Housing Hits the Semiconductor Market; Synaptics Named the Profit Play to Make Now

By William Patalon III and Mike Caggeso
Money Morning

There's a surprising new addition to the long list of industries stung by the U.S. housing slump and the accompanying mortgage crisis: The semiconductor sector.

The housing sector's ills were alleged to have spread to the semiconductor market this week when Microchip Technology Inc. (MCHP) was forced to warn that results for its fiscal second quarter would be below expectations due to lackluster home sales.

Surprised? Turns out that Microchip Tech makes microprocessors that are used in such ubiquitous household gadgets as TV remote controls, garage door openers and remote fan controllers. After the firm announced the earnings shortfall Tuesday, the stock plunged $4.64 per share, or 12.7%, prompting analysts from Thomas Weisel Partners and American Technology Research to yank back their "buy" ratings on the shares of the Chandler, Arizona-based microprocessor maker.

"Although we believe Microchip's long-term business model is among the best in semiconductors, we are downgrading the shares on valuation during this near-term slowdown," Thomas Weisel analyst Kevin Cassidy wrote in a research note that was picked up and quoted by MarketWatch.

The Search for Promising Stocks

The Microchip Tech earnings report is of interest for several reasons.

First, in an investment analysis and preview of the looming third-quarter earnings season that was published early this week, Money Morning cautioned that the uncertain economy would cause investors to scrutinize earnings reports. Companies that disappoint will likely see their shares get savaged. [To access that Money Morning research report, please click here]. Unfortunately for shareholders, Microchip Tech is serving as the perfect case study of what can go wrong during this hair-trigger stretch for investors.

Second, this company alleges it has been singed by the U.S. housing slump and the subprime mortgage mess. If Microchip Tech is truly another victim of this mortgage crisis, it's probably a great company for investors to study in search of ways to avoid similar problems with other companies.

And yet, a number of analysts aren't really buying the company's explanation for the lackluster quarter.

Third, we've pointed out in several other earnings-related research reports that the best U.S.-based investments right now are companies that are overcoming economic softness here in their home market by generating better-than-expected sales and profits abroad. Restaurant operator Yum Brands Inc. (YUM) - which we chronicled in an analysis earlier this week - was able to report better-than-projected earnings of 17%, and boost its outlook for the rest of this year. The reason: Gangbuster sales in China and the rest of Asia that more than made up for the malaise in parts of its business here in the United States.

[To read our analysis of Yum Brands, please click here. As always, this report is free of charge.]

But Microchip Tech appears to be a much less positive story than Yum Brands.

For its fiscal second quarter that ended in September, the semiconductor company reported preliminary earnings of 35 cents per share, or 38 cents per share on an adjusted basis, short of its July prediction of a second-quarter profit of 36 cents, or 39 cents fully adjusted.

Microchip Tech expects revenue to range between $258 million and $259 million, down from an earlier forecast calling for revenue of $264.1 million to $269.4 million.

Wall Street's consensus second-quarter estimate was for Microchip to earn 36 cents per share on sales of $267.3 million.

[Microchip operates on its own fiscal year, and doesn't follow the calendar year; the current quarter - quarter three to most firms - is labeled as its second fiscal quarter.]

Microchip President Steve Sanghi said that the company was "adversely impacted" by the downturn in the U.S. housing market and a decline in consumer spending. While not an ideal situation, our research shows this lackluster showing at home won't torpedo the stock so long as the company makes up the shortfall by doing better than analysts expect in the fast-growing markets of Asia, India and Latin America.

Unfortunately, the company reported that net sales in its "Americas" markets, which include contiguous markets just beyond U.S. borders, were also worse than expected. That's bad enough. But then Microchip noted that sales in Asia were bad, too.

Considering that the company has 10 offices in China and one in Hong Kong - as well as offices in Taiwan, Malaysia, Korea and in other key Asian markets - the dismal performance in Asia had to be excruciating to have to report the shortfall in that key business market.

"The company continued to cite its exposure to weak home construction, but also said consumer spending appears to be faltering and impacting orders by multinational firms with Asian manufacturers," Morgan Keegan analyst Harsh Kumar reported.

Microchip Tech's Sanghi said the company also expects net sales in the December quarter to be less than expected, which he described as "sequentially down."

