Cabot Explorer Issue: September 15, 2022

Inflation Jolts Markets as Semiconductor Stocks Go on Sale

While prices of gasoline are down, prices of most of the other things people buy like food, rent, and medical care are still rising. The reasons are complex and include the war in Ukraine that has disrupted the wheat supply.

A drought in Brazil has put upward pressure on coffee costs. And a bird flu outbreak in January helped ramp up egg and chicken prices. Now a possible railway strike may bring even more inflationary pressure on household food budgets. (Thankfully, it’s less likely now: Late last night rail employers and union leaders finally sat down with government officials in Washington, D.C. for last-minute negotiations and reached a tentative deal to prevent a crippling strike across the country.)

Explorer stocks held up pretty well during this turbulent week as almost all were steady or up, with Chile’s SQM up five points. Stocks stabilized yesterday after a sharp pullback on Tuesday.

Today, our new recommendation is from the semiconductor sector, which has been under pressure lately with many stocks on sale. It is a complex area with lots of moving parts.

New Explorer Recommendation: Taiwan Semiconductor (TSM)

The most advanced category of semiconductors used in smartphones, military technology, crypto, and artificial intelligence can be incredibly small, with only 5 nanometers (nm) between each transistor. A nanometer is a millionth of a millimeter. An Apple A15 processor contains 16 billion transistors – about 90% of them made by Taiwan Semiconductor (TSM).

While nobody right now can compete with America’s software programmers, semiconductor designing, and equipment, most advanced chips come from Taiwan, an island with a population of 24 million about 100 miles away from the Chinese mainland.

Meanwhile, America buys 70% of its most sophisticated chips from Taiwan, posing an economic and national security issue. The other side of the coin is that American semiconductor firms sell quite a bit into China, as you can see from the below chart. The risk here is what happens if these markets are cut off for any reason. For example, Nvidia was recently ordered by the U.S. government to stop selling its most advanced chips to China.

Intel is getting help from the U.S. government through the CHIPS Act, and while I hate corporate welfare, it will need more to pay for a tab that could go well over $100 billion in the next 10 years to make the U.S. and Europe competitive against Taiwan and China’s leading chipmaker SMIC, which has already caught up to Intel on chip technologies.

America catching up with Taiwan and South Korea won’t be easy. Samsung Electronics and Taiwan Semiconductor have already committed to increasing some production in America, but how much will be produced and how advanced the chips will be is still unclear. Intel is using its leverage as the only major domestic chip fabrication company to get U.S. government support but it will also need to attract and hold talent. The good news for Intel is that if the U.S. remains competitive technologically to protect its economic and national security, Intel could be seen as another Taiwan Semiconductor and could possibly become the most valuable company in the world.

But FactSet data shows that over the last two decades, Intel has underperformed, delivering an annual return of 6.7% versus 10.3% for the S&P 500. Over the same time period, Taiwan Semiconductor has returned 18.6% annually, including dividends.

Intel stock has been struggling due to weak demand and margins. INTC shares have fallen 43% since January as Intel is investing heavily in new fabrication facilities while the economy is weakening, making some investors skittish even though the stock offers a 4% dividend and is priced at just under 7 times earnings.

I think we go with Taiwan Semiconductor (an Explorer holding not too long ago) for a few reasons. A Needham analyst expects TSM will grow top-line revenue 15% in 2023 despite an expected fall in industry sales. The company also still owns the high-margin, high-performance chips based on 5 nm and 3 nm node production, which are increasingly in demand from companies such as Apple and Qualcomm. TSM also trades at a very reasonable 13 times forward earnings as the stock has come back to 80 from a 52-week high of 145 on January 13. BUY A HALF POSITION

Portfolio Changes:
MP MATERIALS (MP) MOVES FROM BUY A HALF TO HOLD

Updates

Centrus Energy (LEU) shares were steady this week and the company announced yesterday that it has secured new nuclear fuel sales contracts and commitments with an estimated value of $320 million in the last 12 months – including approximately $270 million year-to-date. Most revenues come from multi-year contracts with major utilities, often signed years in advance.

Based in Bethesda, Maryland, Centrus supplies nuclear fuel and services for the global nuclear power industry. Nuclear power provides more than 50% of U.S. emission-free energy, according to the Department of Energy. Centrus stock is still trading way off its 52-week high and at just over four times earnings. BUY A HALF

Cloudflare (NET) shares were up and down this week, finishing where they started the week at 61. I was not happy to learn that CEO Matthew Prince filed paperwork to sell 471,456 shares of the company, according to information from Goldman Sachs – one of Cloudflare’s key investment banks.

