Turn This Overlooked Stock’s Plunge Into Big Profits
The semiconductor industry has always been extremely cyclical and volatile. Demand for chips fluctuates widely with the product cycles of major tech companies like Apple (NASDAQ: AAPL) and Samsung (OTC: SSNLF). At present, it looks like the industry is signaling a slowdown.
Shares of Samsung are 16% off their year-to-date highs, and this week the company reported its seventh straight decline in quarterly profits. Taiwan Semiconductor Manufacturing (NYSE: TSM) is down 14% since late April on slowing smartphone shipments, and SK Hynix has dropped 20% on the Korean market since early June.
These semiconductor stocks have something in common besides their plunging stock prices. They are the three main customers of another company, accounting for more than 30% of its revenues. And while Samsung, Taiwan Semiconductor and SK Hynix are each down double digits in recent months, this shared supplier is only 8% off its year-to-date high. Plus, the stock is trading at a premium to its five-year average price-to-sales multiple.
With second-quarter earnings approaching, this semiconductor equipment supplier may be due for a correction that we can leverage into a 62% gain.
Before we get to today’s trade, one of my colleagues made a bold call this week — predicting the broader market is at the start of the biggest correction since 2008. He is seeing several major warning signs that also flashed before the dot-com bust and 2008 financial collapse. He has put together a presentation to warn investors about the dangers they face and help them prepare. For a limited time, you can access it here free of charge.
Semiconductor Demand Sinking
PC demand has been weak for years and smartphone demand is now slowing from its meteoric growth. The market in China is becoming saturated, while weak economic growth across the rest of the world is stifling demand.
Global smartphone shipments are expected to increase just 16% this year and only 8% next year, according to Bernstein Research. That’s a huge decrease from a peak of 68% growth just four years ago.
Beyond potential lower demand for semiconductors as a result of this trend, pricing power for manufacturers and other suppliers is likely to weaken as well. Nearly $70 billion in mergers have been completed across the major chip users over the past few months, more than the prior five years combined. This will mean fewer customers for foundry manufacturers and equipment makers.
Many suppliers of equipment and services to the semiconductor industry have already started to see their shares sink. Tokyo Electron (OTC: TOELY) is down 16% this year and Applied Materials (NASDAQ: AMAT) has plummeted 26%.
But investors seem to have forgotten one equipment supplier. Lam Research (NASDAQ: LRCX) is down just 2% so far this year. The $12.3 billion company supplies wafer fabrication equipment, which is used in making semiconductors.
While LRCX escaped the weakness seen by its key competitors thus far, it may not be long before the stock takes a hit — especially considering, as I mentioned, Samsung, SK Hynix and Taiwan Semiconductor account for more than 30% of the company’s sales and have all displayed weakness of late.
With demand for semiconductors weakening and news from key customers turning negative, I am positioning for shares of LRCX to follow the rest of the industry lower.
Make a 62% Gain on a 9% Stock Move
Lam Research is scheduled to report earnings in late July, shortly after Taiwan Semiconductor and SK Hynix post their numbers. An earnings miss by any of these companies could cause shares to tumble.
Analysts expect Lam to post year-over-year sales growth of 17% in the second quarter. Right now, the stock trades at 2.8 times trailing sales, slightly above the five-year average of 2.3, according to Morningstar. My downside target for the stock is $70.60, based on a sales miss this quarter and a negative outlook.
That target is 9% below the current price, but using a put option strategy, we can leverage that move into 62% profits.
Currently, we can buy LRCX Sep 77.50 Puts for about $4.25 per share. That is a put option with a $77.50 strike price that expires on Sept. 18. Each contract controls 100 shares, costing you $425 per contract.
The trade breaks even at $73.25 ($77.50 strike price minus $4.25 options premium), which is 5.6% below the current price.
If weak earnings or outlooks push LRCX to my $70.60 price target by expiration, the option will be worth at least $6.90 ($77.50 strike price minus $70.60 stock price) for a 62% return in 71 days. Place a good ’til cancelled (GTC) order to exit at this price.
Buying the September puts means we will have some time value left in the options after earnings this month. So if they are better than expected, we should still be able to close out the position without a total loss. But I do not see this happening with the recent news in the semiconductor industry.
While LRCX has largely escaped the sell-off in semiconductor equipment suppliers, the industry is clearly facing weaker demand. Investor sentiment could be hit hard as analysts start reducing expectations and companies lower guidance.
Beyond weakness in the semiconductor industry, market expert Jared Levy — who foresaw both the dot-com bust and the 2008 financial collapse — is predicting hundreds of popular stocks could tumble 10% to 30% in coming weeks. Find out why and what you can do to protect yourself by clicking here.