Microchip makers wired for growth

Double-digit sales growth remains par for the course in this sector. That reflects the rising complexity of today’s mobile devices, which not only require microchips in greater numbers, but also with advanced technical specifications. The advent of '4G' wireless Internet, together with surging demand for online media, and burgeoning interest in 'smart' cars, homes, workplaces and watches have whipped up another tailwind. The outcome should be higher royalties for microchip designers and profits for manufacturers.

The twin trends of 'big data' and the 'Internet of Things' are pushing chipmakers to offer a broad suite of power, visual, audio and connectivity products. Rather than developing new capabilities from scratch, many are bolstering their offerings through mergers and acquisitions. For instance, connectivity specialist CSR (CSR) rebuffed a takeover approach from Microchip Technology (US:MCHP) in favour of Qualcomm's (US: QCOM) 900p cash offer – a 57 per cent premium to its market value at the time. Similarly, Cirrus Logic (US: CRUS) took over Scottish chipmaker Wolfson Microelectronics and Infineon Technologies (Ge: IFX) acquired another power-management chip specialist, International Rectifier (US: IRF).

The frenzy of dealmaking has been fuelled by cheap borrowing, chipmakers' large cash piles and recent share price weakness. There are also the usual reasons for tying the knot: combining customer bases, cutting costs and scaling up to secure better deals with suppliers and favourable tax rates from governments.

But chipmakers haven't had a completely smooth ride this year. The likes of Arm (ARM) and Imagination Technologies (IMG), which license out their microchip designs to manufacturers then collect a royalty for each chip shipped, have suffered from a slowdown in the high-end smartphone market. And several of their customers reduced their inventory in the face of macroeconomic headwinds.

Nevertheless, Arm managed to grow sales and pre-tax profits by 8 and 9 per cent, respectively, for the nine months ended 30 September. It has leveraged its expertise in energy-efficient, low-cost microchips to break into new product segments such as servers. It's now eyeing the smartphone, TV, car and city markets, and finance chief Tim Score sees "no reason why they can't all use Arm's technology". However, Arm’s shares trade at a princely 35 times Numis Securities' forecast earnings of 23.6p, which limits potential upside.

Imagination has taken a similar tack - it aims to dominate the graphics market and gain share in the processor, communications and smart camera markets. In the year to 30 April, its licensing sales rose almost a third to £38m as it inked deals with the likes of Toshiba and Lenovo. But it has struggled to offset an exodus of customers from the fiercely competitive smartphone market. And its shares, despite falling 30 per cent in the past year, trade at a similar forward multiple to Arm's shares.

IQE (IQE), a supplier of the 'wafers' used in microchips, has suffered from the same market trends. But it has benefited from strong demand for sensors that can be used to measure activity, scan fingerprints and track movement. That translated into a 22 per cent rise in first-half constant-currency sales at its photonics division. Moreover, its shares trade at an enticing 8 times N+1 Singer’s forecast earnings of 2.1p this year.

Two of the most promising markets for chipmakers are the automotive and industrial markets, which are clamouring for connectivity and 'smart' upgrades. German chipmaker Infineon - which we tipped in late May - earned about €2bn (£1.6bn), or nearly two thirds of its sales, in those two markets over the first nine months of this year. True, its shares have fallen recently due to fears of flagging demand from Chinese distributors. But strong showings from its peers suggest there's little to worry about. And broker Liberum expects sales to climb 12 per cent to €4.31bn this year, and EPS to surge more than two thirds to 0.44¢.

Investing in the microchip sector does carry risks. For instance, Microchip Technology expects to fall short of its second-quarter sales target due to weak demand in the key Chinese market. Moreover, its chief executive believes that "another industry correction has begun… that will be seen more broadly across the industry in the near future."

That hasn't slowed down Toumaz (TMZ), which provides low-power wireless microchips to the digital radio, connected audio and wireless healthcare markets. One of its latest products is SensiumVitals, a small, disposable, wireless plaster that sticks to patients' chests, monitors their vital signs and beams the information to hospital staff. It is currently being piloted in an NHS hospital and Toumaz has another 100 hospitals in its pipeline. Broker Peel Hunt expects the group's pre-tax losses to narrow from £12.1m this year to £1.5m in 2015, giving losses per share of 0.7p and 0.1p.

