Something that’s always intrigued me about the technology sector is the cyclical nature of chip products. These are the companies that manufacture the highly complex computer chips that go into the hardware into our phones and computers, and yet they are treated by the market like commodity producers.
While this might seem counter-intuitive at first, it is important to recognize the rate at which innovation is occurring in this space, and how it is that something as sophisticated as a processing chip can become as commonplace as a chunk of rock in a matter of months.
In today’s article, I’m going to share how it is that chip companies are being valued as much on the basis of production as they are on their capacity for smoothly evolving the product’s complexity over time, making for a somewhat three dimensional evaluation model of production.
One of the most important metrics involved with evaluating a chip manufacturer is their ability to produce cash from revenues. Essentially this means that investors are looking to see that a manufacturer has existing clientele, and is able to turn-over inventory as it is produced. From there, things become a bit more qualitative. Investors want to be able to look at the rate at which innovation is occurring in the industry, and see how it is that the particular chip maker that they are evaluating is keeping up.
This can be done by looking at MD&D statements, and analyzing what sort of capabilities are being invested in, against the capabilities that competitors are working on, and what capabilities clients will require. The main purpose of this is to assure investors that the company’s current cash-flows will be maintained, if no increased, at a level that preserves a dividend.
As a more quantitative-focused investor, I find that a good indicator of how it is that a particularly manufacturer is doing for keeping up with its competition and clientele is by evaluating the R&D spending. Since this expense account explicitly represents the manufacturer’s investments into improving its product.
Given the somewhat linear nature of the expenses associated with this sort of innovation, it becomes fairly simple to compare the R&D expenses amongst competitors, with forgiveness for competitive advantage, and make sure that the company being evaluated is at least keeping pace with the sophistication of its competition.
In taking all of these aspects into account, it becomes apparent that chip manufacturers actually do take on many of the same traits of commodity companies, which is why they are evaluated similarly as cyclical industries. By taking into account linear sales, production, and research expenses as indicators of a company’s ability to keep up with the market pace, we can understand the security of a given dividend, and determine whether or not there is a place for it in our portfolio.