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.

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).

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.

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.

When we previewed earnings, we said, “ST Microelectronics (STM) – Doing the right thing. Hopefully will pay off.” Fundamentally it did not appear to have paid off just yet.

STMicroelectronics Reports 2007 First Quarter Revenues and Earnings:

Net revenues for the first quarter were $2,276 million, decreasing 3.7% compared to the $2,364 million reported in last year’s first quarter, and reflecting a double-digit decrease in the telecom market segment. Flash memory revenues declined 21.6% while all other product sales were flat year-over- year. Sequentially, net revenues decreased 8.4% from the $2,483 million reported in the prior quarter, largely reflecting lower telecom and consumer sales. Flash memory revenues decreased 13.4% sequentially with all other product sales decreasing 7.6%. Year-over-year and sequential growth in automotive, as well as year-over-year growth in the industrial segment were more than offset by declines in other market segments.Gross profit was $785 million for the 2007 first quarter down from the $837 million in last year’s first quarter. The gross margin was 34.5% in the 2007 first quarter. On a sequential basis, gross profit and gross margin decreased from the fourth quarter levels of $901 million and 36.3%.

President and CEO Carlo Bozotti commented, “The trough of the multi- quarter industry correction currently underway appears to be somewhat deeper than we or industry analysts had anticipated.

Well, we told them they needed better forecasts.  That aside, the numbers were slightly below analyst’s sales estimates of $2.3 billion. Earnings per share of $0.08 ($0.09 if you exclude restructuring charges) were also below the $0.12 estimate. And compared to the consensus expectation of $2.41 billion in sales next quarter, management provided a range with a midpoint of $2.43 billion:

Mr. Bozotti stated, “We see sales growth resuming for ST in the second quarter. Specifically, we expect sequential sales growth in the range between 4% and 10%. With respect to the gross margin for the upcoming quarter, two factors are anticipated to limit sequential margin expansion: first, the increased weakness of the US dollar will have a negative impact on ST; and second, an estimated impact of about 40 basis points due to unloading of logic products in our Singapore fab, in connection with the Flash memory carve-out. The result is an expected second quarter gross margin level of about 35% plus or minus 1 percent.”

No specific earnings guidance was provided, but if the other expenses and income are similar to the first quarter levels (ex restructuring) the company would earn approximately $0.15 compared to the $0.17 consensus.

But this is not the time for negativity when it comes to semiconductors, apparently. Like its counterparts yesterday, the poor fundamentals didn’t stop ST from gaining ground in after-hours trading. So, at least for the time being, their good deeds are paying off for shareholders.

The Economic Calendar is relatively light this week. Potential market movers include:

• Wednesday’s Durable Goods report (consensus 2.2%)
• Friday’s advance report on Q1 GDP (consensus 1.8%)

Earnings are another story. We are in the peak part of earnings season this week. A few of the stocks we follow:

Monday

• Altera (ALTR) – valuation is rich but looks set up to beat on earnings.
• Texas Instruments (TXN - Annual Report) – March and June quarters have both had significant downward revisions. Will day of reckoning be forestalled?

Tuesday

• AU Optronics (AUO) – Forecasting losses, but panel business may have bottomed out.
• CDW Corporation (CDWC) – 14.6% sales growth doable given Berbee acquisition.
• CH Robinson (CHRW - Annual Report) – Could beat.
• CSG Systems (CSGS) – earnings should be a piece of cake. If private equity buyers don’t take them out they’ll do it themselves the slow way.
• Lexmark (LXK) – Estimates are doable but we’re always waiting for this company to trip up.
• ST Microelectronics (STM) – Doing the right thing. Hopefully will pay off.
• AT&T (T - Annual Report) – Estimates and stock both keep rising.

Wednesday

• Apple (AAPL) – Hunch: company will blow away earnings, issue horrible guidance and blame it on iPhone build.
• Arkansas Best (ABFS) – We’re staying away from truckers who own trucks.
• Corning (GLW - Annual Report) – current quarter ok, guidance at risk.
• LSI Logic (LSI) – May blame their poor guidance on Agere.
• Maxim (MXIM) – Company is out of gas but focus will be on whether they might sell out.
• Qualcomm (QCOM) – Nokia Nokia Blah Blah Nokia ad nauseam (excerpt from pending conference call transcript)
• Silicon Laboratories SLAB – Sold wireless just when biggest customer began to recover. What other surprises may be in store?
• UPS (UPS) – They shouldn’t have trouble beating the estimates (but that doesn’t mean they won’t).
• Xilinx (XLNX) – Altera with more risk to the earnings target.

Thursday

• Curtiss Wright (CW - Annual Report) – PPI data suggests they should beat big, but it suggested the same last quarter.
• KLA Tencor (KLAC) – Another place we’d rather not be right now.
• Microsoft (MSFT - Annual Report) – Vista is still not living up to expectations.
• MEMC Electronics (WFR) – Earnings surprises have been getting bigger each quarter. Now that we’ve put a semiconductor name on our Large Cap Watch List (Track at Marketocracy) it will probably stop just to spite us.
• YRC Worldwide (YRCW) – See Arkansas Best.
• Sandisk (SNDK - Annual Report) – Will take more than one quarter to clear the channel inventory.

Friday

• Dassault Systemes (DASTY) – We like Ansys (ANSS) better but don’t see why this name wouldn’t beat.
• Ceradyne (CRDN)  – Earnings could be anywhere and don’t really matter.

Enjoy!

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.