A Top-Notch Chip Stock Undaunted by the Flurry of Semiconductor Mergers

Semiconductor stocks have suffered greatly this year and have underperformed the market by a wide margin.
Through Oct. 1, the Philadelphia Semiconductor Index was down 15% year-to-date, while the S&P 500 index was only down 2% by comparison. Fortunately, the semiconductor index has gained some momentum in October, but it still trails the S&P 500 by two percentage points this year.
Revenue and earnings growth across the industry have disappointed investors this year, which explains the poor stock performance for the semiconductor index. This has caused a wave of consolidation throughout the industry. Here is a rundown of the semiconductor mergers so far this year, and a chip stock that may be a compelling turnaround story.

Major Semiconductor M&A Deals

The chip industry is grappling with deteriorating economic conditions. Part of this is due to commoditization of chips. Weaker-than-expected economic growth in emerging markets like China has led to disappointing demand and a global oversupply. This has resulted in price erosion, as manufacturers are forced to cut prices in order to move inventory.
In response, the industry has turned to rapid consolidation.
In June, Intel (NASDAQ: INTC), the largest semiconductor company in the world, bought Altera (NASDAQ: ALTR) for $16 billion.
That deal was announced just a few days after Avago Technologies (NASDAQ: AVGO) announced that it had entered a deal to buy out Broadcom (NASDAQ: BRCM) in a $37 billion cash-and-stock acquisition, which was the biggest deal ever in the chip industry.
More recently, Lam Research (NASDAQ: LRCX) revealed its intention to buy KLA-Tencor (NASDAQ: KLAC) for $10.6 billion.
As the chip business reaches advanced maturity, growth is slowing down, which is resulting in consolidation. Mergers make a great deal of sense right now, as big companies with balance sheets stuffed with cash aren’t getting much bang for their buck when interest rates are this low. And smaller competitors with solid business models are vulnerable as their stock prices have declined this year.

Qualcomm: My Preferred Chip Stock

Qualcomm (NASDAQ: QCOM) is a dominant player in smartphones across a wide range of phone manufacturers. It also has a broad range of semiconductors for new, higher-growth areas such as the Internet of Things. Due to the headwinds mentioned, Qualcomm’s revenue is down 14% through the first three quarters of the year. But the company’s device sales rose 15% last quarter, year-over-year.
Pricing is a challenge, but the global smartphone boom remains intact. And Qualcomm is in the middle of a promising restructuring that could meaningfully reduce costs.
Qualcomm plans to reduce its costs by $1.1 billion annually starting in fiscal 2016, in part by reducing its workforce, and also by cutting its stock-based compensation by $300 annually. As a result, its margins should expand going forward. Management expects gross margins to reach 16% by the fourth quarter next year, with a longer-term objective of 20%.
At the end of last quarter, Qualcomm held $35.2 billion of cash, cash equivalents and marketable securities, representing 7% growth from the same time last year. Its long-term debt-to-equity ratio is a comfortable 30%. Improved profitability and a strong balance sheet could make Qualcomm the next company to announce a huge deal.

Compelling Valuation and Cash Returns

In the meantime, Qualcomm stock is cheap and pays a high dividend. It trades for 16 times trailing earnings per share and just 12 times forward earnings estimates. Meanwhile, the S&P 500 index trades for about 19 times earnings.
Qualcomm is a cash-generating machine with a fortress balance sheet. The company generated $1.75 billion of free cash flow last quarter alone. All this cash is starting to pile up on the books and it’s sharing its cash hoard with investors. Qualcomm returned $6.2 billion to investors just last quarter in dividends and buybacks.
The stock offers a 3.2% dividend yield, as well as strong dividend growth. In the past five years, Qualcomm has increased its dividend by 20% per year. If its turnaround remains on track, Qualcomm stock could offer an attractive total return moving forward.
DISCLOSURE: Bob Ciura personally owns shares of Qualcomm (NASDAQ: QCOM).