Semiconductor Stocks: Four Companies With Large End-Market Opportunity

By Fil Zucchi A couple of days after my write-up on SanDisk (SNDK) (see Tech Sector: NAND Flash Memory Is Changing, So Which Names Should You Play?) UBS came out with a top-down research report making the case for and against specific semiconductor stocks given the analysts' view that, as a whole, semis will likely be range-bound for an extended period of time. UBS longs, based on what they view as secular tailwinds, include Altera (ALTR), ARM Holdings (ARM), Broadcom (BRCM), Marvell Tech. (MRVL), Atmel (ATML), Cypress Semiconductor (CY), Cavium Networks (CAVM), Diodes (DIOD), NetLogic Microsystems (NETL), Skyworks Solutions (SWKS), and SanDisk. Their least-favorite names are NVIDIA (NVDA), STMicroelectronics (STM), Texas Instruments (TXN), LSI Corp. (LSI), and RF Micro Devices (RFMD).

(To see David Stockman's position on Simpson-Bowles, click here.)

Now here's the interesting part about that report: With four exceptions, which I will highlight below, the primary differences between the haves and have-nots center on "technical" differences, such as the ability to scale down on the size of the silicon, improvements in the cost structure, persistence of market opportunity, etc. But in no instances is there a new, large-end market, which can overcome the inevitable reality that commoditized goods can be traded on the margin, but cannot be invested, since minor competitive advantages are temporary and their impact is often too small to make a significant difference to the bottom line. Now for the four exceptions, which are Cypress, Cavium, NetLogic, and SanDisk. As I compared the arguments in each of the company-specific reports, the elusive "large end-market opportunity" jumps out in no uncertain terms. For SanDisk it is the transition to SSDs and away from HDDs, which I addressed in the piece mentioned earlier. What was comforting to see wasn't so much that UBS agrees with me, but rather that their number-crunching concludes that the SSD market potential is roughly the same as what I envision.

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For Cavium the holy grail is all about the inevitable build-out of the IP network to support what is seemingly a never-ending growth in the amount of data being released on the Internet. By extension, this makes Cavium multi-core network processors indispensable, and given the small number of players in this space, and the pure-play nature of Cavium, this company has all the positive attributes of a fast-growing, high-barrier-to-entry investment. With such a positive scenario the catch is that the stock's valuation has been high for a long time and only seems to be getting higher. If you also consider that 40% of its sales are concentrated to Cisco Systems (CSCO) you truly have a high-risk/high-reward play, which requires handling with care. NetLogic is a strange animal in the sense that it controls basically 100% of the search-processor market. Now, who does not like a monopoly, you may ask. But the flip side of that coin is that the company can only grow as fast as its end market, since there is no incremental market share to be taken, and you can rest assured that its fat 60% gross profit margins are front and center on the desks of many wannabe competitors trying to snare a piece of the action. So, as in the case of Cavium, the steep valuation of the stock entails high risks for the high potential rewards.

(To view Jeff Harding's position on quantitative easing and fiscal stimulus, click here.)

Last but not least is Cypress, which is a story I have been telling in Minyanville for many years. I will readily concede that Cypress does not have the same proprietary and "big market" tailwinds as the other three companies discussed above. However, what it does have going in its favor is that it is shifting away from commodity products by creating proprietary solutions which are superior to its commodity counterparts but sell at price points which are very similar. In addition, approximately 18 months ago Cypress made a conscious shift toward maximizing profitability and cash flow, a move that has been very successful and has turned the company into a formidable cash generator. But first and foremost for my money, Cypress has the best management in Silicon Valley, which goes a long way in letting me accept some of this company's weaknesses.

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