by Joe Lan, CFA
The technology sector, especially the semiconductor industry, is extremely fast-paced. Over the past 20 years, we have witnessed exponential advancements in computing power that can be mostly attributed to the development of semiconductors. The tremendous growth in semiconductor computing power has followed Moore’s Law. For those who are not familiar with Moore’s Law, Gordon Moore, one of the founders of Intel, famously said that the number of transistors that can fit onto a single chip doubles roughly every two years, resulting in both faster performance and lower cost. This rapid exponential pace of technology improvement allows numerous industries in the technology sector to offer ever-smaller and more powerful gadgets at ever-lower prices every year.
In this installment of Tracking the Tech Sector, we delve into the semiconductor industry and discuss some general trends. The innovation that is the basis of the semiconductor industry prompts continual improvement in numerous other industries in the technology sector, and this characteristic makes it the natural industry to begin the Tracking the Tech Sector series with. Beyond discussing the general trends and outlook of the semiconductor industry, I also take a close look at two market leaders in the industry—Broadcom Corp. (BRCM) and Texas Instruments Inc. (TXN). These companies are discussed using data elements that are uniquely important to companies not only in the technology sector, but also specifically in the semiconductor industry.
Outlook for the Industry
Despite slow and uneven U.S. economic growth and the current issues that still plague Europe, the semiconductor industry is poised to continue its rate of growth over the next few years as an increasing number of semiconductors are found in ever more items. The global semiconductor industry is linked directly to the demand of its end markets, which are highly diversified. Major markets for semiconductors include data processing (computers, smartphones and tablets, etc.), communications (Internet and telephone systems), consumer electronics (household appliances, televisions and gaming consoles, etc), automotive (cars and trucks) and infrastructure (infrastructure, smart grids and rail services, etc.). As a result, general global economic trends have a strong correlation to growth in the semiconductor industry. Geographically, McKinsey & Co., a leading management consulting firm, stated that China’s semiconductor consumption has grown at around 20% per year and the country now consumes around 40% of the world’s semiconductor production. Needless to say, the economic health of the U.S, Europe and China will play a vital role in semiconductor demand going forward.
According to the International Monetary Fund’s (IMF) 2013 World Economic Outlook, the world’s economy should continue to grow in 2014 and 2015. Table 1 shows the IMF projected growth rates for the world, for developed and developing economies. As the major driver for developed economy growth, a projection for the U.S. is also reported, and as the major driver for developing economy growth, a projection for China is shown.
|Source: International Monetary Fund’s (IMF) 2013 World Economic Outlook.|
While economic growth does not guarantee growth in the semiconductor industry, a study issued by PricewaterhouseCoopers found a strong correlation between the growth rate of global gross domestic product and the growth rate of global semiconductor sales. The study also suggests that demand will continue to be the highest in China, particularly in automotive and industrial sectors.
Standard & Poor’s has a similar outlook on the semiconductor industry. It expects that the current fairly lean company inventories will mean an increase in semiconductor demand as some companies replenish their stocks. The research firm also sees a shift toward tablets, growth in smartphones and favorable tailwinds in the automotive sector.
Key Elements to Examine
There are a number of key elements that analysts use to evaluate semiconductor firms.
As with most technology companies, strength of intellectual capital plays a vital role. Strength of intellectual property refers to a company’s patents, copyrights, design rights and trademarks, as well as more qualitative factors such as pool of talent, ability to create in-demand products and perception of quality. Often, the value of a technology firm is predicated almost exclusively on these intangible assets. Companies with strong intellectual property are generally market leaders with the ability to charge a premium for their products, leading to stronger margins. Additionally, these companies tend to continue to attract the most talented individuals. However, intangible assets are hard to value and are often prone to “impairment,” which requires a write-down of their value in subsequent periods.
Growth drivers and revenue enhancement make up another key element of semiconductor company success. Though this seems obvious in all companies, semiconductor companies often spend a large amount on research and development (R&D) and have sizable fixed costs from massive manufacturing facilities. Growth and revenue increases allow companies to spend additional resources on R&D and improve fixed-cost absorption, leading to a strengthening cycle. Table 2 presents R&D costs as a percent of revenue for semiconductor firms compared to the overall technology sector and the market.
|S&P 500 Index||7%|
|All Listed Stocks||10%|
|Source: AAII Stock Investor Pro.|
Customers and strategic relationships are also key for the industry. Semiconductor companies often have extended relationships with several major customers, supplying technology to these customers for years. The strength of these relationships and, to a certain extent, the success of these customers, play a vital role in the success of a semiconductor company itself. But it’s important for companies to maintain a balance. A high reliance on one or two customers for a big portion of revenue can be risky.
