A homely amphibian used to sing, "It Ain't Easy Being Green." Shove over Kermit and hear the refrain, "It Sucks to be a Semiconductor Company."
This isn't very intuitive, as all those neat little chips and circuits help entertain us and make our work more productive, but the enterprises that produce them have a much tougher time making consistent profits, than say, those that manufacture cigarettes, which have dubious social value.
The reasons for this conundrum are complex but the main issues are fast-paced innovation and low barriers to entry. The fuel of innovation is research and development, which means you need a staff of well-paid engineers and sophisticated equipment. That equates to a generous dollop of working capital. You also have to correctly guess what the market will want and whether it is worth designing and developing for the possibility of a profit. If that assumption is off the mark, or the competition builds something better and cheaper, a decent return on investment is unlikely.
As companies work to stave off competition with new products and stay ahead of the pack, they also tend to undermine sales of their own older product lines, and turn them into legacy laggards. This pattern of rapid obsolescence is why you so frequently see large figures alongside the expense line item "inventory write off" on income statements.
Finally, although particular designs and processes can be patented, ideas diffuse quickly through the tech community. Once it is known that there is a good market for chip X that performs function Y, labs kick into gear. Before you can say "pernickety pesky patent protection" three times, some Taiwanese factory is churning out a similar chip.
As mentioned in a recent article, we Contra Guys waded into the sector last December with our purchase of Solectron (SLR-NYSE). On the Canadian side of the ledger, Zarlink (ZL-TSX), located in Kanata's Silicon Valley North, was added. In both cases the cost was a tiny fraction of what these stocks used to go for a decade ago. We were comfortably familiar with Zarlink as we owned its predecessor, Mitel, and did fabulously well on it as we watched it climb from a little more than $1 in 1991 to our final sale at $22.45 in 2000.
One of the things that perked our interest was that Kirk Mandy, an old hand from the Mitel days, took over as chief executive officer of Zarlink in 2005. Since then, Mr. Mandy has made progress in staunching the steady string of losses, but the riddle of the corporation's pattern of falling revenue has proven harder to solve.
Like many other North American semiconductor firms, Mr. Mandy has set his sights solidly on the road to "fabless," i.e. concentrating efforts on the design of chips while outsourcing the manufacture of silicon wafers to foundries, mostly in the Far East. The balance sheet was also boosted by the sale of some operations to Intel.
One of the big questions surrounding Zarlink was what it was going to do with its nest egg of cash. There was also speculation that it made it a more attractive takeover target. That haziness was dispelled on June 25 with the announcement of the acquisition of Legerity Holdings for $134.5-million (U.S.). Texas based Legerity had revenue of $113-million in 2006, primarily concentrating on chips used in voice over IP. Strengthening the product mix in their traditional forte of voice communications makes sense to us.
The news was greeted with a burst of enthusiasm that blasted the share price up by 17 per cent on huge volume. But the euphoria was very short-lived as taciturn comments from analysts rolled in, and the stock closed the day up by a slim penny, at $1.86. The stock closed yesterday at $1.90, up a penny.
BMO's Brian Piccioni opined: "Prior to this announcement, Zarlink was a poor-performing company with a strong balance sheet. Now Zarlink appears like a larger company with limited cash and higher working capital needs." He cut his price target from $2.50 to $1.50. Ouch!
Despite the difficulties that make this industry so tough, there is one thing we know with absolute certainty: The production of silicon chips is not a registered charity. That means somebody, somewhere, somehow is going to make a profit. Many others will fail.
We've made our bet that Zarlink will eventually join the select few in the winner's circle and have set a target of $11.49. Oh, are those the same hecklers in the peanut gallery we heard when Mitel was purchased at $1.01?
This column first appeared on GlobeinvestorGOLD.com.