Technology Equity Research: The Kraken of Wall Street?
Right after we published that long-awaited article on equity research, the next question became:
“What about specific groups in research? What about fixed income or buy-side research?”
You’ll have to wait for those last 2 topics, but the first request is answered with this interview on technology equity research.
Our interviewee joined the tech ER team at his bank a few years’ back and now focuses on semiconductors, a sector that’s sometimes more like old-school manufacturing than over-hyped mobile apps.
Here are the circuit specifications for today’s discussion:
- How and why you might want to join the tech equity research team rather than tech investment banking, even if you have vivid dreams of taking the next great start-up public.
- What types of assignments you should expect – from initiating coverage reports to company notes and terminating coverage reports.
- The frameworks and analytics used to analyze companies, and the classes that might give you a leg-up on the job.
- Where to go when you’ve gotten tired of following quarterly earnings and you’re ready for the next move.
Separately, special thanks to Jack Sheng, for his additional insight on how to analyze technology companies and understand the broader sector.
Design and Implementation: How to Get In
A: I liked research because you get more room to take the initiative and analyze companies critically; banking is much more process-driven.
Our job is to figure out the “story” behind the numbers, and especially to track how companies have developed over time.
I liked being able to get a more complete picture of a company as it changes over time.
As for the buy-side: sure, if you’re certain that’s what you want to do and you have the chance to get in, go ahead.
I wanted to start at a bigger firm with more networking opportunities and get to a position where I could move around more easily.
Q: Any tips on breaking in? We’ve covered equity research a few times before, so maybe you can comment on anything additional / different?
A: I would strongly recommend a class on financial statement analysis – it’s critical to everything we do, and many bankers, surprisingly, know very little about this or what key ratios mean.
As you’ve mentioned before, the CFA and networking with CFA groups can help a lot, but you also need relevant work experience to get anywhere.
Remember, though, that a good understanding of the numbers isn’t enough to break into equity research.
You also have to be personable to develop good relationships with buy-side clients (similar to what senior bankers do), and you have to think like a consultant in terms of understanding the big picture.
How Many Chipset Shipments Does It Take to Move the Market?
Q: So what moves the market for semiconductor companies?
A: Applicability. The health of wireless communications, wired infrastructure, and industrial companies (those that focus on power generation and distribution, including for automotive use) shapes the demand for semiconductor products.
It’s a very cyclical industry, similar to chemicals, because prices fall over time as newer and smaller chips are produced and companies keep dropping their prices to compete.
So semiconductor companies are under constant pressure to innovate and deliver new products that can be sold for higher prices, at least initially.
It’s almost like how generics in the pharmaceuticals sector arrive after patents have expired and drive down drug prices.
For semiconductors, the competitive landscape consists of:
- Integrated device manufacturers.
- “Fabless” semiconductors companies (they design and market the chips, but outsource the actual manufacturing).
- Large integrated original equipment manufacturers.
Category #2 is often viewed the most positively by investors because companies there have much less overhead and can therefore grow more quickly, with less capital, at higher margins.
Semiconductor companies compete for market share, higher margins (e.g., by lowering their fixed costs), and better products (e.g., by manufacturing a chip that’s embedded in the hottest new mobile device).
One company, Avago, cites these factors as necessary to compete effectively:
“Quality, technical performance, price, product features, product system compatibility, system-level design capability, engineering expertise, responsiveness to customers, new product innovation, product availability, delivery timing and reliability, and customer sales and technical support.”
The most important parts are product innovation, availability, and delivery timing – if a company misses the latest tech trend, its fortunes won’t be good.
To analyze these companies’ cost structures, you have to look at the supply chains for more complicated components (anything beyond commodity chips).
Raw materials aren’t the main cost drivers in most cases, but sometimes you’ll see manufacturing delays when many companies are all asking the same suppliers for the same components.
Just think about what happens when there’s too much demand for shipping and too little supply, with too few vehicles to transport packages.
Q: Great. And you mentioned the types of companies above, but what about the products themselves?
What do the individual sub-markets look like?
A: Before I begin, some terminology will be useful:
“Digital integrated circuits” produce on/off electrical mechanisms; “linear integrated circuits” track, amplify, or convert signals related to physical conditions such as heat or provide voltage regulation.
Here’s how I see the main product categories – the companies above might do some or all of these depending on how big and diversified they are:
- Broad Line: These firms are known to produce a wide variety of gadgets, including computers and handheld devices (ex: Intel and Texas Instruments).
- Equipment Materials: Areas of operation include panel displays (read: monitors and television screens), silicon systems, energy and environment-related materials, and materials for photovoltaics (ex: Applied Materials and ASML Holdings).
- Integrated Circuits: Used in every electronic device imaginable (ex: Taiwan Semiconductor and Broadcom).
- Memory Chips: The more, the merrier (ex: Micron and Rambus).
- Specialized: These firms produce items for specific functions, such as particle acceleration or infrared cameras (ex: ARM Holdings and Linear Technology).
Q: What about the key metrics and multiples?
A: R&D as a % of sales is important, because a higher percentage there indicates more re-investment into the business and higher growth potential – assuming the money is being spent wisely.