Along the same lines, switching costs are also important for the semiconductor industry. Switching costs are the negative monetary, psychological or effort- and time-based costs consumers may incur as a result of changing brands, products or services. A number of firms have been successful at creating such strong ecosystems that customers do not want to incur the time and expense to switch to a competitor.
The book-to-bill ratio compares orders received to units shipped and billed for a specific period for a company. This ratio is used frequently in analyzing technology firms, specifically those specializing in hardware such as semiconductors. A book-to-bill ratio greater than 1.0 means that more orders were received than shipped and billed during the period, a sign of strong demand. Generally speaking, a book-to-bill ratio over 1.0 is a good sign for technology companies. Of course, there are negative implications if a firm’s book-to-bill ratio is consistently above 1.0, which may indicate that the company cannot keep up with demand and may be losing opportunities (or needs to expand in the near term). However, not all companies provide their book-to-bill ratio. In the first part of 2014, the North American semiconductor industry posted book-to-bill ratios of 1.04, 1.01 and 1.06 in January, February and March, respectively.
Broadcom Corp. (BRCM) is a global semiconductor company providing products for wired and wireless communications. Broadcom chips are used globally by leading manufacturers and are embedded in an array of communications products that are structured around three segments: broadband communications (devices for home use including laptops and desktops), mobile and wireless (handheld devices including tablets) and infrastructure and networking (infrastructure). The company’s products for the home include integrated and complete chip designs for set-top boxes and broadband access. Handheld device products are primarily for mobile devices that include integrated wireless connectivity and cellular chips. Products for infrastructure include integrated chips for Ethernet, communication processors and wireless infrastructure chips.
Strength of Intellectual Capital
Broadcom is a leader in the semiconductor industry and has shown the ability to integrate a wide variety of functions onto a single chip. The company currently holds more than 9,000 U.S. and 3,850 foreign patents, which is an increase from the 7,800 U.S. and 3,100 foreign patents that it held in 2012. In addition, the company has more than 9,000 additional pending patent applications in the U.S. and foreign countries.
The company has developed a highly skilled R&D staff that consists of a large team of engineers, many of whom are leaders in their particular field or discipline. As of December 31, 2013, Broadcom had approximately 9,800 R&D employees, which is approximately 78% of its total employees. The company stated that 850 of these employees have Ph.D.s. The ability to attract and retain talent is vital. It takes years for a company to train individuals on design and improvement of proprietary designs, and Broadcom has one of the best staffs. These key employees are involved in advancing the company’s core technologies as well as product development. Broadcom is focused on increasing intellectual property integration and the timely introduction of new products, which are essential to the company’s growth.
Table 3 shows Broadcom’s R&D expenditures in dollar amount and as a percent of revenue for the last three years. Broadcom also has design centers throughout the U.S, including principal design facilities in Irvine, California, and Santa Clara County, California. Internationally, the company has design facilities in Asia, Europe and the Middle East.
|R&D Expenditures (Billions)||$2.49||$2.32||$1.98|
|Percentage of Revenue||30.0%||29.0%||26.8%|
|Source: Broadcom 10-K report.|
Growth Drivers and Revenue Enhancement
Broadcom has expertise in a variety of chip designs that serve numerous industries. Geographically, Broadcom generated over 50% of its revenue in 2013 from China and Hong Kong. The diversification of Broadcom’s end products along with the geographical distribution of its products means that the company’s growth for the next few years will be closely tied to the growth in the Chinese and Hong Kong economies.
While Broadcom should continue to perform well in the networking and broadband segments, the mobile arena could potentially be the company’s biggest driver of growth. Samsung and Apple (AAPL) are the company’s two largest customers and these two firms have a dominant position in the mobile and smartphone arena. It is certainly plausible that Apple and Samsung will continue to flourish, especially in the expanding Chinese and Hong Kong markets and in the smartphone and mobile computing arena, which would make Broadcom a beneficiary.
Customers and Strategic Relationships
Semiconductor firms often have strong strategic relations with a number of companies. It is often difficult for a consumer to move from a semiconductor supplier to a different supplier due to costs associated with implementing new technologies in products. We do not expect Broadcom to be able to take significant market share from other established semiconductor companies, but, along the same lines, we expect Broadcom to continue working with its current customers.
