Undercover Columnist

Hot chips

Recession may have slammed the brakes on the digital revolution, but the latest semiconductor-industry figures suggest a technological revival is already taking place. According to the Semiconductor Industry Association (SIA), there was a jaw-dropping 56 per cent year-on-year sales rise in February to $22bn. Semiconductor sales for the latest PCs and mobile phones are predicted to jump 10 per cent and 17 per cent respectively in 2010, says the SIA, with consumers clamouring for flashy smart phones, and Apple’s latest iconic gizmo, the iPad.
iPad
More than 500,000 iPad tablets were snapped up in the first week of US sales, about 25 per cent more than the most optimistic predictions. Demand was so great that it has forced the company to slam the brakes on its planned global launch due to stock shortages. Consumers outside the US, including Brits, will now have to wait until the end of May to get their hands on an iPad.
Remaining at the cutting edge of technological developments is as vital for the semiconductor industry’s success as it is for Apple’s. Even with forecasts of strong volume growth, the industry faces an inevitable drop in selling prices as new chips become standard and commoditised. Just as the price of PCs, DVD players and digital cameras falls rapidly in the shops, so there is continual pressure on suppliers to cut prices, too.
Bellwether points the way
For investors, timing is the key to this cyclical market and optimism currently holds sway, especially in the wake of record first-quarter revenues reported by US chip giant Intel last week. Intel is a bellwether of the global semiconductor industry. It posted an astonishing 44 per cent hike in Q1 revenues to $10.3bn, about $500m above market forecasts. Such an impressive performance owes much to sales of Intel’s new mobile processors, including its i7 quad-core chips.
Signs are encouraging within its core PC market as well. Corporations may have cut their spending to the bone in order to survive the past two years, but, ultimately, they have to invest if they want growth. Since many corporate computers are, on average, three to five years old (virtual dinosaurs in the fast-moving world of PCs), they start to cost more to keep than to replace. There comes a time when the only solution is to buy new ones. Bolstered by the successful release of Microsoft’s Windows 7, plus new product launches from server and PC manufacturers, the need for PC upgrades has recently become more pressing, and Intel sees signs of “a return to corporate demand”.
Concern over energy efficiency is fast becoming a new driver for the semiconductor industry, too. Fifty years ago, if power ran out, companies would simply build another plant. Now they raise prices, which means slashing energy consumption is vital to cutting costs. That’s good news for companies making more efficient electronics, and for the long-term future of the semiconductor industry.
Intel tends to report its financial results quicker than most of its peers, so its numbers bode well for the raft of Q1 trading updates from the industry scheduled for the end of April and early May – including ARM (29 April), plus Wolfson Microelectronics and blue-tooth chip maker CSR (both 5 May). Market researchers IDC and Gartner recently upped IT spending growth estimates for 2010 to 3 per cent and 4.6 per cent respectively, while Gartner recently predicted 20 per cent growth in global semiconductor revenue this year to $276m.
KPMG’s annual survey of semiconductor executives also paints an upbeat picture of the industry. According to its study, more than half of all respondents (54 per cent) expect revenue growth of 10 per cent or more during 2010, with 18 per cent eyeing 20 per cent-plus. “After a year-long global slump, demand for silicon chips and semiconductors is rebounding due to increased demand for wireless and consumer electronics,” says the survey’s author, Ron Steger, partner in charge at KPMG’s global semiconductor practice.
Gremlins in the machine
However, there are dissenters amid this crowing chip-making fraternity. Broker Liberum Capital reckons that signs of weakening demand are already all too obvious, arguing that netbook/laptop sales have been weakening, sales of LCD TVs over the Chinese New Year were disappointing, and that cars sales in Europe are wobbling as the scrappage schemes run out of fuel. According to Liberum, German vehicle registrations were down 20 per cent year-on-year in February and March.
“We believe the recent strength in semiconductor orders has been on the back of double ordering and inventory building across the supply chain,” warns Janardan Menon, industry analyst at Liberum. “This is likely to put pressure on share prices.” This view appears to be supported by VLSI Research, a consultancy owned by US tech giant Oracle, whose recent industry study suggested that February inventories jumped 46 per cent year-on-year and are close to the record levels of October 2008. “The sector is overheating in our view,” insists Mr Menon.
The technology hardware sector, within which the semiconductor companies reside, has beaten the wider market considerably during the past three years, rising in value by one-third compared with the 12 per cent slump in the FTSE All-Share index. More recently, over the past three and six-month periods, technology hardware has outperformed the All-Share index by about 6 per cent and 9 per cent respectively.
ARMAlarming valuation
ARM is a good case in point. It has a long pedigree designing cutting-edge microprocessors and the shares have exploded into life, soaring from a low of 104p within the past year to about 235p at the time of writing. Yet Liberum’s Mr Menon worries about lost market share to Intel in the hot smart-phone market and potential inventory corrections that could undermine ARM’s royalty rates. On an implied 2010 PE ratio of 35, it is not difficult to see why a slew of brokers, including RBS, Citigroup, UBS and Deutsche Bank, have downgraded their recommendations on the shares simply because the price has run ahead of itself.
FAVOURITES…
Edinburgh-based Wolfson Microelectronics is an interesting recovery play. Its failure to produce goods on time meant Apple dumped the company in 2009, sparking a raft of profit warnings. However, chief executive Mike Hickey has shifted the company to long life-cycle products rather than high-cost launch versions, a move that has helped slash costs and double output. If it can convince the market that design wins can be retained, the shares could sparkle once more.
OUTSIDERS…
ARM licenses its designs to manufacturers and receives royalties on each chip, as well as one-off licence fees. It even pays dividends. Yet, there are question marks over its ability to fend off competition from Intel, particularly in the smart phone arena. While Q1 figures are likely to be strong, and investors must pay for true quality, having more than doubled in a year to trade on a forecast 2010 PE ratio of 35, the shares are too pricey.

