The themes for the future are clear; improving technology and connectivity, allied with convenience continues to drive the mobile computing revolution. This will maintain rising sales of tablets and smartphones for personal and business use, together with a shift away from processing in the office (desktops or local server storage) towards cloud applications (apps) and off-premise data storage.

Yet the share price performance of the relevant sector has been disappointing. The Technology Hardware and Equipment sector is down more than 13% year to date with only three out of the UK’s 39 UK industry sectors performing worse. This is even more surprising considering the hefty 87% premium that convinced shareholders in Edinburgh-based audio chipsets designer Wolfson Technologies (WLF) to accept a £291 million takeover by Texan rival Cirrus Logic in April.

Much of the sector dour performance can be calibrated to ARM (ARM), which represents roughly 91% of the sector’s value, and its disappointing share price slide from £10.99 on 1 January to the current 875p, a year low for the stock. Investors were left disappointed when ARM reported (23 Apr) lacklustre underlying first quarter semiconductor royalty revenue growth of just 7.9%, far below the 19% target for 2014 as a whole. That saw the shares lose 4% on the day to 944.5p, and the decline has continued since.

‘The market is mistakenly viewing royalty revenues as lower quality,’ said analysts at Charles Stanley at the time. There are several factors that could help spark a royalties rebound. These trends include, according to Charles Stanley, the semiconductor industry’s accelerating switch to 64-bit architecture thanks to mobile computing, enterprise networking, chips for ‘Internet of Things’ devices and as bumper first quarter new licences start to generate cashflow. ARM’s licensing revenue is what drives future royalty income and 26 new licences were signed in the first quarter, helping revenues jump 38% to $111.6 million. Impressive cash generation means dividends could grow faster than the rough 19% growth rate at which earnings are expected to expand.

ARM has not been alone in failing to offset royalty disappointment with rapid licence growth; Imagination Technologies (IMG) has suffered similarly. The £562 million company delivered an impressive beat on licencing revenues in full-year results (24 Jun) that implied a strong second half of its financial year. Imagination chalked-up £38.3 million on licences compared to the £35.1 million anticipated by analysts at Investec, sparking a near 6% share price jump on the day to 246.9p. Yet analysts largely looked beyond the silver lining to see only the cloud. Royalties were, just like ARM, the bone of contention.

The worry remains that demand is slowing from key customer Apple (AAPL:NDQ) ahead of the iPhone 6 launch in September, while pressure from low-cost smartphones flooding the market isn’t helping sentiment.

These are tough times for Imagination as the semiconductor designs company continues to grapple with a difficult, and painfully slow, transition. The strategy is to build a more expansive business model and customer base beyond the graphics expertise it has developed over many years. This was to be accomplished in part via PURE, its consumer DAB digital radios and other devices arm, but more importantly with the help of the $100 million acquisition of MIPS, completed in February 2013. That bolt-on deal builds on Imagination’s graphic processing unit (GPU) chipsets expertise with central processing unit (CPU) technology, effectively putting the company on a collision course with ARM.

That GPU/CPU power struggle has still to play out, while recent news that Intel (INTC:NDQ) has sold part of its stake in Imagination hasn’t helped sentiment. But concern - and in some quarters, consternation - runs deep over Imagination’s continued commitment to PURE. Management vigorously defends the business, insisting that it remains core to the company’s long-run ‘Internet of Things’ and connected devices ambitions and that argument has merit. But what galls onlookers, not to mention investors, is the business investment Imagination continues to pour into PURE while stubbornly refusing to deliver tangible returns.

Revenues from the business peaked at £33.6 million in the year to April 2010, and have declined every year since, falling again in the financial year to April 2014 from £25.8 million to £23.2 million. In those latest results Imagination points out progress, launching a new line of Jongo wireless speaker products in key UK and US markets and an ongoing refresh of DAB products. The company claims that it is seeing ‘strategic interest from key players in our wireless and multi-room speaker technologies’ resulting in a several new license wins, yet sceptics argue that with digital radio easily available on most smartphones, tablets and many TVs, separate DAB radios could soon be obsolete. Wireless connectivity looks its best bet, where surround sound speakers can be connected to hi-fi systems and TVs without the clutter of wires running around a room. But the proof of the pudding is in the eating, and Imagination must start to reverse the decline in PURE revenues sooner rather than later.

