Heavy Semis

I had a rather interesting back and forth via email today about the Semiconductor sector; My answers are italicized and indented. After some editing and polishing, we present for your semi enjoyment:

Merrill Lynch recenty downgraded chip stocks to underweight from overweight; They also cut semi-equipment stocks to neutral from overweight. Earlier this month, Morgan Stanley said it expects Intel’s third-quarter revenue could come in below estimates. Goldman downgraded Taiwan Semi and United Microelectronics. UBS downgraded semis to neutral from overweight. Deutsche Bank cut Intel’s rating to hold from buy, Lehman trimmed its earnings targets, and Merrill downgraded Intel from neutral from buy.

What the Hell is going on in the this space?

To use a recently popular phrase, this sounds like a bit of groupthink to me.

I pay close attention to the analysts who have both a good track record in the space, and aren’t afraid to go against the crowd. Guys like Thomas Kurlak, who got bullish near the bottom, and recently reiterated his belief that we are still early in the semi-recovery cycle. While that may conflict somewhat with my own macro-perspectives, I’m willing to give a healthy amount of weight to guys who have made excellent sector calls in the past. So I defer in part to Kurlak.

But I remain cautious looking out to mid-2005.

Its not all bad — Semiconductor Equipment and Materials Information (SEMI) predicted sales for suppliers to the chip industry will leap 63% this year, and the SIA projects global chip sales will jump about 29% this year.

Yet there is a lot of pessimism regarding the sector . . . Is the outlook for 2005 already a problem?

I don’t agree with the specific Pessimism for the rest of 2004, but my macro model shows some real problems by mid to late 2005. That’s not specific to Semis – its more of a “How will the economy keep going, once the ‘pig is through the python?’ At higher interest rates, increased commodity prices, raised taxes regardless of who wins in November, and with the stimulus fading, why will the recovery keep expanding?

Darned if I can figure it out.

All day yesterday, Wall Street was waiting for Intel’s 3rd Q outlook. Margin pressure and a modest lowering of Q4 expectations hammered th stock. What does this indicates for the chip and chip-equipment stocks? Will they bve able to avoid the fate that Merrill laid out for them?

I think some of Intel’s problems are due to the real competition developing in the CPU space. One of the unsung aspects of Intel’s margin pressure was AMD – they have matured into a real competitor, and are no longer just an also ran. Their new server chip got rave reviews, is well priced, and will migrate to the desktop. I suspect Intel’s margin issues are only going to get worse going forward.

Inventory levels at chip makers are one thing that seems to concern some of the industry’s analysts, who think that there may be a glut of capacity later on in the year and pricing power may suffer.

I am expecting a surge of orders in the 4th quarter, to take advantage before the accelerated depreciation tax rule, which passed a few years ago, sunsets. It behooves big buyers of hardware / capital improvements to step up and make their buys in 2004 rather than wait til 2005. The Semi expectations of this surge helps to explain the inventory build up – gotta make hay while the sun is shining, and it will shine brightly in Q4.

Of course, this sort of “reverse channel stuffing” (Channel vacuuming?) could hurt sales in 2005. But that’s the law of unintended consequences for you.

What about capital spending? Will the recent batch of warnings from software companies affect semiconductor companies?

Spending on both enterprise software and capital equipment purchases will take advantage of accelerated depreciation rules — hence, the exptectation for a Y2K like run in Q4.

And valuations? Do you see opportunities in the chip sector — as a group, or individually?

Tech valuations are usually too high. The question is, are they absurdly over priced, or merely expensive? Intel, AMD and Sandisk have become, if not cheap, well certainly more reasonably priced than they were.

2005 chip sales estimates range from negative 6% to positive 28%, according to SEMI officials. Where do you think they will fall in that range? Based on expectations for GDP and capital spending growth, it seems that it would be unlikely for chip sales to fall off a cliff. Historically, what kind of performance have chip stocks had at this stage in an economic recovery cycle?

Its hard to make any sort of comparo between this cycle and any previous cycle. There has been incredible post bubble damage, 9/11, unprecedented stimulus, and a war – all the while with very tepid job creation. I simply cannot find an analogous era with which to compare the cycle to.

My viewpoint is that the soon-to-be-gone accelerated depreciation will be the driver in Q4.

As to the chip to recovery cycle, that’s exactly the sort of question I defer to my semiconductor experts.

The Philadelphia Semiconductor Index is down around 20% for the year. Is that a buying opportunity — or the beginning of a longer slide?

I’m looking for a bounce into the end of the year, and possibly the first or second Q ’05. After that, there could be trouble.

Any concerns about a possible slowdown in China, as it relates to spending in the chip sector?

Bwah ha ha ha – slow down in China – that’s rich . . .

Oh, you were being serious? China is the US of the 21st Century. It will take almost a worldwide depression to slow down them down . . .

UPDATE: Friday. July 16, 2004 6:49am
I just saw that Herb Greenberg has an interesting article — Why semi stocks may be over valued — on the same subject, only he’s (surprise) Bearish on the sector.