While unable to provide specific guidance, Sanghi said that "based on the current level of uncertainty in the consumer segment of the business, we expect that the range of our guidance will be wider than typical."

In a rare bright spot in the report, Microchip Tech said it expects to maintain its quarterly dividend increases and to continue with an ongoing stock-buyback plan. It purchased 4 million shares of Microchip stock last quarter, as part of an authorized buyback of 11.5 million shares, and the company says it is prepared to buy more.

Excuses, Excuses?

What makes matters worse for Microchip Tech is that this isn't the first time the company has attempted to shift blame by attributing profit-shortfall woes to factors beyond its control. In the second-quarter of its 2007 fiscal year, the company blamed its inability to meet demand on the military-engineered coup in Thailand, the country in which it operates its Bangkok-based primary-assembly-and-test facility.

Then, in the September quarter, Microchip said there would be essentially no sales growth due to a declared state of emergency in Thailand. Some analysts have labeled this tactic as "scapegoating," and grouse that it's a way for management to dodge accountability for company problems they likely caused, or for challenges they likely failed to meet.

There's no doubt the U.S. housing market has slumped, American Technology Research analyst Doug Freedman told Forbes. But he wonders why the company cannot offset the housing weakness by increasing its business in geographic markets or business sectors that are thriving, such as personal computers, which have had stronger-than-expected sales, or handsets. Freedman thinks the real issue is that Microchip has faced increased pressure in a more competitive landscape.

His reasoning: Only 8% of the company's sales are tied to the housing market, via products such as garage door openers or thermostats or air conditioners, which means housing really isn't the core market management is making it out to be, Freedman contends.

"What people are struggling with is that when we look at competitors we're not hearing the same types of issues," Freedman told said. "So it is hard for us to understand what is hurting Microchip that has them overexposed to the U.S. housing and U.S. consumer market in comparison to their competitors."

Said Kumar, the Morgan Keegan analyst: "This is the first sign we have seen that broad-based semiconductor companies are being impacted by the decline in home equity values and tight credit markets."

Freedman downgraded Microchip to "neutral" from "buy" and lowered its price target to $37 a share from $47 a share. Analyst Romit J Shah, of Lehman Bros. Holdings Inc., (LEH), maintains his "underweight" rating on Microchip Tech, reducing his target price from $36 to $34.
With the downgrades Tuesday, Microchip saw its shares nosedive: They plunged 12.7%, or $4.64 each, to close at $31.98. Yesterday (Wednesday) the shares closed at $32.62, up 64 cents, or 2%, each.

The shares are down 23%, or $9.84 each, from their 52-week high of $42.46.

The Competitive Landscape

Microchip Tech's main rivals include Atmel Corp., (ATML) and Cypress Semiconductor Corp., (CY). Analysts say that they're not seeing the same issues in those two businesses that Microchip Tech is claiming to be the key source of its own problems.

And rival Synaptics Inc., (SYNA), which Freedman says lacks the size and diversification of Microchip, but is actually "soaring." On Tuesday, as Microchip's shares were being pummeled, Synaptics' shares rocketed $2.16 each, or 4.8%, to close at $50.47. There was apparently some rocket fuel left over, for Synaptics' shares raced higher by another $1.06 a share, or 2.1%, yesterday, to close at $51.53.

Several analysts seem to view Synaptics as the far better investment play, despite its size and diversification deficits. The reason: It has terrific new touch-screen technologies, which many analysts believe are going to permeate the electronic device market. It's experiencing annual revenue growth of 45%, but has also experienced a huge run-up in price in recent months.

In an analysis earlier this week in TheStreet.com, trader, author and analyst Timothy Sykes says that "touch-based interfaces are the future, and Synaptics is the clear winner here. Keypads and keyboards will be like the black-and-white television screens of decades past - I mean, this could really be revolutionary. And I'm not alone in this thinking."

Indeed, after Synaptics was bounced from the product once before, Bear Stearns Senior Analyst Andrew Neff recently announced that Synaptics' touchpad technology has returned to the Apple Inc. (AAPL) iPod.

William Patalon III is Managing Editor of both Money Morning and The Money Map Report.

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About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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