Homegrown talent

The UK has a vibrant role in the global semiconductor industry despite many large players being situated elsewhere in the world. South Korea, Japan and Taiwan share much of the manufacturing volumes with Silicon Valley, still regarded by most as the natural home of the microchip and where the world’s biggest producer Intel is based. Yet ARM is the world’s biggest semiconductor intellectual property (IP) company and that lives in Cambridge, UK.

Also based in Cambridge is CSR (CSR), which has developed a strong Bluetooth wireless connectivity chips business; while IQE (IQE:AIM), operating out of overseas and Cardiff hubs, is a leader in wafer preparation.

In theory, the UK semiconductor industry should be in rude health. According to the Semiconductor Industry Association (SIA) worldwide sales of semiconductors hit $26.3 billion for in April 2014, a year-on-year increase of 11.5% and a slight tick upwards from March’s $26.2 billion. ‘The global semiconductor market maintained its strong momentum in April, with year-over-year sales increasing across every region and product category,’ says Brian Toohey, the SIA’s president and chief executive officer (CEO). ‘The market remains well ahead of the pace set in 2013, which was a record year for semiconductor revenues.’

Worldwide semiconductor sales for 2013 reached $305.6 billion, the industry’s highest ever annual total and an increase of 4.8% on the $291.6 billion chalked-up in 2012. Total sales for the year narrowly beat expectations from the World Semiconductor Trade Statistics (WSTS) organization’s industry forecast of $305 billion. The global semiconductor industry exceeded $300 billion in sales for the first time ever in 2013, spurred by consistent, steady growth across nearly all regions and product categories,’ reported the SIA’s Toohey in February, ‘indicating that recent momentum is likely to carry over into 2014.’

Forecast from the WSTS chime with Toohey’s confidence, which expects record global semiconductor revenues every year right through to 2016.

In the midcap market investors should also be looking at CSR, which is Shares’ favoured play on the UK semiconductor space. CSR has a more traditional business model in which it designs and builds the chips for sale into original equipment manufacturers (OEMs), predominantly used for Bluetooth communications and GPS location.

In the past there have been fears that Bluetooth is old technology and such direct machine-to-machine linkage would be overtaken by area-wide connection like WiFi. Yet that has not happened as mobile devices have needed direct connection to cars and in-home hi-fi and speaker units. Also pushing Bluetooth forward are new low energy Bluetooth connectivity technology which has helped revitalise the market and with it CSR’s fortunes. The company is having particular success with its IP-owned, patented Bluetooth Smart technology.

CSR has not been immune from the sell-off within the UK’s semiconductor space this year. Its shares have slumped 28% since hitting 806.5p in March, an eight-year high, on short-term tapering of revenue growth as low-margin legacy components are phased out, a theme well-flagged by the company and sensible in the long-term. To illustrate that latter point it’s worth looking at CSR’s gross margins.

In 2013, overall gross margins of 52.8% obscured a sharp split between the 60.2% earned on core product sets in voice/music and autos compared to the 30.1% from legacy consumer electronics and mobile products. What this trend implies is that while headline revenues may show short-term declines, underlying growth will accelerate, and deliver high-quality profits and earnings down the line.

Analysts remain largely upbeat about the long-term growth prospects of the UK semiconductor specialists and, as sentiment changes tack, we believe that will drive a re-rating of the Technology Hardware and Equipment sector. Six months from now we could be talking about this sector as being one of the UK’s strongest performers, unforeseen shocks permitting.

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Number of stocks: 8

Market cap: £13.5 billion

ARM (ARM) 875p

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Market value:£12.2 billion

Prospective PE Dec 2014: 37.4

Prospective PE De: 30.5

CSR (CSR) 582.5p

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Market value: £980 million

Prospective PE Dec 2014: 21.1

Prospective PE Dec 2015: 16.7

Imagination Technologies (IMG) 212.1p

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Market value: £562 million

Prospective PE Apr 2014: 32.2

Prospective PE Apr 2015: 28.9

(Click on graphics to enlarge)