Undercover Columnist says:

The semiconductor industry remains tied to the continual renewal of consumer electronics and, to a lesser extent, global car sales and renewables. But this is a highly-cyclical market and an early responder to economic recovery, too. This explains the impressive share price performances in recent months and more of the same looks likely throughout the rest of the year for the best companies with the most exciting technologies. However, overall we are neutral on the sector.
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Demergers back in fashion

Demergers have been thrust back onto the investment radar after telecoms groups Cable & Wireless and Carphone

Carphone Warehouse does the splits with Talk Talk

Carphone Warehouse does the splits with Talk Talk

Warehouse did the splits. The management’s of both companies had argued that splitting up their group assets into two separate and clearly defined businesses would unlock shareholder value.

The long awaited demerger of Carphone Warehouse on Monday into retail and telecoms operations saw the share prices of both make steady progress in initial trading. Shares in Talk Talk, the old group’s telecoms subsidiary and the UK’s second-largest broadband provider, had risen to 133.5p, as we went to press, while new Carphone Warehouse shares, which holds the old group’s 50 per cent stake in Best Buy Europe, the consumer electronics retailer, was trading around 166p. Analysts at investment bank UBS had expected shares in Talk Talk to be priced at 115p and those in new Carphone at 153p.

Cable & Wireless completed its long-awaited demerger last week and the early reaction of the respective share prices was telling. Cable & Wireless Worldwide, the largely UK-based corporate telecoms services business, jumped close on 23 per cent in early trade to hit highs of 92p, yet in stark contrast, the communications division, which operates telecoms businesses across the globe, fell in opening trading to 56p. Cable & Wireless Communications lost its place on the UK’s blue-chip FTSE 100 index this week.

Corporate demergers have long been seen as valuable routes to unlocking shareholder value thanks to an impressive track record. The value of shares in the former British Gas business have risen almost 10-fold since the group’s 1997 demerger into Centrica, BG Group and National Grid. Other value-adding demergers have included drugs developer AstraZeneca being spun out of ICI, and mobile phones giant Vodafone being demerged from Racal Electronics.

The Carphone Warehouse and Cable & Wireless demergers are just the latest in a slew of spin-offs across Europe over the past few weeks. These have included Taylor Wimpey splitting out US housebuilding arm, oil services group Petrofac demerging its oil wells business, and the separation of the UK banking arm of Spanish group Santander, which includes the old Abbey business.

Undercover Columnist says:

Demergers have a long track record of success in unlocking shareholders value that would otherwise be hidden away. Our picks would be Cable & Wirelesss Worldwide and Talk Talk, which both offer decent growth potential and might well encourage takeover attention.

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Chip makers sizzle

A revival in microprocessor sales figures promise to underpin share prices within the UK semiconductor sub-sector this year, including ARM, CSR and Wolfson.

According to latest figures published by the Semiconductor Industry Association (SIA), sales for February of $22bn drifted 1.3 per cent compared to January, yet this represents a huge improvement for the industry over the last 12-months, up year-on-year over 56 per cent.

SIA president George Scalise says February sales reflect continued recovery in semiconductors, with demand driven by electronic products in emerging economies.

Apple's state-of-the-art iPad

Apple's state-of-the-art iPad

Huge semiconductor sales aimed at the latest PCs and mobile phones are predicted this year, with the SIA projecting 10 per cent and 17 per cent growth respectively in 2010. This is partly inspired by huge demand for smart phones and Apple’s new iPad, which shifted 300,000 units in opening day US sales on Saturday.