A smaller number of customers have historically accounted for a substantial portion of Broadcom’s net revenue. The portion of net revenue attributed to these customers has increased in the last several years, as shown in Table 4. The table also highlights the increasing reliance of Broadcom on Samsung due to Samsung’s the rise of sales, especially in China.
|Top Five Customers||48.3%||46.9%||42.3%|
|Source: Broadcom 10-K report.|
Broadcom has not discussed its book-to-bill ratio since 2005, and we were not able to find recent figures for units shipped or billed for the recent fiscal years. Generally, the book-to-bill ratio is discussed in earnings releases, management conference calls with analysts or 10-K and 10-Q filings. However, there are times when none of these reports contain the information, which was the case for Broadcom.
As with all investments, there are certain risks associated with Broadcom. Specifically, one of the greatest risks involves Broadcom’s large reliance on mobile, especially Samsung, for its current growth. Samsung has been able to greatly increase its market share, especially in emerging economies, due to its wide range of handsets. More recently, however, the company is facing intense competition from cheaper options built by Chinese manufacturers. With Apple in the high-end arena and cheaper options available in the lower-end arena, Samsung may be approaching its peak market share in mobile. The company has also invested heavily in making chips for Nokia, which has shut down its Symbian platform in favor of Windows (it was recently bought by Microsoft), meaning that it will likely be less reliant on Broadcom chips.
Because of Broadcom’s heavy reliance on Samsung and Apple, company growth is also heavily tied to the general health of the smartphone and mobile computing segment. Product cycles for smartphones and mobile computing are notoriously fast, and products go in and out of favor with consumers very quickly. As opposed to firms that supply most of their chips to broad industries such as automobile or industrial, Broadcom’s exposure to the smartphone and mobile computing landscape increases the risk of revenue fluctuations. In addition, research from McKinsey & Co. is predicting that automotive and industrial sectors will drive semiconductor demand in the next few years rather than smartphone and mobile computing, which adds to Broadcom’s risk. Samsung and Apple may also have pricing power over Broadcom, as the company wants to avoid losing them as customers, which would present an additional risk factor. There has also been recent talk of Apple making its own chips, which would significantly hurt Broadcom sales.
Texas Instruments (TXN) designs and manufactures semiconductors for electronics firms around the world. The company expects its analog and embedded processing segments to be the primary growth engines in the years ahead, so it has focused its resources on these two segments.
Analog semiconductors change real-world signals such as sound, temperature, pressure or images into a stream of digital data that can be processed by other semiconductors. Analog semiconductors are also used to manage power in every electronic device, whether plugged into a wall or running on a battery. The company estimates that it sells analog products to more than 100,000 customers in a variety of industries and markets, but particularly concentrated in personal electronics and industrial. Sales of analog products generated about 60% of Texas Instruments’ revenue in 2013. According to the company, the worldwide market for analog semiconductors was about $40 billion in 2013 and the company’s analog revenue in 2013 was $7.2 billion, or about 18% of the worldwide market, which is the leading position in a very fragmented market.
Embedded processing products are the “brains” of many electronic devices. The embedded processing products are used in many markets, particularly industrial and automotive. Sales of embedded processing products generated about 20% of the company’s revenue in 2013. Texas Instruments stated that the worldwide market for embedded processors was about $17 billion in 2013, with the company’s embedded processing segment taking about $2.4 billion of that market. This was the number-two position and represented about 14% this market.
Other areas represent a small and decreasing portion of the company’s total revenue. Texas Instruments is continuing to wind down other aspects of its wireless business to stay focused on analog and embedded processing products.
Strength of Intellectual Capital
Morningstar provided some great insight on the strength of Texas Instruments’ intellectual capital, stating that the company’s proprietary designs represent an effective barrier to entry. “Analog engineering talent is difficult to come by, as greater emphasis is placed on digital chip improvements, and it often takes years to train up-and-coming analog engineers in the intricacies of chip designs. Thus, it is extremely difficult for startups to replicate the many years of analog expertise held by incumbents.” Large analog chipmakers also face stringent quality requirements in some markets, such as the automotive industry, where defects can be as low as one part per million. This makes it extremely difficult for new, smaller companies to compete with the major players, even though the analog marketplace is quite fragmented. In addition, there is not much of a price difference among analog chips, so customers purchase analog chips based on performance, which gives Texas Instruments’ proprietary designs even more weight.
Texas Instruments, like most chip firms, owns numerous patents, and has many patent applications pending in the U.S. and other countries. Texas Instruments has developed a broad patent portfolio and is continually adding additional patents. The company also has agreements with numerous companies involving license rights. These semiconductor patents are an ongoing contributor to revenue and, going forward, the company needs to be able to successfully develop new and improved designs and win additional patents to continue to enjoy market leadership.