The company recently posted a strong second-quarter earnings report with its revenue rising 54% year over year. Cloudflare makes around 60% of its revenue from large customers spending at least $100,000 annually. Cloudflare gained a record 212 new large customers in the second quarter. BUY A HALF

Fanuc (FANUY) shares were up early in the week but gave some back and more to finish just over 15 again. On the other hand, this stock is perfect for this sort of market. Global sales of industrial robots grew 27% year-over-year to a record in 2021 after two years of declines, according to the International Federation of Robotics. Fanuc is the world’s leading manufacturer of industrial robots and FANUY offers us a high quality stock that should be firm with its strong balance sheet with plenty of cash. My six-month price target for this low-risk stock remains 25. BUY A HALF

Ford (F) shares were up slightly this week buoyed by August sales up 27% year-over-year versus overall industry sales growth of 4.8%. EV sales have grown four-fold from over a year ago and the all-electric F-150 is the fastest turning vehicle in Ford’s lineup. The Detroit automaker sold 58,283 F-series pickups in August. For comparison, in July, Ford’s U.S. sales climbed 37% and Ford had a 70% bounce in SUV sales while U.S. sales of trucks climbed about 20%. Ford stock is still a buy as it trades at just over five times trailing earnings. BUY A HALF

Freeport-McMoRan (FCX) shares were even-keeled at 30 this week despite concerns about lackluster economic growth. A couple of things are going on regarding copper prices. The long-term demand trend from the transition to electric vehicles, renewable energy, and electrification implies a marginal increase in demand. At the same time, the difficulty of nailing down mining permits due to environmental concerns means supply will be constrained, too.

The Phoenix-based global mining giant operates seven copper mines in North America, two in South America, and one of the world’s largest copper and gold mines in Indonesia (Grasberg). Freeport is managing its finances well with a return on equity of 27%, return on assets of 12%, and has an ample cash reserve of $9.5 billion. With a valuation of just under 10X earnings, I think we have upside potential but the current pullback makes me pause and I’m keeping this at hold. HOLD A HALF

Infineon Technologies (IFNNY) shares finished the week dead even as other semiconductor stocks were crushed this week. The company’s EPS is expected to grow 38% this year, exceeding the industry average of 11.9%. Year-over-year cash flow growth is over 100% – higher than many of its peers. Infineon is a leading broad-based European chipmaker founded when the company was divided from its Siemens parent in 1999 and is focused on auto markets rather than consumer electronics. BUY A HALF

Kraken Robotics (KRKNF) shares followed up last week’s 20% gain with a flat week, which isn’t bad in this market. Kraken has been among the first Canadian companies qualified to sell directly to the Government of Canada without further competition. The company recently signed a follow-on contract to supply additional KATFISH™ for the NATO Navy’s new mine hunting vessels. Kraken Robotics has also landed a major contract to provide new sonar systems for the Royal Danish Navy.

Based in Newfoundland, Kraken Robotics is a marine technology company providing ultra-high resolution, software-centric sensors and underwater robotic systems. This is certainly a speculative idea but shares trade at just 0.32 per share and I believe Kraken is a well-run company in a strategic area of growth and therefore a prime takeover candidate by a larger maritime contractor. Consider a small position. BUY A HALF

MP Materials (MP) shares were up a point this week. Recently reported earnings per share surged 139% from the prior-year quarter’s levels but rare earths concentrate prices have pulled back sharply so I’m moving this stock to a hold.

This stock is a way to play clean tech, defense, semiconductors, and other advanced and emerging technologies through some of their basic inputs. It currently ships more than 90% of its products to China for processing and recently inked a long-term supply agreement for GM’s EV programs. MOVE FROM BUY A HALF TO HOLD

Sociedad Química y Minera de Chile S.A. (SQM) shares were up five points this week to finish at 113. SQM’s dividends are sizable with an annual yield of 10.3% and an impressive five-year annualized dividend growth rate of 12%. Investors and analysts may be concerned about comparisons going forward as SQM’s earnings for the second quarter were up 857% year over year. SQM is a double play as the company is also the largest producer of potassium nitrate used for fertilizer so the stock offers two drivers of revenue and profits. HOLD A HALF

The next Cabot Explorer issue will be published on September 29, 2022.

JUST PUBLISHED — New book from Chief Analyst Carl Delfeld