This year’s estimated revenue of $242bn should rise to a record $262bn in 2011, predicts the SIA, breaking the $256bn of semiconductor sales chalked up in 2007.

Undercover Columnist says:

Britain’s semiconductor specialists are geared to recovery but many trade on double-digit premiums to the technology sector’s PE of 26. IQE and CSR are among those to buck this trend on respective PEs of 20 and 13.

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Ad times are a changing

The bombed out advertising sector is at last emerging from the dismal recessionary battering that has pummelled profits and swiped millions of pounds of company valuations.

MeerketThat’s the underlying theme of latest global advertising estimates produced by Carat, the media consultancy owned by London-listed Aegis. It recently upped its forecasts for worldwide ad spend this year from one per cent growth to 2.9 per cent, rising to four per cent in 2011, thanks to the gradual return of business and economic confidence.

This echoes similar growth forecasts put out by media investment firm GroupM, part of WPP’s vast media empire, in December. Adam Smith, futures director at GroupM, says “confidence seems to be improving, though based on anecdotes rather than substance.”

Over the past few weeks there has been a relative deluge of comment from the four corners of the advertising spectrum. The unveiling of full year figures by a number of media industry companies, including WPP, Aegis, Chime Communications and Cello, to name just a handful, has also put 2010 prospects under the spotlight, where cautionary optimism has been a recurring theme.

Aegis chairman John Napier says that the succession of new business wins during late 2009 had continued into January and February. Aegis sealed $2.7bn worth of new business last year, three-times the $900m won in 2008. Elsewhere, industry heavyweight Sir Martin Sorrell, the founder of WPP, the world’s largest advertising group, made similarly progressive noises at the beginning of March, raising hopes for “a more stable year” in 2010, after calling 2009 a “brutal year.” WPP saw 2009 revenues increase by five per cent, after stripping out currency fluctuations, yet profits still collapsed 16 per cent to £812m.

“Growing optimism has been in evidence for a little while,” says Roddy Davidson, media analyst at broker Altium Securities. But an implied revival remains more of a feel than anything tangibly real. Even the bigger companies remain too “shy to stick their heads above the parapet,” he says.

Worldwide squeeze

Unsurprisingly, the same issues have been extracting a heavy toll on media agencies across the globe. While advertising trends continue to improve Maurice Levy, chief executive of French media giant Publicis recently cautioned that the crisis that has laid waste to the advertising industry for 18-months or more isn’t yet over and pointed out that deeper cost cutting is still required.

This came alongside organic revenue figures – a closely watched barometer in the ad industry that strips out currency effects, acquisitions and disposals – fell 5.4% in the final quarter of 2009, a modest improvement on the 7.4% drop in the June to September period. Smaller French peer Havas saw a marked improvement in fourth-quarter organic revenue while US-based Omnicom also reported a smaller-than-expected decline during the final three months of last year.

Since it is pretty typical for the highly cyclical advertising industry to lead the way out of recessions, it would be easy to make bold assumptions that the cycle has finally bottomed out. Alex de Groote, Panmure Gordon’s media analyst, sits firmly in the optimists camp. “I’m positive across the board,” he says but points specifically at ITV as a stock to watch given its recent upbeat remarks. Speculation has recently emerged implying that advertising revenues in April could be 29 per cent up, compared to the 15-20 per cent increase formerly expected by the market. Panmure’s de Groote believes that ITV forecasts could be “smashed out of sight” this year.Cinzano

Yet challenges clearly remain. While Sir Martin Sorrell expects 2010 to be a more stable year “advertising remains challenged by clients’ continued demands for efficiency.”

“The apocalypse was avoided, and it was followed by the less worse phase. We are in the stability phase, but have not returned to growth yet,” he says.

Industry transformation will sit at the heart of any revival. As Altium’s Davidson sees it, there is increasingly a trend to move towards targeted campaigns that get consumers onside. Developing a “good niche away from blunt, vanilla advertising to targeted campaigns gives more bang for your buck.”

In contrast, “Traditional advertisers will spend millions of pounds producing a co-ordinated campaign,” but then get “knocked off course” by dissenters within the blogging and social networking environment.

The Tweeters speak

Earlier this month the Advertising Standards Authority unveiled a new code of practice that includes a social responsibility clause that aims to crackdown on advertisers that attempt to break the spirit of if not actually the letter of the law. This has prompted David Jones, the head of Havas Worldwide, to warn that negativity created within the social networking media, such Twitter and Facebook, is now a bigger threat to advertising campaigns than regulatory penalties or bans.

But while the advertising agencies do their level best to spot emerging trends and fashions in consumer tastes and behaviour, making hard and fast predictions about the future remains a mugs’ game. For example, rough a year ago when we last looked at the advertising industry in-depth it seemed very likely that consolidation within the advertising space was very likely with ambitious, and cash-rich, companies seemingly likely to take advantage of bottom-of-the-cycle share price valuations etc.