Texas Instrument’s R&D expenses signal a slight pullback recently, as shown in Table 5. While a reduction in R&D expense is generally an unfavorable sign for semiconductor firms, Texas Instruments’ pullback may be due to its increased focus on analog chips and away from wireless chips. Compared to wireless chips, analog chips tend to have longer life cycles, which require less research and development. Table 5 also shows R&D expenditure as a percentage of revenue: It is important to note that the decrease in R&D over the last few years does not seem to be negatively impacting revenue expansion.
|R&D Expenditures ($ Billions)||$1.52||$1.88||$1.72|
|Percentage of Revenue||15.4%||14.7%||12.5%|
|Source: Texas Instruments 10-K report.|
Growth Drivers and Revenue Enhancement
Texas Instruments generates revenue from all over the world. The company generates around 60% of its revenue from Asia, not including Japan. This area of the world is one of the fastest-growing. In contrast to Broadcom, Texas Instruments does not have a large customer that it relies on to generate more than 10% of its sales. Texas Instruments has strong sales in automotive and industrial, which should be large drivers of growth going forward. According to a PricewaterhouseCoopers study, the automotive industry, especially in China, is positioned to continue its impressive growth, with additional families purchasing automobiles and additional chips per automobile. PricewaterhouseCoopers believes that the automotive chip segment will grow by 12.2% annually in the BRIC region (Brazil, Russia, India, China and South Africa) and 7.1% annually in the U.S. over the next three years. In total, the research firm expects the automobile industry to grow by 6.8% annually. Texas Instruments is well positioned to benefit from this growth.
Customers and Strategic Relationships
As mentioned, Texas Instruments does not have a single customer that accounts for more than 10% of its revenue highlighting the company’s customer diversification. An important characteristic of the company’s embedded processing products is that its customers often invest their own R&D to write software that operates on Texas Instruments’ products. This investment tends to increase the length of customer relationships because many customers prefer to reuse software from one product generation to the next.
This gives us confidence that Texas Instruments will be able to generate revenue and earnings in the foreseeable future. Once electronics manufacturers select an analog chip, they tend to stick with the chip for the life of the device because it is costly to redesign a device in order to swap in a competing chip that might not necessarily be compatible with the rest of the product. In turn, analog chipmakers like Texas Instruments tend to have lower ongoing R&D costs and capital expenditure investments relative to wireless chip and microprocessor makers, which helps to contribute to healthy returns on capital for shareholders. However, having a large number of smaller customers means that Texas Instruments is unlikely to benefit from outsized growth through the success of one customer, such as Broadcom might experience with Samsung or Apple.
Texas Instruments, unlike Broadcom, reports its book-to-bill ratio, which has seen a favorable trend lately: It increased from 0.94 at the end of 2013 to 1.03 after the first quarter of 2014. In the company’s first-quarter conference call, the firm mentioned that the current backlog leads Texas Instruments to expect that it should have reasonable growth in total revenues in the second quarter of 2014. Recall that a book-to-bill ratio over 1.0 means that the company was able to book more orders than it was able to finish and bill during the quarter. Generally, a book-to-bill over 1.0 is a good sign, though a continuous book-to-bill ratio significantly over 1.0 may signal that a company is not properly meeting all demand.
Even though the embedded and analog chip markets are highly fragmented, companies usually have their own proprietary designs, which means that a shift in market share is very gradual as it is difficult for companies to take customers from other firms. While Texas Instruments has high exposure to growth industries in high-growth regions, it is not guaranteed that the growth will come to fruition.
In addition, Texas Instruments, like most leading semiconductor firms, also has high fixed costs due to the manufacturing facilities needed to produce semiconductors. Since these costs are fixed, they cannot be reduced easily. The semiconductor market historically has been characterized by periods of tight supply caused by strengthening demand followed by periods of surplus inventory caused by weakening demand. These periods are typically referred to as upturns and downturns in the semiconductor cycle. The semiconductor industry is a highly cyclical business predicated on earning enough when the market is strong to be able to spend enough on R&D and production costs while maintaining production facilities when demand is soft.
Comparing the key analysis elements for each firm provides a picture of the differences between two very similar companies. Both companies own a wide range of patents, have their own proprietary designs and employ a staff of able engineers. For companies of such similar size and visibility, it is difficult to distinguish a leader in strength of intellectual capital. Both Broadcom and Texas Instruments are strong companies that can attract and retain talent, but neither has the “star” drawing power of Apple or Google (GOOG). However, Texas Instruments spends significantly less on R&D both as a portion of revenue and on an absolute basis than Broadcom. For the sake of comparison, Qualcomm (QCOM) spends approximately 20% a year as a percentage of revenue on R&D, while Micron Technology (MU) spends approximately 10% per year on R&D. Using these figures as a gauge, it seems that Texas Instruments’ R&D expenditures is consistent with that of its peers, while Broadcom has significantly outspent its peers in recent years. Broadcom’s R&D spending in has come in conjunction with increases in revenue, while Texas Instruments' revenue has been static for the past few years.