Another promising prospect is Nanoco (NANO), which makes fluorescent semiconductor nanoparticles called 'quantum dots' that can be used in lighting, LCD displays, solar cells and bio-imaging. True, its full-year operating loss widened by nearly three quarters to £9.2m. But the group recently signed a joint development deal to make LED lighting products, and US partner Dow Chemical is helping it to build a new factory in South Korea, which could lead to a contract with Samsung, LG or another local customer. Broker Canaccord Genuity forecasts a cash profit of £1.4m in the year to July 2016, surging to about £19m in 2016-17.

Finally, Dialog Semiconductor (Ge: DLGX) continues to bet the house on Apple (AAPL) - a decision recently vindicated by the early success of iPhone 6. The supplier to the wireless, mobile, automotive and lighting industries garners about four-fifths of its revenues from Apple. Analysts at Kepler Cheuvreux forecast cash profits of $231m (£143m) this year, giving EPS of 1.57¢, rising to $294m and 2.28¢ in 2015.

Favourites:

Dutch chipmaker and near-field communication (NFC) specialist NXP Semiconductors (NV: NXPI) looks set to soar. Apple's iPhone 6, Apple Watch and Apple Pay all utilise its technology and should help to drive mainstream adoption. NXP is also growing quickly - its first-half operating profit rose by 46 per cent, after surging by more than half last year. Although its shares have already risen four fifths in the past year, they trade at only 14 times consensus forecast earnings.

Pure Wafer (PUR), which refurbishes the wafers used for testing in semiconductor manufacturing, is another of our sector picks. It recorded a 22 per cent rise in pre-tax profits in its recent full-year results and announced a maiden full-year dividend. And its shares, after slumping a quarter in the past year, trade at a tempting eight times forecast earnings.

Outsiders:

CML Microsystems (CML) makes microchips for the storage and wireless communication markets, both of which have weakened recently. And last half it lost a customer that accounted for about 10 per cent of its storage sales. Those factors explain why broker Cenkos is forecasting a 14 per cent slump in sales this year to £21m, and EPS more than halving to 13.2p. Furthermore, its shares trade at a toppy 22 times forecast earnings.

A broad-based business is typically a blessing, but it can also be a curse. STMicroelectronics (Fr: STM), which supplies the wireless, automotive, industrial and set-top box markets, faces "possible weakness on multiple fronts," says broker Liberum Capital. Reduced customer inventories and fierce competition have weighed on the business and could drive a 5 per cent dip in revenue this year.

The broker's view

It's been a mixed picture for the semiconductor industry this year. After a reasonable first-half performance, marred by patchy smartphone demand, there are now signs of caution in the supply chain and industrial market. But we view recent inventory reductions as largely the result of supply chain sensitivity to economic news flow and suppliers erring on the side of caution, rather than as an indication of lower consumer demand.

After 15 years of smartphone-led growth, microchip companies are looking for the next big thing, whether it be automotive, Internet of Things or wearables. We don't see tablets - which are getting squeezed by consumers opting for large-screen 'phablets' or laptops instead - as a big growth area going forward. The increasing complexity of devices and higher data traffic are contributing to sector growth, but aren't particularly new trends.

However, there has been a distinct acceleration in the electronics content of cars. We think Infineon will be a very strong beneficiary of that trend, and results from its peers suggest automotive demand is healthy and industrial demand is stable. We expect the roll-out of its new 300mm fab to help increase group margins to over 20 per cent by fiscal year 2018. And we think its currently depressed share price provides an attractive buying opportunity.

We view Imagination as having the most potential upside in our coverage given its high operational leverage and expanding market opportunity. We see little difference between Imagination's core technology and Arm's, and it has expanded its market opportunity by investing in new areas such as MIPS and Ensigma, its processor and connectivity offerings. Still, we expect financial improvements to take time due to the five to seven year lag between researching new products and receiving royalties.

We have buy ratings on Infineon and Imagination, with price targets of 250p and €11 respectively.

Janardan Menon is technology analyst at Liberum Capital.