Yet in reality takeovers have largely failed to materialise. For example, of the 15 companies that we listed in our feature (Signs of life in the advertising sector, 7 April 2009) only online field agency Research Now has been taken over, after accepting an £85m deal from US product testing consultancy e-Rewards. Media buyer Aegis also continues to rule out any sort of tie-up with Havas despite the latter’s 2.9.9 per cent stake, much to the disappointment of many investors and further dampening industry takeover excitement.

Three steps to Heaven

Still, crystal ball gazing can be fun if nothing else. GroupM’s Adam Smith sees three key issues surrounding the success or failure of the advertising recovery. First, it will be “fuelled by TV,” where advertising spend “hit a serious trough” last year. Secondly, recovery in the automotive and financial markets, which Smith together accounted for roughly half the decline in ad spend during the recession, so by default, any wider rebound must include these two vital areas. And finally, he expects to see a “polarisation in digital advertising,” where content perceived to add genuine value to end users will remains expensive, the rest becomes a commoditised numbers game.

What seems likely to drive share prices during the rest of 2010 and beyond is good old fashioned fundamentals, including top and bottom line progress. “Earnings will be the biggest driver for share prices,” says Altium’s Davidson, with “ratings expanding in anticipation of that.”

Undercover Columnist says:

Buying directly into the advertising arena is really a play on wider economic recovery and stability, but as an early cycle mover, that time could well be now. Brightening prospects for many companies already, partly thanks to excitement surrounding the Winter Olympics and upcoming World Cup, could see a raft of forecast-busting figures this year, with PR another interesting area to tap into.

Undercover Columnist Picks:

Little market researcher Cello had a horrible year in 2009 but upping its overseas presence and cost cuts will bolster profits. On a prospective PE ratio of 4 and offering a safe 4.3 per cent dividend yield, the shares are attractive at 30p. Elsewhere, we like the look of Chime Communications because of its large PR exposure, an area likely to trade well this year, while broadcaster ITV remains an interesting play coming from a very low base on the advertising front. At 60.75p the shares trade on a 2010 PE ratio of about 20, yet this is based on lowly expectations of just 3p EPS. Many in the market think these targets could be well beaten, putting a 70p Morgan Stanley price target well within reach.

Rightmove may also be seeing ad rates improving but tied to the wider house price market as it is, the shares may yet stumble if interest rates start rising. The shares have been strong lately, up 20 per since early Jan, but a PE of 20 suggests that the share is over-egged given the threat from increasing competition.

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Money meritocracy will rise to the top

Rats leaving the sinking ship

Rats leaving the sinking ship

Regulators and governments alike have got their fingers crossed that reforms on executive pay will stop bankers going bonkers again. He theory runs that new layers of red tape on pay, bonuses and other incentives will avoid any repeats of banks dragging the entire global economy close to its knees in the way Lehman Bros et al did, but it’s a fool’s hope.

Part of the attraction of a career in high flying finance, and what scares most reasonable people away, is that it is as close to a meritocracy as exists. It’s dog eat dog, sink or swim, there’s little middle ground. Traders trade and, assuming it comes off, hero status is assured, albeit temporarily. Lasso in clients, you’re a winner.

The flip side, of course, is what makes the Square Mile and Wall Street so dangerous. You lose money more than once and you’re out of a job. Just like that. Gone. There is no tenure, no job security. Ten and 20-year careers end in a flash. That’s one reason why so many are paid so well. It’s a bit like combat pay. Survive and prosper, or get out, and if you’re going the firm hopes it happens before you lose it any money. It’s not the post office. It’s trial by fire.

You would think that would make the entire workforce afraid to do anything for fear of being tossed out on their can, back into the cruel, cruel averagely paid world. But a meritocracy works in the opposite way. You have very smart people trying to prove to each other that they are smarter than everyone else. Unlike acing a chemistry exam or even nailing your A-levels, the score is kept with real money – how much of the bonus pool you command for your do-or-die heroics.

home moneyLehman Brothers was a classic Wall Street meritocracy. They wanted to one up Goldman Sachs to win the meritocracy game and get paid in spades. Let’s leverage this sucker up with mortgages. A trillion dollar balance sheet. Hey, if not us, who? When that trade went south, Lehman went bust. You lose money, you’re out. Goodbye. Unless of course the government bails you out.

To prevent the next blow up, the G20 is trying to limit pay and banish risk. But no matter what bureaucrats do, the financial world’s meritocracy of getting paid will live on. They’re going to figure out a way around any new rules. The game might move to hedge funds or some other dark corner of the financial market, but no amount of reform is going to kill this animal instinct.

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