RealMoney Silver - The Case for a Continued Semiconductor Rally

The Case for a Continued Semiconductor Rally
By Bill Trent
RealMoney.com Contributor
4/21/2008 1:14 PM EDT

Ladies and gentlemen of the court, I stand before you today to offer evidence that the recent rally in semiconductor stocks, which has lifted the SOX index nearly 10% this month, is set to continue. While market data are unlikely to ever offer proof beyond a reasonable doubt, I believe the data meet the "preponderance of evidence" standard.

Exhibit 1: Supply and Demand

Aside from the latest trough, in recent history the last time the Philadelphia semiconductor index (SOX) was below the current level was in August 2004. That month, orders for new semiconductor manufacturing equipment, as reported by Semiconductor Equipment and Materials International, were $1.5 billion -- more than double the prior-year figure. This far exceeded the 34.8% growth in semiconductor sales reported by the Semiconductor Industry Association.

What's more, the triple-digit growth rate had been in place for five consecutive months, and equipment orders had grown faster than semiconductor sales for nine months running. Clearly, the equipment being installed was far above what was needed to meet end-user demand for semis, justifying the 30% decline in stock prices experienced by the group.

Things really are different this time. Equipment order growth has trailed semiconductor sales growth for a full year, yet the stock prices have fallen 30%. The capacity restraint that has been shown is bound to show up in higher utilization and profit margins sooner or later -- possibly sooner, if Intel's (INTC) guidance is any indication.

Exhibit 2: Pricing

Tighter supply should eventually be evidenced by stronger pricing. After a surprisingly steep loss of pricing power, it finally appears to be abating. According to last week's PPI report, prices for semiconductors declined 12.5% in March compared with the prior-year period. Although this is still above the average price erosion, just two months ago the year-to-year decline was 21%. I take the current read as a sign that the worst is over.

Click here for larger image.

Source: Bureau of Labor Statistics

Looking toward specific names, I ran a screen on Zacks Research Wizard to identify companies whose gross margins have recently rebounded from trough levels. Programmable logic device makers Altera (ALTR) and Cypress Semiconductor (CY) fit the bill nicely. Their gross margins have been rising for a couple of quarters. However, they have also rallied a bit further than the average semiconductor.

The other strategy would be to try and get ahead of the curve by buying those whose margins haven't yet clearly bottomed. One such name is Marvel (MRVL) . While the analog and mixed-signal chipmaker's margins ticked up a bit in the February quarter, they remain well below average, and while the stock is pushing against the 50-day average, it hasn't made as forceful a thrust as those mentioned above.

Finally, for the truly daring, there is Micron (MU) . Its gross margins in the latest quarter were negative, owing to the rampant overcapacity issues in the memory segment. It looks to me like the consensus estimate for the fiscal year ending in August 2008 is for an average gross margin of 5%. Given that the company's average gross margin over the last five years is 15%, I believe there's room to beat those expectations.