We look at gross margins and sometimes even EV / Gross Profit for companies that do their own manufacturing, since margins are often low and incrementally higher margins can be a competitive advantage.
There’s also a focus on market share and average selling price (ASP) as key metrics; prices tend to fall over time as competitors aim for higher market share.
Sometimes in merger models, we’ll even look at accretion / dilution to gross margin per share – see this presentation on the NetLogic / Broadcom deal for an example.
For a real-world example of the metrics and multiples used, see this Fairness Opinion from Qatalyst Partners on the Texas Instruments / National Semiconductor deal (go to pg. 30).
And for another good example, check out this Fairness Opinion on Advanced Micro Devices (AMD), prepared by Merrill Lynch.
Got Coverage Initiation?
Q: Great. So moving back into the specifics of equity research now, can you tell us how exactly your team decides to pick the companies you cover?
A: It’s mostly a matter of trading volume.
Investment banking fees sometimes factor in, especially if the client has just raised equity and now expects periodic research reports.
But the stocks with the most volume generally get the most coverage.
In practice, this means that larger companies often receive more coverage and attention than smaller ones.
But that also creates opportunities for boutique and middle-market banks to compete by focusing on companies that bigger banks ignore – and in the tech industry, there are lots of small, thinly-traded public companies.
Q: So what do you do once you’re assigned to cover a specific company?
A: As a junior person, most of your time is spent on:
- Modeling / technical work.
- “Interviews” – asking a company’s management team about their business.
The exact split depends on the rest of your team, but generally we do not spend as much time on modeling as you might think.
Most of the work consists of tweaking models, and tech companies tend to have simple financial statements anyway.
Q: OK, thanks – so what about the different types of reports you work on?
A: There are a few categories, which I’ll explain below:
Initiation or Initiating Coverage [of a particular company]: You would start off by introducing the company’s operations, products, and approach to value creation (business strategy).
It’s sort of like a company profile in an investment banking pitch book, but it’s much more in-depth – sometimes these reports are 50-100+ pages and take months to create.
Sometimes IB analysts even request our initiating coverage reports to create their company profiles.
Since many larger semiconductor companies are diversified, you’ll often see a sum-of-the-parts valuation in our initiating coverage reports so we can break out each business segment’s value separately.
Initiation or Initiating Coverage [of a particular sector]: Every once in a while, an equity research team may produce a set of “strategic research” reports on a sector all at once.
They often come with broader commentary that summarizes sector drivers and concerns; they can be pretty insightful, and even if you’re on the buy-side you can pull a lot of useful data from these.
Other equity research teams might simply compile individual company reports and call that a “sector report.”
Company Note: These reports tend to follow major announcements or analyst day conferences.
You’ll more than likely see an income statement in these notes, but not necessarily the full projection model for all the financial statements.
Business Unit Note: Seldom found, but incredibly useful. These reports provide extensive detail on the operations and acquisitions relevant to a particular business unit.
It also presents the sector drivers and trends that impact a business unit’s revenue and costs.
For a good example, see Alliance Bernstein’s report on Honeywell’s Aerospace business unit (you might be able to find this one online if you search around).
Terminating Coverage: This type of report is usually more procedural than informative. It usually states that the bank has stopped covering a certain company (for business reasons or because the company was acquired or taken private), and tells you not look to the bank for further information on it.
As with most other business decisions in equity research, this one comes down to the trading volume and the team’s resources; if the volume can’t support the time/money being spent, coverage will likely be terminated.
Q: So what do you actually do to create these reports?
For example, what’s the process for writing an initiating coverage report?
A: You always start by reading the company’s 10-K filing (or Annual Report for companies outside the US) and talking to the management team.
They’ll walk you through their business, their marketing materials, and their “story,” and it’s your job to decipher how accurate it is.
Will they really grow mobile chip shipments by 15% next year? Can they really outsource a key manufacturing process to boost gross margins by 5%?
You do that by cross-referencing what they say with suppliers, customers, and competitors, and paying attention to overall industry trends.
The qualitative portions of the report are similar to the Porter’s Five Forces analysis that all consultants seem to love – you assess how the company stacks up to competitors in the same space.
As you’re collecting the data, you’re also building the operating model you’ll use in the report and future reports.
You spend a lot of time figuring out which business units are growing or contracting, and how those units drive income statement line items.
For example, if one segment of revenue has increased lately, is it due to increased market share? Higher/lower ASPs? Higher-than-expected component shipments from suppliers? More demand from electronic device companies?
Then, you have to extract the key drivers and make sure your model and report reflect them.
Time for a Motherboard Upgrade: Exiting Equity Research
Q: What do tech equity research analysts upgrade into after finishing their mission?
A: Most sell-side analysts go to the buy-side (mostly hedge funds), business school, or a corporate strategy (“How should the firm diversify its operations?”) group.
There are so many tech-focused buy-side funds of all shapes and sizes that your options are wide open.
You could also potentially get into roles in “competitive intelligence,” where you track performance relative to comparable firms across business lines and geographies.
You get a strong sense of the key operating metrics in ER, so this job also makes a lot of sense.
Q: Any final comments?
A: Don’t just wait for opportunity to show up and ask you to do something. Get on your feet and get going!
Q: Thank you for your time!
A: Happy to help.
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