Editor's Note: This article was originally published at 12 p.m. EDT on Real Money on Aug. 19. Sign up for a free trial of Real Money.
Is it time to unplug from semiconductor stocks? While I'm not a chart watcher, my friends are, and they are growing increasingly worried about the Philadelphia SOX index. It seems the character of the index changed after the Fourth of July holiday. The SOX ran up 15% from mid-May to early July and since then has shown signs of topping. According to them, momentum has slowed. Since I'm not a technician, I decided to take a look at the fundamentals of the two hottest names in the group.
Year-to-date, the best performing stock in the semiconductor group is TriQuint (TQNT) , up 132%. The second best performer is merger partner RF Micro Devices (RFMD - Get Report) , which is up 128%. The merger between the two should be completed in the second half of 2014.
In the 1990s, both companies were seen as niche semiconductor makers churning out boring, low-margin parts for microwave communications and radar. But when the smartphone business took off six years ago, TriQuint and RF Micro Devices were perfectly positioned. Both companies have extensive portfolios of high-performance chips that are critical to mobile devices. In fact, about 66% of TriQuint's revenues come from mobile handsets. The rest of the company's revenue comes from networking infrastructure (21%) and defense (13%).TriQuint and RFMD are both known for their expertise in working with gallium arsenide (GaAs). GaAs is a very difficult material to work with and is used for high-frequency communications. Because GaAs is such a specialized field, TriQuint has had to develop its own proprietary manufacturing techniques and owns its own fabs. TriQuint and RF Micro have a huge advantage over other semiconductor companies in the communications game. A typical 3G handset contains five power amplifiers, all made out of gallium arsenide. In fact, the most critical parts of a cellular handset are 100% gallium arsenide. This has kept semiconductor bullies like Broadcom (BRCM - Get Report) out of the high frequency game. In a 3G handset, TriQuint's bill of materials is around $3.75, but in a 4G LTE phone, the bill of materials is over $12.75. Of course, those handsets need to connect to base stations and both companies are major suppliers to base station makers. Infonetics Research estimates China alone will need about 700,000 new cellular base stations to support its 4G rollout. In mobile communications, TriQuint's addressable market is over $7 billion a year, growing at 15% a year. While many people think the smartphone market is saturated, they don't realize that 50% of the phones in the world are still 2G. As those phones are upgraded, RF Micro Devices and TriQuint should benefit. Seventy percent of RF Micro's revenues come from power amps and signal filters. Together, both companies have a unique and defensible position in the semiconductor industry. Their product portfolio spans power amplifiers, signal filters, antenna tuning, Wi-Fi, radar and optical drivers. Boring no more. Since the combined companies have a unique position in the industry, they are able to drive revenues above the industry's growth rate with a 25% operating margin. In the first year of the merger, management thinks gross margins should improve over 700 basis points, as the companies eliminate overlap between product lines. In the just-reported second quarter, TriQuint saw its revenue grow 21% over last year and 30% sequentially to $230.8 million. Gross margins jumped from 29.8% last year to 40.2%. With such strong stock performance this year, it's pretty obvious the market has figured out the merger was a good idea. With my chart-watcher friends concerned about the group's momentum, I have to be cautious. For now, I'll stay on the sidelines and see if they are right.