Supply shortages in the semiconductor sector are weighing on many stocks, both inside and outside the chipmaking industry. It's bad news for many stocks and their shareholders, but the unique situation also creates buying opportunities for semiconductor investors.
Here's a quick rundown of the chip shortages, followed by a couple of strong investment ideas.
What's going on?
The semiconductor industry relies on a brittle supply chain. Most chip designers don't have manufacturing lines of their own, depending on a small handful of third-party foundries to turn their blueprints into physical products. The leading foundries, in turn, have optimized their chipmaking operations for supplying processors to the global electronics manufacturing hubs in China and Taiwan.
That's normally a good strategy, but a combination of political pressure, natural disasters, and the COVID-19 pandemic triggered a massive supply-side shortage last year. The deficit lingers on today, shaking up the semiconductor industry itself and the many sectors that depend on a steady supply of chips.
The most obvious idea
Let's start with the foundries. Market makers have already caught on to the idea that United Microelectronics (UMC 0.00%) and Taiwan Semiconductor Manufacturing (TSM -1.23%) will benefit from the supply shortage, as customers are stuffing their order pipeline completely full. As a result, United and TSMC have crushed the market over the last two years. These companies are great, but their stocks are fully valued today.
Smaller players in the chip-manufacturing sector have seen smaller price bumps. I'm particularly interested in Tower Semiconductor (TSEM 3.25%). The Israel-based company runs most of its chip-manufacturing business out of facilities in Japan, Israel, Texas, and California, which helps the company sidestep the political heat in Greater China.
Tower Semi's stock is beating the Street over the last two years but by a far smaller margin than the big boys:
Tower Semi stands on the threshold of a potential golden age, given its unique ability to produce and deliver large volumes of chips that are as American as apple pie and baseball. Yet the stock trades at just 2.2 times trailing sales while United's shares command a 3.4 price-to-sales ratio and Taiwan Semi is soaring at 11 times sales.
The company is also poised to ramp up its manufacturing activity right now. Some of its foundry facilities are running at close-to-full capacity, but others have plenty of headroom for additional orders.
According to CEO Russell Ellwanger in the recent first-quarter earnings call:
As of today we see an increased level of utilization to 80%. Fab 2 was at 80%, presently at 85%. Newport Beach, California Fab 3 was at 75% utilization as we continue to adjust for an increased silicon-germanium mix. Our San Antonio factory, Fab 9, was at about 70% utilization. Looking at our TPSCo fabs in Japan, utilization for an 8-inch foundry business was at about 70% rate.
Nuts and bolts
The leading chip foundries are investing billions in expanding their production capacity. That's great news for the makers of the materials and equipment that are used in the manufacturing facilities. There are many solid ideas here, but photomask-specialist Photronics (PLAB 1.71%) stands head and shoulders above the rest.
Photronics recorded 12% year-over-year revenue growth in this Wednesday's second-quarter earnings report. Sales to the chipmaking sector led the way with a 16% boost. Earnings jumped from $0.13 to $0.17 per diluted share.
The company benefits directly from growing manufacturing capacities across the industry. The strong second-quarter results sprung from rising wafer starts and higher capital investments in the chip sector as a whole.
As CEO Peter Kirlin said in the earnings call:
Many chip manufacturers have announced plans to develop or expand semiconductor manufacturing in the U.S. and Europe. While it's premature to discuss the specific impact these new fabs may have on our business, I believe there is reason to be optimistic. We expect this will continue and our position as the largest merchant photomask manufacturer should enable us to continue to invest and grow with these industry trends.
Somehow, this well-run company in an enviable market position has not become a market darling. In spite of this company's many business advantages, the stock has traded sideways for the last two years. You can pick up some Photronics shares at the bargain-bin valuation of 14 times forward earnings or 1.4 times trailing sales.