Safety in semis?

Safety is perhaps not the right word, as you can probably never have safety in the semi-conductor space. The speed of product innovations and the severity of the cycle can potentially blow you out of the water at any time.

Nevertheless, two UK small caps that might be worth a closer look are CSR and Wolfson Microelectronics. Both companies operate in the semi-conductor industry. They are “fabless”, which means they do not manufacture their own semi-conductor wafers (a highly technologically intensive and expensive process). Rather they buy the wafers, and then use them in their own products that are sold onto end customers, mostly in the consumer electronics industry. CSR specialises in wireless connectivity, particularly Bluetooth. According to their annual report, last year they shipped 40% of the world’s Bluetooth chips. Wolfson’s specialises in audio chips, targeting newly released consumer electronics products where quality is paramount. They have a reasonably diverse end market customer base including handset OEMs, personal media players, games consoles, TVs etc.

Both companies have a number of issues. In the near term, the global recession is hammering, and will continue to hammer their revenues. Estimates for Wolfson’s 2009 revenues have fallen by nearly 50% in the past 9 months. Longer term, there are also some concerns about loss of market share to larger competitors. For CSR, the concern is that handset OEMs and other customers will move toward multi-purpose chips that do more than just Bluetooth. Indeed this is one the reasons the company has recently bought out a struggling GPS chip computer with a view to combining their products together. Wolfson faces similar issues, having recently lost a the I-pod contract to a US competitor.

All doom and gloom them? Not entirely. The potential attraction of these companies is the valuation. Both shares have fallen around 80% from their peaks in 2006. Back in the bull market the market looked to price the shares off expected earnings. Margins and returns were high on the back of the worldwide consumer boom. What is interesting is that the shares have now traded down to a level that is not far off the liquidation asset value.

Using Ben Graham’s approach of ignoring all the intangible assets and netting off the total liabilities against the tangible assets, we come out with share prices not a million miles away from current prices. Marking the 2008 year-end property and inventory at 50%, the receivables and cash at 100%, and netting off all the liabilities gives a net asset value of $109m for Wolfson and $276m for CSR (both companies are dollar reporters). Converting into sterling this gives per share values of 65p for Wolfson and 148p for CSR.

Granted, after the recent risk rally, both shares currently trade higher than these levels – Wolfson is at 108p and CSR is at 240p. However, one would have to be very negative indeed about future prospects for either company to argue that they should trade in inline with the tangible net assets on an ongoing basis. Under any scenario which does not involve permantly collapsing end markets, both companies continue to generate cash and deliver high returns on equity and capital employed. And presumably at some point the consumer electronics market will at least start to stabilise. Even for 2009, both companies expect to deliver at worst flat cash flow (although this may tougher for CSR now following their acquisition). Also worth noting is that both shares did actually trade more or less in-line with the net-tangible assets back at the lows in February and November 2008 (they have both risen c.55% since). If we do see a pull back in markets, I would definitely look to start buying these stocks if they start to trade back down toward the tangible asset value.

Wolfson report Q1 on Wednesday. It will be interesting to see what they say about the full year outlook and what their cash flow situation looks like for Q1 which will surely be one of their worst quarters ever.