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Buying the technology megatrend

Booming smartphone and tablet sales are creating investment opportunities in the UK semiconductor market
December 12, 2012

Snazzy smartphones and tablet PC devices are not just for Christmas. Despite a faltering global economy, the latest wireless gadgets are in popular demand all year round. This megatrend is not only good for device manufacturers, but also for a string of UK semiconductor companies involved in the supply of mobile-phone chips. Investors might flinch at some of the double-digit forecast PE ratios (see chart), but market growth is similarly exceptional. This sector is booming and is propelling a bull market in the technology hardware sector, which has risen almost 500 per cent over the past four years, making it the best-performing sector in the FTSE All-Share index.

There are few signs that the wireless megatrend powering share price performance is weakening. IDC, a research firm, believes smartphone shipments will reach 718m units this year, an enormous 45 per cent increase. And next year, IDC forecasts the figure will top 917m. Tablet PC sales are also roaring ahead. A 42 per cent jump, to 166m shipped units, is expected in 2013. IDC believes mobile-phone semiconductor revenue worldwide will rise 7 per cent this year, to $57.4bn (£35.6bn), and then reach $62.4bn in 2013.

"This year has been terrible for most semiconductor application markets with the sole exception of wireless," says Dale Ford, senior director at IHS iSuppli, a market research company. More encouragingly for investors, Mr Ford says consumers are still splashing out on smartphones and tablets, while sales of other once-hot products - such as PCs and flat-panel TVs - are on the wane.

And IHS's ranking of the world's top 20 semiconductor suppliers by revenue suggests wireless is the best place for semiconductor firms to be. While seven of the top 10 are expected to see revenues fall during 2012, Qualcomm (QCOM) bucks the trend. With its chips used in a growing number of smartphones and tablets - which also incorporate CPU (central processing unit) designs from Arm Holdings (ARM) - Qualcomm's full-year revenues are projected to grow by an enormous 27 per cent to $13bn. That lifts the US company from sixth to third position in the IHS ranking, sitting behind Intel ($47.5bn) and Samsung Electronics ($30.5bn). Semiconductor companies traditionally focused on the PC market such as Intel and AMD fare less well. Their sales are expected to fall by 2.4 per cent and 17.7 per cent, respectively.

The introduction of LTE, a superfast mobile broadband technology, also promises new opportunities. According to broker Edison, the LTE-enabled iPhone 5 contains 11 Radio Frequency (RF) chips versus six to seven in the iPhone 4. That should benefit IQE (IQE), which supplies bespoke semiconductor silicon wafers to major RF chip suppliers.

On-trend companies

Arm Holdings charges licence fees on its microprocessor designs used by semiconductor companies - around 200 of them so far - which go towards research and development and operational costs. Profits are made when a semiconductor company sells an Arm-designed chip to an equipment manufacturer, which generates a royalty fee. The period between licensing and royalty payments can be as long as four years, but smartphone-related royalty payments - which are higher than basic feature-phone royalties - are now paying off handsomely. In its third quarter, Arm boasted a 27 per cent jump in royalty revenue, to £106.8m. By comparison, the UK firm says the industry royalty growth average is 4 per cent. "We've got strong momentum in royalty revenue, volume shipments and licensing," says Warren East, Arm's chief executive. "Our backlog is at a record level."

Also helping Arm's royalty sales are the inroads made by its more expensive and powerful Cortex-A chips, plus the growing popularity of its Mali-based processors for graphics. But Arm is not only about mobile phones. Of the 2.2bn Arm-designed chips shipped during the third quarter, half were to the non-mobile segment. This includes digital TVs, set-top boxes, microcontrollers and smartcards. Arm chips also support Windows 8, Microsoft's latest operating system, on the 'lite' version of the recently launched Surface tablet.

Edinburgh-based Wolfson Microelectronics (WLF) is riding on the smartphone growth wave, too, courtesy of its innovative audio hub solution. To improve smartphone power consumption, Wolfson takes the voice and audio capabilities from the CPU and combines them on a separate audio hub chip. Sales of Wolfson's mobile audio hubs leapt 53 per cent in the third quarter, boosted by the popularity of Samsung's Galaxy III LTE-enabled smartphone. It helped give the Scottish outfit its first quarterly pre-tax profit in two years ($1.6m) versus a $2.9m loss the previous quarter.

CSR has also experienced a dramatic turnaround in fortunes, but more from reshaping its exposure to the smartphone market rather than increasing it. For $310m cash, CSR sold its low-margin handset connectivity business to Samsung in the summer. This not only increases the company's cash pile, but also allows CSR to focus on higher-margin chip solutions for streaming music and audio to devices using Bluetooth (a short-range radio technology) and to tap into the growing auto info-tainment market.

Company NameTIDMMarket capPriceForecast PETotal revenueTotal revenue (last financial year)Total revenue growthForecast EPS growthDY
Arm HoldingsLSE:ARM£10.4bn754p44£492m£407m18%17%0.4%
Imagination Technologies LSE:IMG£1.14bn438p33£128m£98m30%26%-
CSR LSE:CSR£549m339p14£543m£513m30%53%1.2%
Wolfson MicroelectronicsLSE:WLF£221m197p43£101m£101m-3.2%--
IQE AIM:IQE£168m29p15£75m£73m-8.5%-13%-

Source: S&P Capital IQ

Lack of Imagination

It is not all good news for UK semiconductor firms, though. Imagination Technologies (IMG), a UK-based designer of GPUs (graphics processor units), was dealt a blow in September when Texas Instruments - one of the company's top royalty payers - said it was moving out of the smartphone and tablet markets. The news sparked a retreat from investors, pushing the share price down from 520p to 470p. The share value has continued to drift, sliding to around 440p at one stage, and far from the 12-month April high of 734p.

Increased competition is also a concern. Arm is making progress with its own graphics processor (Mali), while Qualcomm has developed its own GPU - Adreno - which is integrated into the company's snapdragon processors. If better efficiencies can be achieved through close attention to GPU and CPU integration, that might benefit Arm and Qualcomm at the expense of Imagination's standalone designs. Imagination has responded with a move into CPU, offering to buy MIPS, a US design company, for $80m. However, there are other bids for MIPS, so that's not guaranteed.

Lee Simpson, an analyst with broker Jefferies, believes the competitive threats from Arm and Qualcomm are overplayed. For one thing, he argues, Imagination has plenty of royalty revenues in the pipeline through Apple (a minority shareholder in Imagination) and other smartphone manufacturers using the Android operating system. "The enormous growth in smartphone shipments more than trumps other concerns," he says.

For Imagination's full-year 2013 results, ended June, Mr Simpson forecasts an adjusted EPS of 14.51p, a 40 per cent increase over last year's 10.47p, although the 2013 forecast is a downgrade from 23.01p on account of a weakening average royalty rate and thinner licensing than previously expected. For 2014, Mr Simpson expects licensing deals struck in the 2010-11 period to start bearing fruit in royalties, as well as delivering higher margins from the addition of broadcast and video. "We know that Samsung made a licensing deal with Imagination in 2011, so, who knows, it could be in the next Galaxy smartphone," says Mr Simpson.