell-through (COGS) it is possible to identify companies that have been producing more than they can sell and hence may see margins fall. It is also useful to identify those whose profits will rise because they need to increase production in order to meet demand.

Continuing my series on semiconductor inventory trends, I used Zacks Research Wizard to calculate production levels relative to COGS for nearly 40 semiconductor companies.

The five companies with the highest production levels relative to sell-through are Actions (ACTS), Cypress (CY), Monolithic Power (MPWR), Micron (MU - Annual Report) and MicroSemi (MSCC). These companies may face gross margin pressure as they wait for demand to catch up with production.

The five companies with the lowest production to COGS ratio are Applied Microcircuits (AMCC), PMC-Sierra (PMCS), Silicon Image (SIMG), Conexant (CNXT) and Anadigics (ANAD). These companies may see improving gross margin when they ramp production levels up to meet the demand and replenish inventory.

Special mention goes to Large Cap Watch List (Track at Marketocracy) member MEMC Electronics (WFR), whose production levels have been insufficient to meet demand for seven consecutive quarters.

Disclosure: William Trent has a long position in SMH.

Dell (DELL) reported preliminary results for the first quarter of fiscal year 2008, with revenue of $14.6 billion, operating income of $947 million and earnings per share of $0.34. Analysts were only expecting the company to earn $0.26 on $14.0 billion in revenue.

The company took deliberate actions to concentrate on solutions sales, realign pricing and drive a better mix of products and services in the quarter. While these actions slowed overall unit growth, a 14 percent year-on-year improvement in average selling prices contributed to improved gross margins, revenue growth of three percent and operating margins of 6.5 percent.

Three percent top line growth still pales compared to  Hewlett Packard’s (HPQ - Annual Report) results, but given the weak overall corporate spending on tech equipment isn’t too shabby.

In the quarter, gross and operating income margins were positively affected by a favorable decline in component costs.

Nothing like having your suppliers be in worse shape than you are to improve profitability, eh?

The company noted, of course, that not only this year’s numbers but last years are subject to revision based on the ongoing investigation into the company’s accounting practices. Investors must hope they can put the issue behind them once and for all, and sooner rather than later. For myself, not being able to trust the numbers is keeping me on the sidelines.

DRAMeXchange wonders if DRAM prices will bottom out soon:

Current market observations show the DDR2 chip price possibly bottoming out. If this occurs, it should drive up the chip demand, and spur a rebound in the spot price.

Memory chips were the last domino to fall, so to speak, to the oversupply situation.  As such, I would expect them to be the last to recover. The quote above, that demand will rise because prices stop falling, appears counterintuitive at first. Perhaps the suggestion is that buyers were putting off purchases on the expectation that prices would be lower if they waited. I can’t really buy that argument, though, because I don’t think PC makers and other DRAM users would worry about the price if they had their own end demand – they would just buy what they needed and pass along the higher price to whatever extent possible.

In fact, quite the opposite likely occurred. For example, for several quarters Hewlett Packard (HPQ - Annual Report) has been making “strategic buys” of inventory they already thought was excessively cheap.

So while the “bottoming out” is not likely to spur demand, it may well spur a reduction in supply.  The same DRAMeXchange report hints at that as well:

Despite the fact that Taiwan DRAM makers posted a gross profit of nearly 50% in 4Q06, and 30% in 1Q07, DRAMeXchange believes the persisting DRAM price declines in May will cause them to post a loss in 2Q07.

Although DRAM makers must still ship their chips in May, they indicated no additional price cuts would be made, due to the continuing losses. Prices have thus started to increase for last week. Yet, the end market demand is not expected to pick up in May and June, and PC shipments have been performing worse than expected in May, in the wake of a weak seasonality. Furthermore, PC OEMs, major spot market buyers, and module houses still have inventory levels lasting for more than a month. DRAMeXchange believes that by only relying on buyers in purchasing cheaper chips, the DRAM price increase will be limited at least before June.

With prices already dangerously low, Hynix has already started to switch some of its DRAM production to NAND Flash instead.

With capacity being shifted to other products, and the profitability issues impacting the ability to invest in more capacity (as long as the companies heed the signs) the lower supply is what will allow demand to catch up and restore equilibrium to the market.

STMicroelectronics (STM), Intel (INTC - Annual Report) and Francisco Partners today announced they have entered into a definitive agreement to create a new independent semiconductor company from the key assets of businesses which last year generated approximately $3.6 billion in combined annual revenue. The new company’s strategic focus will be on supplying flash memory solutions for a variety of consumer and industrial devices, including cellular phones, MP3 players, digital cameras, computers and other high-tech equipment. The partners in the deal were gushing with superlatives, which you can read in the press release.

