It has been a great year for semiconductor stock. This is important to the industry as stocks are often used to finance acquisitions and major investments. The industry is also known for its extensive use of options and warrants to keep executives and key people locked in. There is no problem in connecting results to rewards unless the increasing stock price is a result of speculation and not underlying results. A stock bubble might benefit a couple of lucky bankers but to most stakeholders it is damaging. The value created by the bubble will have to be paid back, and then some. People will get great bonuses and then get fired. Investments started and stopped.
The obvious question
Nobody wants to spoil the fun and ask the obvious question: “Why are semiconductor stocks growing when the semiconductor revenue is not?”
Although revenue growth is one of the most important value drivers there could be other reasons for stocks to climb. One of the valuation methods used by financial analysts is the Shareholder Value Analysis (SVA). The analysis values a company based on its ability to deliver future cash flows. The model has 7 value drivers (as can be seen in the graphic) that create the valuation of a company. If the market change opinion about a company’s future revenue growth rate, the SVA shows a higher value for the company and the market respond immediately by adjusting the stock price accordingly. In theory at least. If the stock market and the underlying value drivers are out of sync, there is a high probability of a depression or a bubble.
The 7 drivers are:
- Revenue Growth. Although there was an uptick in Q4-16 revenue the industry has been in low single digit growth for some time. This is not likely to change.
- Operating Margin. Operating margins fell by 170 basis point from Q4-15 to Q4 -16
- Taxes. The tax environment has two opposing forces: It is becoming more difficult to offshore profit for lower tax reasons and potentially lower corporate tax in the US.
- Working Capital Investments The investments in working capital are likely to be flat following the revenue growth.
- Fixed Capital Investments It is not becoming cheaper to participate in the industry. Both investment in replacement and new equipment only goes up.
- Cost of capital. After many years with access to cheap captial, there are signs of increasing costs.
- Life of strategy. There are many signs the current strategies are coming to an end. Exploding costs of chip design and the end of Moores law.
From our perspective, there are no value drivers for the industry that warrants the current increase in stock prices. This does not mean that investing in individual companies still can be a good idea. All markets have winners and losers.
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