Analysing Semiconductor stock from the couch

The financial markets are still hearing mixed reviews from the semiconductor industry on the outlook for 2005, ranging from marginal growth to contraction on a year-on-year basis. Based on our investigation, we believe that 1H:05 should still deliver positive growth in terms of chip sales, before contracting in 2Q:05 to deliver a sequential q/q downturn in 2H:05. So far, we have seen some chipmakers, such as the foundries in Asia and some of the IDMs (integrated device manufacturers) lower their earnings outlook for FY05 and as a result, lowered 2005 capital spending plans. These cuts will first be for capacity/volume related chip production but would then move on to advanced production using cutting-edge technology if the downturn prolongs indefinitely.

Before explaining our views on the dynamics of the semiconductor market, we believe that one needs to look at current stock market sentiment and then the correlation between the chipmaker capital spending and chipmaker sales, both of which are influenced by the economic environment. The second point provides an understanding to the cyclical nature of the semiconductor capital equipment market, in terms of its length (from peak to peak) and magnitude (from peak to trough). Whilst equipment makers are affected by these economic cycles, some equipment makers can gain some shelter from economic swings if they have a secular positioning, such as a competitive edge, better technology, stronger management expertise or good strategy execution.

What is the market seeing:

There has been mixed news flow in the last several weeks, which provided a short rally in late September, followed on by momentum buying and selling as third-quarter earnings were announced / pre-announced with some disappointment, resulting in some earning downgrades in the sector. The fundamental environment in the semiconductor industry is deteriorating as a result of slowing sales growth and contracting profit margins, creating nervous short-term focused investors. Historically, cycle downturns have been triggered off by a combination of a worldwide recession, rising oil prices, inventory burns and/or over capacity of IC chips. To be fair, the forth-coming downturn is arriving even before the investment community had acknowledged that we were recovering from the previous upturn. The current downturn is factored by the severe oil price pressure as well as inventory burns and sporadic over capacity of ICs. These three conditions resulted in the loss of consumer confidence in the sector. In the last few weeks, we have received anecdotal evidence to suggest that conditions are getting more challenging. Whilst it can be argued that the market may want to buy into some semiconductor stocks on the back of low valuations, we do not believe that the large cap European stocks have benefited. If we compare ASML, Infineon and STMicro vs. the Philadelphia SOX index between Jan 1st 2004 and Sept 8th 2004, these three stocks fell by 35.9%, 28.6% and 37.5% respectively whilst the SOX fell 30.7%. In the rally that followed to date, ASML, Infineon and STMicro gained 3.7%, 4.5% and 2.2% respectively, whilst the SOX gained 12.2%.

Anecdotal evidence gives mixed views in the two key markets for ICs

Current signs suggest that business conditions are becoming more difficult, indicated either by a weak 4Q outlook and aggressive price wars to sustain market share. In the mobile communications world, we have seen Nokia (NOK: NYSE, Hold, US$14.9) and Samsung Electronics (5930: Korean SE, NC, Won430,000) deliver 3Q earnings that displayed immense pricing erosion on mobile handset ASPs in order to protect market share and unit growth. They expect 4Q:04 to exhibit similar pricing pressure to capture and maintain consumers attention.

The PC market exposed companies have been more positive. The likes of Acer (2353 TT: Taiwan SE, NC, NT$46), Quanta Computers (2382 TT: Taiwan SE, NC, NT$53.5) and Compal Electronics (2324 TT: Taiwan SE, NC, NT$30) raised their outlook for notebook unit sales for 2005 whilst both Intel and AMD (AMD: NYSE, NC, US$15.5) were upbeat on the demand pick-up for microprocessor chips for both desktops (in Asia) and notebooks (in North America). Samsung Electronics DRAM division continues to see sales and earnings growth for 4Q and the DRAM spot market (as indicated by DRAMeXchange) suggests that contract and spot prices for 256Mbit 400Mhz DDR DRAM will continue to track up for the near-term, as confirmed by Hynix (000880: Korean Stock Exchange, NC, Won12,150) and Infineon (IFX: NYSE, Buy, US$10.42). As a result, we believe that DRAM chipmakers are likely to continue spending to ramp their production facilities through a downturn, to be ready to capture any consumer demand rebound. Hynix confirmed that they would spend US$2bn in 2005, up from an expected 2004 capex of US$1.5bn.

In contrast, foundry players like TSMC (TSM: NYSE, Hold, US$7.13) and UMC (UMC: NYSE, NC, US$3.37) have seen their sales growth and utilisation rates slow down (rate were exceeding 100% leading into the summer but are now below 100%) in the last couple of months. As a result, they have indicated that they will lower their capital spending budgets for equipment in 2005 as out-sourced work by IDMs is reduced.

Capex announcements have been filtering in by the large IDMs, but the market is expecting to see a capex contraction next year. So far, STMicroelectronics (STM: NYSE, Underperform, US$17.98) at their 3Q:04 earnings call cited that 2005e capex would be 25% less than 2004 at US$1.5bn whilst Texas Instruments (TXN: NYSE, NC, US$22.47) cited on October 25th that they plan to accelerate their ramp plans for their 300mm fab in Richardson, Texas called DMOS7. This would mean that Texas Instruments capex for 2005 should be higher. We could see further stock price depreciation when these large IDMs cut capital spending more than the market expects.

However, we believe that the Japanese chipmakers will continue to ramp their facilities in order to recapture market positioning, lost over the last decade. The move to 300mm and smaller linewidths offers chipmakers a way back into the competitive stream, and we do not believe that the Japanese chipmakers will turn away the opportunity.

Poor visibility continues for the medium-term:

These mixed views from chipmakers are providing limited visibility for semiconductor equipment manufacturers to provide guidance to the investment community. Whilst we are factoring in a recovery in shipment volumes and pricing levels for some chipmakers in 2005 (+10% growth in total chip sales in 2005 to US$245bn), we believe that it is likely that a decision by the remaining large IDMs to cut capex will occur. This will weaken any prospects of a general earnings recovery for equipment suppliers in 2005. In our opinion, initial cuts in equipment spending will be on volume related capacity equipment, particularly in areas where unit IC supply begins to overshoot unit demand. If these conditions worsen or continue for an extended period of time, we would expect chipmakers to start cutting back on technology related equipment buys (i.e. equipment that would provide a competitive edge beyond the next 12-months).

Within the semiconductor equipment sector, equipment makers will witness order delays, but when depend on whether the tools offer a technical edge and how tough market conditions are. In Europe, ASMLs lithography tools are one of the most critical pieces of machinery, allowing chipmakers to differentiate their capabilities. Because of this complexity, coupled with the fact that delivery lead-times for lithography machines are varying from 6-months to 14-months at present, means that cancellations or postponement of equipment orders by the chipmakers are thought through strategically and carefully. For ASML and the equipment market, this has already started to take place.