Analysts Vivek Arya, Adam Gonzalez and Wills Miller said the potential for tax reform and rising interest rates have renewed interest in the U.S. SMidcaps, as reflected by the 8 percent gain in the Russell 2000 in the past month, 500 basis points above the S&P 500.
With semiconductors being more global than domestic, the analysts expect fund flows and a likely year-end chase for beta to potentially favor selected SMidcap semis.
Top SMidcap Semiconductor Picks
The analysts highlighted Buy-rated ON Semiconductor Corp ON, Cypress Semiconductor Corporation CY, Cavium Inc CAVM and Advanced Micro Devices, Inc. AMD as the firm's top picks.
The firm indicated that each of these have product-cycle catalysts, with 25 percent, plus, upside potential to its price target. Additionally, the firm noted that these companies have forward 2018 PE multiples below the expected earnings growth.
"Our key thesis is that the consolidation-driven benign pricing environment, and new cyclical (industrial/auto) and secular (IoT, cloud, 5G) growth drivers, can enable SMidcaps to exceed growth and profitability levels versus prior cycles," the firm said.
ON Semiconductor Offers Highest Multiple Re-Rating Potential
BofA Merrill Lynch sees ON Semiconductor as offering the highest re-rating potential in the semiconductor sector. The firm expects the company to potentially outgrow two times, relative to the consensus, with the company being diversified across industrial auto markets.
The firm also sees operating margin expansion from 15 percent to 19 percent. Overall, the firm said it sees 15 percent, plus, free cash flow growth, which it feels would be sufficient to retire a third of the company's $7.5 billion current market cap.See also: Nibbling At A Semiconductor ETF
Cypress Has 41% Upside
The firm said the latest Apple Inc. AAPL's iPhone 8+ teardowns confirm Cypress' position as the fast-charging supplier, given its estimate that the company makes up 75 cents of content in nearly 65 million/178 million new iPhone 8 and onward models projected for calendar year 2017 and 2018, respectively.
Additionally, the firm sees upside from complementary chips in wall chargers.
Accordingly, the firm estimates to $50 million of potential Apple sales in the second half of 2017 and $178 million in 2018, which represents 5-percent upside to its current model.
The firm thinks worries about an auto cycle could have been overstated, as it expects the U.S. weakness to be mitigated by strong content growth in premium cars as well as Europe/China auto units. The firm sees the 3 percent dividend yield of the company as unique in small caps.
Best In Class: Cavium
BofA Merrill Lynch noted that Cavium Is up only 3 percent in the year-to-date period, as worries regarding networking infrastructure capex, especially in China, and the QLogic acquisition weigh down. This is despite the company reporting solid second-quarter results and raising its outlook, the firm noted.
"We believe this has created an enhanced opportunity for one of the fastest growth companies in semis (15-20% topline growth, 25%+ EPS growth potential), with unique assets in multicore security processors, enterprise storage, ARM servers and networking chips," the firm said.
Additionally, the firm said Cavium is very well positioned for the upcoming 5G wireless cycle, as it believes it is the only vendor that can challenge Intel Corporation INTC and Broadcom Ltd AVGO in large markets. The firm's price target represents 33 percent upside from current levels.
Very Positive On AMD
The firm noted that persistent stock selling by AMD's largest insider Mubadala and the delays in gaining tangible market share against Intel and NVIDIA Corporation NVDA has created volatility in the company's stock. However, the firm said it is very positive on AMD's new portfolio of EPYC server chips and Ryzen PC chips.
These chips, according to the firm, have disruptive features at attractive prices and the potential to take material share away from Intel in 2018. With Mubadala's stake shrinking, the firm thinks its selling could cause less of an impact going forward.
- ON Semiconductor: $23, representing 27-percent upside potential.
- Cypress Semiconductor: $20, representing 39-percent upside potential.
- Cavium: $85, representing 31-percent upside potential.
- AMD: $18, representing 41-percent upside potential.
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