Power up: 12 semiconductor stocks well placed for the Internet of Things

This article is part of a series called The Future is Smart: How the Internet of things is changing business.

Follow the series at tgam.ca/internet

One of the problems with investing in the Internet of Things – as documented in this space last week – is that many of the companies producing the connected devices and analyzing the data are gigantic concerns. This new stream of revenue is fast-growing, but it's also a drop in the bucket for companies like Google Inc., Apple Inc., General Electric Co. and Cisco Systems Inc.

There's another way to play the trend, however. After all, Internet of Things devices, such as the PC and smartphone before them, need computing power to function. And that's where the makers of semiconductors, once again, are poised to sell billions of chips to make our world go. (Analysts at Citigroup forecast IoT semiconductor sales to grow at a 29 per cent annual rate from 2014 to 2017, versus 3 per cent for the overall semiconductor industry.)

There are, however, an overwhelming number of choices of chip makers. According to S&P Capital IQ, there are 100 public companies on the major U.S. and Canadian exchanges whose primary business is semiconductors. (Only one of the 100, tiny ViXS Systems Inc. is on the TSX.)

You could buy a semiconductor ETF – there are six of those, according to website ETFdb.com (see lower table) – but not all chip makers are well-positioned for the Internet of Things, the concept of a whole array of physical devices connected to the Internet, gathering and sharing data, and helping us make better decisions. So we quizzed semiconductor-sector analysts to get a few names of specific stocks that might rise along with the IoT trend.

First, however, let's get a very basic explanation of the role semiconductors play in the Internet of Things. Harsh Kumar, an analyst at Stephens Inc., uses the Nest thermostat, owned by Google, to illustrate. The typical IoT device, he says, needs chips for four to five functions.

In the case of the Nest, a sensor chip must determine the room's temperature. An analog-to-digital chip converts that information into something the device can interpret. A microcontroller processes that information in order to change the temperature. Another chip converts that directive back to analog information so the home's heating-and-cooling system can make the change. And a communications chip is in charge of relaying all of this to the home's owner via cellphone or similar portable device.

Many semiconductor companies attuned to the IoT opportunity are now trying to amass a portfolio across all the pieces – sensors, analog chips, microcontrollers, and communications chips, Mr. Kumar says. The leader, so far, is Silicon Labs (SLAB), which "has been on this train for about three years now, and it's probably got the most robust and somewhat complete portfolio relative to other players," he said. As a result, "it gets rewarded with a very high multiple, for that reason. It's almost 24, versus an average of 17 to 18 times for [other semiconductor] companies."

That pricing makes Mr. Kumar slap a "neutral" rating on the shares, because at Friday's close of $56.08 (U.S.), they're trading above his $55 target price. But eight of 14 analysts covering the stock have "buy" ratings, including Ian Ing of MKM Partners, who calls Silicon Labs the "top way to play IoT" in the semiconductor space and has a $60 target price. "We find SLAB attractive either as an organically growing IoT company or a potential asset of interest to larger companies looking to increase exposure," Mr. Ing writes.

Stephens's Mr. Kumar says investors should take a close look at the small number of public companies with strong microcontroller businesses. "You have probably 50 to 60 analog companies and several sensor companies, but you have a limited number of microcontroller guys that matter."

In addition to Silicon Labs, those names, says Mr. Kumar, are Microchip Technology Inc.; Atmel Corp.; NXP Semiconductors NV, and industry giant Intel Corp., which has a microcontroller business. He has a "buy" rating on Atmel, because in his view it "has a lot of potential in terms of operating leverage," with margins in the 14-per-cent to 15-per-cent range that could grow to approach the 32 per cent at many peers.

Microchip Technology is the top semiconductor pick at Citigroup. "The company's share gains, high margins, management of cash and outstanding track record on acquisitions have resulted in superior earnings growth," Citi's analyst team said in a recent IoT report.

The chip-design intellectual property companies, which make money from licensing technology rather than manufacturing chips, are the best-positioned to benefit from IoT, believes analyst Gary Mobley of the Benchmark Co. Their licences include technology crucial for microcontrollers, he says. That list: ARM Holdings PLC and Imagination Technologies Group PLC, which both trade on the London Stock Exchange; and Nasdaq-listed CEVA Inc.

The analyst team at Canaccord Genuity, having travelled to the Consumer Electronics Show in Las Vegas among a number of tech conferences this year, has grouped the chip makers into specific IoT themes.

You like the trend of the connected car, one of the biggest trends at this year's CES? Canaccord has "buy" ratings on Ambarella Inc., whose chips are used for dashboard and backup cameras; NXP, which, in buying Freescale Semiconductor Ltd., will now be No. 1 in automotive semiconductors; and industry giant Qualcomm Inc., which is extending its smartphone products into automotive. Canaccord also cites Atmel and Nvidia as top players in auto IoT, but has "holds" on the shares.

Canaccord also notes Ambarella's video efforts in the consumer market and joins others enthused about Silicon Labs, citing its chips' presence in Nest thermostats and applications by giant cable company Comcast Corp. Home and business security systems are another theme – and Canaccord again cites NXP, as well as "buy"-rated ARM Holdings.

Finally, Canadian investors with a taste for income can consider Texas Instruments, a top pick at Citigroup in part because of its commitment to return cash to shareholders, resulting in one of the highest payout ratios in semiconductors, the Citigroup analysts say. "We believe its operational excellence combined with superior usage of cash will result in the highest earnings growth in our coverage universe."

Semiconductor stocks

Buying stocks in semiconductor companies is a way for investors to play the Internet of Things trend, because connected devices need chips to function. There are, however, an overwhelming number of choices of chip makers: 100 on the major North American exchanges. So we quizzed semiconductor-sector analysts to get a few names of specific stocks that might rise along with the Internet of Things.