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Avoid the One Chip Wonder

There's a lesson to be learned from these former highfliers in the chip industry.

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Since its inception in the 1950s, the semiconductor industry has been the key driving force behind the numerous technological advances that have transformed the world. Just in the last 20 years, the semiconductor revolution has brought us numerous life-changing advances such as the computer, mobile phone, and Internet. However, the profound influence that chipmakers have had on the world has not necessarily translated into long-term success and profits for the companies involved. In fact, throughout history, the industry's wasteland has been littered with many once high-flying firms that changed the world only to crash and be forgotten over time.

As investors, it's important to remember this oft-repeated lesson when looking at the landscape of semiconductor stocks. The latest "one chip wonder" company with the hot new technology has come many times before and will come many times again. By knowing how this story often ends, we can recognize and avoid the trap of investing in these firms, even though the rest of the stock market may be enamored with them in the short run.

The Typical Semiconductor Story
A "one chip wonder" company (which we'll call Acme) is a relatively young firm with one product line that drives the bulk of its sales. Acme becomes a hot name in the semiconductor universe because of its rapidly growing revenue; the firm's chips are used to provide the cutting-edge technology behind the latest world-changing gadget or application, which is selling like hotcakes. By being the first company to offer these new chips, Acme will almost always have parlayed its first-mover advantage into a technology leadership position and dominant market share in its emerging chip segment. Soon enough, the firm will become a Wall Street darling and will begin to see its share price rise. Investors become convinced that Acme will become the next  Intel (INTC) because the new must-have gadget powered by Acme's chips will one day be as ubiquitous as the personal computer. While such bright prospects may have the market flocking towards Acme's stock, these situations are often the ones that investors need to avoid in the chip space.

The fundamentals of the semiconductor industry have evolved to make it very difficult for the Acmes of the world to sustain their success. Although Acme may claim the most advanced technology behind its chips, this must not be mistaken for a long-term competitive advantage. There will almost always be other chipmakers with the technology capabilities to eventually develop chips to take market share from Acme. Further, chips for almost all devices, including the latest must-have gadgets, are now designed around standards and specifications that have been agreed upon by the technology industry. This is critical for integration and technology development along the supply chain, but it fosters competition and levels the playing field in the new semiconductor market segments.

As the once-heady expansion rates of the semiconductor industry have given way to more mature growth over the years, the prospects of Acme's chip segment will attract an onslaught of competition from both small and established semiconductor companies. As a result, it is often only a matter of time before Acme's dominance in its emerging chip segment gives way to rapidly declining market share as competitors arise. Even though the world-changing must-have gadget will continue to sell well, Acme will begin to face rapidly declining average selling prices for its chips, brought on by increasing competition, and will see its revenue and profitability plummet. As the story goes, unless Acme can defy the odds and successfully diversify into other segments of the chip industry, the firm will eventually bleed red and fade into oblivion. Once beloved by Wall Street, Acme will see its stock price plummet and will end up in the wasteland of "one chip wonder" busts.

Past and Future One-Chip Wonders
This plot has played out over and over, and while the company and technology will be different each time, this can serve as a general framework for recognizing "one chip wonders." In fact, we can apply this story to a number of once-hot chip stocks--and even to some chip firms that will likely to turn out to be "one chip wonders." Below are several examples.

Company:  SiRF Technologies (SIRF)
Claim to fame: GPS device chips
SiRF came to prominence with the growing popularity of GPS systems in recent years. At its peak, the firm had over 90% share in the GPS chip segment and boasted a technology lead in the space. Although SiRF's ICs are used in GPS devices from the likes of  Garmin (GRMN) and TomTom, as well as in converged mobile devices, like the Blackberry from  Research in Motion (RIMM), the firm's edge could not prevent a plethora of competitors from entering the market. In the past year, SiRF has had a tough time fending off established chipmakers such as  Broadcom (BRCM) and  Infineon (IFX) and has seen its business hit a roadblock. To make matters worse, the firm is in the midst of defending itself against patent litigation from Broadcom. While patent settlements and cross-licensing agreements are commonplace in the semiconductor industry, SiRF will unlikely be able to regain its past glory even if it can put legal issues behind it.

Company: Sigmatel
Claim to fame: MP3 player chips
Sigmatel come to the fore with the rise of the MP3 player. In the middle of this decade, the firm emerged to dominate the market for chips used in MP3 players, thanks to its first-mover advantage. At one point, the firm even supplied chips for  Apple's (AAPL) iPod Shuffle. However, the MP3 chip market ultimately became crowded with competitors, including Samsung, PortalPlayer, and  Actions Semiconductor (ACTS). The success of Apple's iPods didn't help the firm either: Sigmatel couldn't defend its position as a supplier to Apple's iPod product line from competition. Sigmatel stock reached as high as the mid-$40's during its prime, only to get bought out by Freescale for $3 per share as the firm's fortunes faded.

Company:  Sigma Designs (SIGM)
Claim to fame: Internet protocol television (IPTV) set-top box chips
Sigma Designs has been a prime candidate to become one of the next "one chip wonders." The firm's revenues have ballooned over the past couple of years, driven by sales of chips used in set-top boxes for IPTV. IPTV is a technology that's rapidly being adopted by telecom carriers, such as  AT&T (T), to stream high-quality television to homes through the Internet. Sigma Designs holds the technology lead in IPTV chips and dominates that market segment, having successfully defended its stronghold so far. However, the high growth potential of its business has caught the attention of established chipmakers such as Broadcom and  STMicroelectronics (STM). Even semiconductor behemoth Intel looms as a possible threat for Sigma down the road. It's likely only a matter of time before Sigma Designs' business comes under siege by competition.

The next time the market tags a hot chipmaker as the new must-own stock, keep the storyline above in mind: it may very well be another "one chip wonder" that will eventually end up on the trash heap of once-hot semiconductor companies.

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