For my part, I don’t doubt that the new company exudes wonderfulness from a strategic standpoint, being “From the outset, the company will be a leading supplier of flash memory solutions for wireless communications,” with “the scale to benefit from the increasing demand for memory resulting from the growing amount of information and content that is becoming more mobile and is now based almost entirely on digital technology.” Instead, I was most interested in the structure of the deal itself:

Under the terms of the agreement, STMicroelectronics will sell its flash memory assets, including its NAND joint venture interest and other NOR resources, to the new company while Intel will sell its NOR assets and resources. In exchange, Intel will receive a 45.1 percent equity ownership stake and a $432 million cash payment at close. STMicroelectronics will receive a 48.6 percent equity ownership stake and a $468 million cash payment at close. Francisco Partners L.P., a Menlo Park, Calif.-based private equity firm, will invest $150 million in cash for convertible preferred stock representing a 6.3 percent ownership interest, subject to adjustment in certain circumstances. Concurrently, the parties have arranged for the new company to receive firm commitments for a $1.3 billion term loan and $250 million revolver. The term loan will be underwritten by a consortium of banks. Proceeds from the term loan will be used for working capital and payment to Intel and STMicroelectronics for the purchase price. The transaction is subject to regulatory approvals and customary closing conditions and is expected to occur in the second half of 2007.

This structure is interesting for a couple of reasons. First, Intel and STMicroelectronics will be receiving $900 million for the 6.3% stake they give up, but Francisco Partners will only pay $150 million for it. The rest will be provided by new debt held by the venture, with the risk presumably shared proportionately among the owners.
Second, the $900 total payments to Intel and STMicroelectronics for the 6.3% they will not own effectively values the total company at $14.3 billion, or roughly 4x revenues (though that valuation overstates things a bit because the convertible preferred shares offer a superior risk/reward than regular common shares would). Alternatively, the $150 million paid for the stake would assign a valuation of just 0.7x sales. The latter figure is similar to the 0.6x sales “enjoyed” by flash leader Spansion. However, neither appears even close to Micron’s (MU - Annual Report) 1.5x sales, or SanDisk’s 2.9x.

More interesting still is the fact that a partner was brought in for a 6.3% stake at all. One very important consequence is that the minority partner prevents either Intel or STMicro from owning 50% or more, which affects the way the joint venture’s results will flow through to the parent company financial statements.

Intel – the Equity Method

For Intel, the ownership stake of 45.1% suggests that the new company’s results will be reported using the equity method. This means, essentially, that only the JV’s net income and equity will appear on Intel’s financial statements. Assets, liabilities, sales, expenses and pretty much everything else stays off Intel’s financials. The obvious benefit is that net profit margin will be higher as it reflects the net income (numerator) but not sales (denominator) from the JV. In addition, other ratios such as return on assets and debt/equity could potentially appear more favorable.
STMicroelectronics – Equity or Proportionate Consolidation?

For STMicroelectronics, which adheres to International Accounting Standards (IAS) but also reconciles them to U.S. GAAP due to its U.S. exchange listing, the issue is a bit more complicated. IAS 31 states that “proportionate consolidation better reflects the substance and economic reality of a venturer’s interest in a jointly controlled entity, that is control over the venturer’s share of the future economic benefits.” Although the equity method is an allowed alternative under IAS 31, the clear preference is for STMicroelectronics to proportionately consolidate – that is, record its 48.6% share of assets, liabilities, revenue and expenses.

Yet the press release describes both STMicroelectronics and Intel’s ownership as “equity ownership stakes” which may imply that they both intend to use the equity method. That, in turn, suggests that STMicro’s 48.6% stake (making it the largest owner) somehow does not allow it to “jointly control” the entity. Perhaps Francisco Partners has an influence (such as Board membership) that is out of proportion to its 6.3% financial stake.

The Role of Francisco Partners

Without the third partner, Intel and STMicro would either have had to structure the deal to give STMicroelectronics control (which would require them to report all of the venture’s financials as their own) or to arrange a payment that would give them equal ownership. Intel would still be able to use the equity method in either situation, but perhaps would not want STMicroelectronics to be the controlling party. By bringing in the third partner, it knocks both of the primary owners into a more equal secondary status that both may consider more fair.

And of course, the more favorable financial reporting is a nice side effect.

Disclosure: William Trent has a long position in SMH.

When a mature business can’t generate enough cash to fund its operations, it usually takes the hint and
Micron Announces Proposed $1.1 Billion Offering of Convertible Senior Notes:

Micron Technology, Inc., (NYSE:MU – News) today announced that it intends to offer, subject to market and other considerations, $1.1 billion aggregate principal amount of unsecured Convertible Senior Notes due June 1, 2014. Micron also intends to grant the underwriters an over-allotment option to purchase up to $165 million aggregate principal amount of additional notes. The interest rate, conversion price and other terms of the notes will be determined by negotiations between Micron and the underwriters. Morgan Stanley & Co. Incorporated will act as sole bookrunning manager for the offering.In connection with this offering, Micron plans to enter into capped call transactions with one or more counterparties, which may include some of the underwriters and/or their affiliates. The capped call transactions are expected to reduce the potential dilution upon conversion of the notes. The capped call transactions are expected to be in three tranches with cap prices ranging from approximately 50% to 100% higher than the closing price of our common stock on the date of pricing.

Micron intends to use a portion of the net proceeds from this offering to pay the cost of the capped call transactions entered into in connection with the offering of the notes. The remaining proceeds from the offering will be used for general corporate purposes, including working capital and capital expenditures.

So, in a one-two punch that almost seems designed solely to infuriate me, Micron is using complex convertible securities, which I consider to be financial sleight-of-hand, so they can keep funding the capex levels I already think are too high. Why can’t they take the hint that there are too many memory chips already, and cut their capex by $1.1 billion instead?

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.