Dip Into The Chipmaker

After a poor showing in the first of 2015 a new round of consolidation is boosting the semiconductor stocks. Several companies’ stands to benefits it regains pricing power and possible takeovers. Use the leverage of options to bet on higher stock prices.

Semiconductor companies have long been plagued by Moore’s law which speed and memory double nearly every two years. While that exponential improvement does not happen in a straight line it has created an essentially commoditized industry that lacked pricing power.

This became particularly painful during the 90’s when capacity expanded dramatically to match the explosion of the PC industry. Ultimately even the winners such as Intel (INTC) whose growth and profitability slowed and the stocks stalled, remaining flat for several years.

Over the past decade growth recovered as mobile devices proliferated and chips started to become embedded in all manner of equipment from cars to household appliances. This increase in demand coincided with consolidation which took significant capacity out of industry. Suddenly the few remaining makers of basic DRAM memory chips, which had become the most commoditized of the products, regained pricing power and their stocks became stellar performers.

From 2012 to 2014 shares of Sandisk (SNDK), Western Digital (WDC) and Micron (MU) each gained more than 300% during the two year period. But by the middle 2014 the cycle started to turn down as a lack of PC upgrades and no new major mobile product platforms were introduced. This led to precipitous decline in DRAM prices in during last 6 months.

DRAM prices.

The shares of SNDK, WDC and MU followed suit, all having declined by approximately 20% thus far in 2015.

A Turn Up in Demand

But analysts are expecting a pick up in both price and demand during the second half of the year. The main drivers will be phones in which the iPhone 6s, led by China, should cause a 27%-35% increase mobile DRAM demand. A report out of Jefferies also cites a “rapid burn off of PC chip inventory that will lead to a restocking in Q3 of 2015.” The overall impact should be a stabilization DRAM which could lead to pricing power and expanded profit margins.

The other major catalyst is the recent wave of consolidation. These include Avago’s $37 billion offer for Broadcom (BRCM), which represented a 20% premium and will go down as the largest chip acquisition on record.   And last week Intel confirmed the long rumored purchase of Altera (ALTR) for $16.7 billion.

Most industry analysts expect there to be further consolidation. The remaining major players, Western Digital, Sandisk and Micron all have market caps above $20 billion making them difficult for any to digest. But they could certainly be acquirers and stand to benefit from the higher valuations being awarded and the leverage a consolidated market brings.

Technical Consideration

Any of those three could present good buying opportunities now, especially if you use low cost call options to leverage up your profit potential. But I like Micron best on the basis of its chart.

MU 060215

It formed a nice double bottom at the $25-$26 level and now is building a bullish flag above the $20 and 50 dma. This presents a good risk/reward entry point.

The Trade:

I’m keeping it simple with the outright purchase of calls which will give me unlimited upside potential. I’m using LEAPs to give the thesis plenty of time for the second half demand story to play out along with any further mergers.

Buy January $28 calls at $3.25 a contract

I would have an initial price target of $34 a share which would bring the value of the calls above $6 for a near 100% gain prior to the January 2016 expiration.

— Steve Smith

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About the Author: Steve Smith