Broadcom and Texas Instruments also have very similar competitors. Morningstar shows that the companies compete heavily with each other. In addition, Broadcom and Texas Instruments both compete directly with Intel and Taiwan Semiconductor Manufacturing. There is not much differentiation between the companies from a competition standpoint.
The two companies also have different end-market exposure, leading to different drivers of growth. Broadcom’s recent growth has been due to its higher exposure in the smartphone and mobile computing arena. Apple and Samsung now account for more than 30% of the company’s revenue. Alternatively, Texas Instruments is less reliant on smartphones and mobile computing and has more exposure to the automotive and industrial industries. Both companies are heavily exposed to the Greater China region, and to a lesser extent the U.S. and Europe. In recent years, smartphone and mobile computing exposure, especially in development markets such as China, has been a strong catalyst for growth. This has undoubtedly helped Broadcom grow its revenues, as evidenced by the company’s increasing revenue stream from Samsung. However, going forward, research is showing that the automotive and industrial areas may lead the charge.
The main difference in the companies’ customers and strategic relationships is that Broadcom relies heavily on Samsung and Apple, while Texas Instruments does not have a large customer on which it generates more than 10% of its revenue. This is a significant difference. Even though customers tend to stick with a semiconductor firm, the fact that Broadcom’s success is heavily influenced by the success of two large customers is an added risk. Should Apple or Samsung discontinue its relationship with Broadcom, it would impact operations significantly.
From a valuation standpoint, it is difficult to use metrics such as price-earnings ratio (P/E) due to the cyclicality of semiconductor firms. Therefore, Table 6 provides several other valuation metrics that may be better options. Normalized P/E, which averages earnings over a specific time frame, is often used for highly cyclical companies. In Table 6, I use two different normalized P/E calculations: Normalized EPS 1 uses average earnings per share over the last seven years and normalized EPS 2 uses the average earnings per share over the last three years and estimated earnings per share over the next three years. Calculating normalized earnings using an average of the last seven years results in $0.93 per share for Broadcom and $1.76 per share for Texas Instruments. Normalized earnings calculated by averaging the last three years and next three years gives $1.95 per share for Broadcom and $2.18 per share for Texas Instruments. Using the two companies’ closing prices on April 25, 2014, the normalized P/E 1 for Broadcom is 32.0 and for Texas Instruments is 26.3, while the normalized P/E 2 is 15.3 for Broadcom and 21.3 for Texas Instruments.
|Broadcom||Texas Intruments||S&P 500|
|EPS||P/E||Rel P/E||EPS||P/E||Rel P/E||P/E|
|Normalized EPS 1||$0.93||$1.76|
|Normalized P/E 1||
|Normalized EPS 2||$1.95||$2.18|
|Normalized P/E 2||
|Expected Growth Rate||8.6%||10.5%|
|Source: Yahoo! Finance and AAII Stock Investor Pro.|
Table 6 also shows relative price-earnings ratios for the companies compared to the S&P 500 index going back seven years. Relative P/Es show whether companies have historically traded at a discount or a premium to the market. Once again, it is difficult to gauge with highly cyclical firms, but these figures indicate that Texas Instruments trades with less volatility relative to the market than Broadcom does.
Overall, Texas Instruments seems to have a better complete profile. Broadcom is spending an exorbitant amount on research and development, and while R&D spending is generally a good sign for semiconductor firms, Broadcom’s expenses may be tied to having demanding customers such as Samsung and Apple. The diversification of Texas Instruments’ customers and the company’s exposure to the automotive and industrial industries in emerging economies should allow Texas Instruments to grow at a faster pace going forward. Analysts at I/B/E/S seem to agree, calling for a three- to five-year growth rate of 10.5%, compared to 8.6% for Broadcom.
From a valuation standpoint, the picture becomes a bit more muddled. TXN trades at a slightly lower normalized trailing price/earnings ratio, but at a higher normalized price/earnings ratio when earnings are normalized using a combination of historical earnings and future earnings estimates. Investors seem to be taking a cautious approach with Broadcom, as the large expected increase in earnings may not be realized. In addition, investors appear to be placing a slight premium on the relatively stable earnings of Texas Instruments. Personally, I believe that TXN’s slightly higher forward valuation is warranted for its faster growth, more reliable earnings and diversification of customers, making Texas Instruments the better stock choice.
[Disclosure: Texas Instruments is currently held in AAII’s Dividend Investing portfolio.]