The industry is making its way into new markets as an increasing number of devices are hooked up to the internet and given brains. (Source: Bloomberg)When a sector has as big a run as chip stocks over the last year, the temptation is to take money off the table. Maybe not this time. The Philadelphia Semiconductor Index, composed of 30 chip-related companies, has gained 47 percent since last April, fueled by an unprecedented flood of mergers and orders for products that make up the guts of gadgets like refrigerators to smartphones. That’s made the $300 billion industry look expensive relative to earnings as growth is expected to moderate.
What it hasn’t done is make a seller out of Kim Forrest, senior equity analyst at Fort Pitt Capital Group, which manages $2 billion and owns Intel Corp. and Texas Instruments Inc. Bear cases on semiconductors miss that the industry is making its way into new markets as an increasing number of devices are hooked up to the internet and given brains, she said.
“The number of products that these things go into has expanded,” said Forrest, who thinks the rally will continue while cautioning that expansion from new demand will be lumpy. “Cars are getting smarter.” The price-earnings ratio for the semiconductor index is 28, compared with an average of 22 over the last seven years and 22 currently in the S&P 500 Index. Chip stocks are trading at records after a rally that exceeds every industry but financials over the last 12 months.
It’s no use comparing today’s valuations to historical norms, said Betsy Van Hees, an analyst with Loop Capital Markets in San Francisco. Consolidation has helped many acquirers add scale, reduce costs, raise prices and improve profitability. Earnings are rising to justify the gains in stock prices, she said. “Old valuation guidelines don’t apply,” Van Hees said. “We’re entering into a different era for the industry.”
While the road to destitution is paved with claims that this time it’s different, look at a company like Micron Technology Inc., the third-best performer in the benchmark chip index over the last 12 months. On March 23, the company forecast third-quarter revenue of as much as $5.6 billion. That compared with an average analyst estimate of $4.8 billion.
Still, the two highest fliers in the Philadelphia index over the last year, Advanced Micro Devices Inc. and Nvidia Corp., are starting to look a little more pedestrian.
AMD, after gaining more than fivefold in the last 12 months, has seen its short interest as a percentage of the free float rise to 13.7 percent compared with a multiyear low of 4.9 percent in September, according to Markit data. Its return to regular profitability depends on the popularity of its new Ryzen processor, which went on sale in early March. Some reviewers have criticized its gaming performance. And last month, AMD’s largest shareholder, Mubadala Development, sold almost a third of its stake.
Goldman Sachs Group Inc. analyst Toshiya Hari initiated coverage of the stock on April 6 with a sell rating, saying that even if those new chips are successful, the company’s competitors are likely to fight back with price cuts, hurting its future profitability. Nvidia, which added more than $40 billion to its market capitalization in the same period, fell below its 50-day moving average on Feb. 17 for the first time in more than a year. The company’s shares have been downgraded to the equivalent of sell by at least three analysts since February.
Among the bearish arguments against the company are its high valuation, declining fundamentals and increasing competition. Nvidia surged last year as investors bet on its ability to become the main provider of chips that power self-driving cars and artificial intelligence systems.
Some of the issues that increased industry sales and the boost in shares may be slowing. The market for chips will expand by a double-digit percentage in the first half of 2017 and slow in the second, according to Srini Pajjuri, an analyst with Macquarie in San Francisco. Most of that expansion will probably come from the memory market, benefiting companies like Micron. Consolidation also is drying up. There have been only two chip-related acquisitions valued at $1 billion or more announced in 2017, according to data compiled by Bloomberg. That compares with 13 last year.
“As M&A slows and as revenue momentum slows, the upside potential is definitely limited,” Pajjuri said. He expects some stocks like Broadcom Corp., Intel and Micron to outperform and the industry as a whole to be “range bound.” Fort Pitt’s Forrest said the push by companies to own technological capabilities that will be at the heart of things like self-driving cars is such that acquisitions could continue, despite the higher prices. That said, investors need to be more choosy and not bet on across-the-board gains by chip companies unless the economy picks up.
“If you’re going to invest in this sector, you really have to do your homework and understand which ones grow with the total addressable market and most importantly is this a winning technology,” she said. “You have to understand that not all of the technology will survive.”