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These Unpopular Tech Stocks Are a Great Value

As digital technology speeds ahead, analog firms stand to be the real winners.

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Computers are built to understand zeros and ones--digital data. But for you and me, these digital bits are pure gobbledygook. The interface between the computer world and the real world comes in the form of analog chips.

Analog chips take real-world signals such as temperature and sound, processing and converting them to the zeros and ones that a computer understands. We think the analog chip business has many attractive economic features and that some of the strongest analog chipmakers stand to gain big from the accelerating shift toward digital content. Our favorites include  Maxim Integrated  (MXIM),  STMicroelectronics (STM),  Texas Instruments (TXN), and Analog Devices (ADI).

Computers Are Everywhere
Go to your local store and buy a dishwasher or clothes dryer. Chances are that even these low-tech, everyday items will rely on multiple computer chips to do their jobs. Functions that used to be controlled by mechanical devices such as gears and thermostats have increasingly been taken over by digital chips called microcontrollers. These chips are cheap to make, easy to install, and can't be cheaply repaired when they break (good news for a dishwasher maker). Microcontrollers must interact with the real world, and do so through the interface provided by analog "helper" chips.

Every time you see someone with an  Apple (AAPL) iPod or watching a movie on DVD, think analog as well. The music and images stored in digital format must be converted to analog signals that humans can understand; again, this job falls to analog chips. The demand created from our increasing reliance on computers for entertainment, information, communication, and daily chores is one reason we think analog chips will continue to be hot products for years to come.

Analog Economics Are Good
The economics of analog chip firms are far superior to those of their digital chip brethren. In order to stay on the cutting edge of digital technology, digital chipmakers must either spend billions of dollars on state-of-the-art "fabs" or accept the lower margins that result from outsourcing production to contract manufacturers. To make matters worse, digital technology progresses at a breathtakingly fast pace, so enormous capital expenditures must take place every few years. Increasingly, there are only a few companies in the world that can afford these huge costs. Contrast this with analog technology, where state-of-the-art means innovative, patent-protected circuit design rather than cutting-edge fabrication technology. The focus on design rather than fabrication means that analog chipmakers are not saddled with the huge financial burden of building multibillion dollar fabs every few years. The savings naturally gives rise to healthy profit margins and strong, stable cash flows.

The Power of Price
Analog chipmakers typically are either insulated from pricing pressure or can exert pricing power. There are two kinds of consumers of analog chips: large, global conglomerates and small- to midsize product designers. For a large customer like  General Motors (GM), the materials that go into a car cost thousands of dollars, out of which only $20 or so are analog chips. Because the chips are such a small part of the total bill of materials, these big buyers tend to negotiate less on price and more on functionality, durability, and the like. Smaller buyers, ordering lower quantities, do not have the negotiating leverage to successfully haggle with the much larger chipmakers. In either case, the analog companies are in the catbird seat when it comes to setting prices at levels that will allow them healthy profitability over the life cycle of their chips.

Switching Costs Favor Analog Firms
Once an analog chip is "designed into" a particular product, engineers are not wont to switch to a competitor's chip. Switching chips midstream would mean that engineers would have to redesign and retest the product just to make sure the new chip worked as expected in the device. Selling analog chips does take some time and effort on the part of the analog chipmaker, but once the order is finalized, that chip is virtually guaranteed to generate revenues for as long as that product it helps power stays on the market. For example, a dishwasher sold in 2007 probably has the same chip as one that sold in 2000; that's seven years of revenue for a chip on which the analog chipmaker hasn't had to spend research and development or marketing resources for years. This means that revenue at analog chip firms is much more stable across different stages of the business cycle than at high-tech companies, which rely on being the first to market with the latest cool gadget.

In the following section, we've gathered some thoughts on our favorite analog firms. We think all four of these firms are trading well below what their businesses are really worth.

 Maxim Integrated Products (MXIM)
Maxim specializes in designing high-performance analog chips, with a margin profile that rivals the most profitable software firms; its gross margins are in the high 60s, and its operating margins are in the 40s. We like Maxim's differentiated chip designs, extensive product portfolio, and team of talented engineers that are in short supply in the industry. We think these competitive advantages should enable the firm to continue earning outsized returns and creating value for shareholders in the long run. Although there are some concerns that Maxim's new strategy to enter high-volume consumer electronics markets may hurt margins, we believe Maxim has the ability to accelerate operating earnings growth by expanding sales at a faster pace than expenses. Its recent delisting from the  Nasdaq (NDAQ) exchange hurt the stock price, but we think the event has no impact on the solid long-term prospects of Maxim.

 Texas Instruments (TXN)
Texas Instruments derives about half of its semiconductor revenues from analog chips, but the market still seems to think of it as a one-trick pony in the digital mobile phone chip arena. We think that TI's scale, its excellent client relationships, and its strategic approach to manufacturing will end up serving its shareholders very well. We also like TI's long tradition of high standards of corporate governance; in fact, it is one of only a handful of companies that merit Morningstar's A Stewardship Grade. In addition, TI has an extremely aggressive stock buyback policy and, while its dividend yield is still low, it has increased payouts an average of 15% per year since 2003.

 STMicroelectronics (STM)
Europe's largest chipmaker has strong ties to top European manufacturing firms and generates roughly a third of its revenues from sales of specialized chips for the automotive and industrial markets. In addition, it has a long history with number-one mobile phone handset maker  Nokia (NOK), to which it supplies a large proportion of the Finnish giant's analog chip requirements. We believe that ST Micro's decision to jettison its volatile, low-profitability memory division will allow the company to focus more on its core operating divisions and begin generating better returns on invested capital.

 Analog Devices (ADI)
Little known outside the semiconductor industry, Analog Devices is the market leader in data converters and amplifiers that bridge the digital world with the real world that we live in. We believe Analog Devices is well-positioned to expand in promising areas such as consumer electronics and automotive, as demands are increasing for more real-time and accurate interaction between consumers and electronics devices. Its recent decision to sell the ailing businesses in digital signal processing and wireless communication should also allow the firm to allocate resources where most profits can be made, leading to better efficiency and investment returns.

Morningstar Equity Analyst Dan Su contributed to this article.

Erik Kobayashi-Solomon does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.