Chip Upturn Proves to Be an Illusion
By Thomas Kurlak
RealMoney.com Contributor
9/7/2004 10:30 AM EDT
URL: thestreet.com
Semiconductors BEARISH
Chips have been a disappointment this summer.
The slowing economy and China's impact on the supply chain have hurt these stocks.
Semiconductors will rebound eventually, but other sectors look better for now.
I got killed in semiconductor stocks this summer, and I feel awful about it. The sudden economic slowdown caught the chip companies in inventory-buildup mode preparing for what was supposed to be a strong second half. Now they are adjusting their outlook statements downward as they grapple with slowing demand.
The extent of this economic sluggishness is less important than the speed at which it developed. The rule of thumb used by Intel (INTC:Nasdaq) co-founder Gordon Moore was that semiconductor industry sales grow at about five times the rate of growth of GDP. The slower 2.8% level of GDP growth now, compared to 4% in the first quarter, has the effect of reducing semiconductor growth from a theoretical 20% to 14%. That's a large change in just a few months.
In a May 19 column, I talked about the "stop-go economy" that George Soros put forward in his interview on CNBC last winter. Reviewing that column has been sobering for me. I wrote then that Soros didn't like the outlook for U.S. stocks or bonds because he felt the economy is propped up by too much debt and is too dependent on low interest rates. When growth picks up, interest rates rise quickly, stalling any recovery. He compared the U.S. economy to the U.K.'s in the 1980s. The spike in rates last spring (among other things, like oil prices) has certainly affected economic growth.
Hindsight
In that column I also said that managements of tech companies were starting to guide analysts to lower second-quarter sequential sales growth. (Now we are getting much more cautious sales guidance, as well as lower profit-margin forecasts.) I wish I had heeded the Soros advice and given more weight to the slower sales outlook, rather than expecting a continuation of the semiconductor upcycle.
Instead I suggested that we keep watching for more signs of a stop-go economy, management guidance on margins, the price of DRAMs, and to be aware of the impact of the aging "Wintel" monopoly on P/E ratios. Finally, I concluded that investors need more patience and that they prepare for possibly slower near-term growth, which I believed was already discounted into chip stock prices by then.
Well, I was wrong on the discounting part. And I have to admit that I was critical of Wall Street's sell-side analysts calling a cycle top since last January while I still saw upside. You never stop learning, and I've re-learned an old lesson about connecting the dots. By mid-June there were too many negative data points coming in from companies like Fairchild (FCS:NYSE) (order cancellations), National Semiconductor (NSM:NYSE) (slower distributor orders), Cisco (CSCO:Nasdaq) (higher inventories) and Kulicke & Soffa (KLIC:Nasdaq) (orders down, pushbacks), etc.
What kept me bullish through these inputs was the length and depth of the last down cycle, which would normally imply a long, steady recovery. What I didn't adjust for was the changed structure of the U.S. economy (debt level) and the much larger role that new markets, especially China, are playing in this tech cycle. When China put on the economic brakes last spring, it sent a ripple back through the supply chain that is still being felt.
So where do I go from here? I lick my wounds, set aside some reserves and try my luck in other sectors until things look better. With the Index of Leading Economic Indicators declining for the last two months and consumer confidence slipping, it's hard to see end-demand acceleration in the near term. Therefore, inventories will have to come down more and chip production will need to be slowed. The chip-pricing strength I counted on in a tightening supply/demand balance is not going to happen this year. And analysts now fear that new capacity coming on will lead to a glut next year. Things change fast.
But much of our troubles come back to getting the economic forecast right. The semiconductor industry's linkage to the economy is now too tight to miss on this. And it doesn't help that we are supplied with every conceivable economic scenario. I think we'll muddle through to the election, then probably get some positive seasonality followed by a black hole of uncertainty in the first quarter. That uncertainty will depend partly on who gets elected president, the state of the world terrorist threat, growth at our top trading partners, particularly China, and the level of U.S. interest rates.
It's unlikely that an acceleration in semiconductor demand is imminent. But at the new lower level of expectations, a positive surprise can happen when we least expect it. Longer term, the leading chip stocks look undervalued given that global growth will eventually carry demand above supply and the upcycle will resume. I'm not in the camp of those saying tech is dead and nothing new is on the horizon to accelerate growth. It always gets to this after a big decline.
Semiconductor managements have the brakes on now, so the preparation for less growth sets up the next recovery phase. It's the timing that is unknown.
In late 2002, I saw all the preconditions in place for a recovery. We have to do that again, perhaps on a smaller scale because fewer excesses need to be erased after such a short upturn. I hate to say it (again), but a major new buying opportunity is developing. For those of you who still care, study of the history of semiconductor cycles past will be a profitable effort again in time. |
