RealMoney Silver - More Pain Ahead for Semis

More Pain Ahead for Semis
By Bill Trent
RealMoney.com Contributor
12/4/2007 6:29 AM EST

Recent data points are shaking my confidence in the near-term outlook for semiconductor stocks.

After being bearish for more than a year, I had turned cautiously bullish earlier this year because it looked like potential supply (which I measure as orders for new semiconductor equipment) was coming back in line with demand (which I measure as the year/year change in semiconductor revenues).

Unfortunately, the latest data show this trend weakening faster than I thought it would.

On Monday, the Semiconductor Industry Association (SIA) released its sales report for October, saying worldwide semiconductor sales rose to $23.1 billion, an increase of 5% over the $22 billion reported in October 2006 and 2% higher than the $22.6 billion reported in September of this year.

That 5.0% sales increase year over year was a slight decline from the 5.8% year-over-year growth reported a month ago, but was still the second-best growth reported since January. Taken alone, I wouldn't consider this report troubling in terms of the supply-demand balance because it shows stable, if not slightly improving, demand trends.

However, on Nov. 15, Semiconductor Equipment and Materials International (SEMI) released its October book/bill report for semiconductor equipment orders and sales. The bookings figure was flat with the final September 2007 level of $1.24 billion and 16% less than the $1.47 billion in orders posted in October 2006.

The fact that demand growth (up 5%) was greater than supply growth (down 16%) is generally supportive of positive performance for semiconductor stocks. The performance of the SOX index during the last five periods, in which such conditions prevailed, is presented below.

In each of the periods other than 2001 to 2002, the excess demand growth relative to supply resulted in positive returns for the SOX. Unfortunately, the current period to date most resembles 2001 to 2002. That similarity is also noticeable in the size of the relative peaks and troughs in supply/demand balance.

As the chart illustrates, there is typically a fair degree of symmetry between subsequent peaks and troughs, which is only natural because over time one would expect balanced supply and demand.

That 2001 peak in excess demand, however, occurred quickly and was shallow relative to the long, drawn-out period of excess supply that preceded it. So far in 2007, the chart is looking very similar. If the relationship continues to hold, it could be some time before semiconductor stocks again experience the normal cyclical upswing.

There are still some reasons for cautious optimism. For one, the semiconductor industry data are sometimes subject to large revisions. With that in mind, I'm not going to get too hung up on the data released in a given month.

Furthermore, recent forecasts have continued to show a cautious approach to adding capacity. Gartner Dataquest forecast that 2008 capital investments by the four largest foundries will decline 9.6% year over year.

The largest foundries are Taiwan Semiconductor (TSM) , United Microelectronics (UMC) , Chartered Semiconductor (CHRT) and Semiconductor Manufacturing International (SMI) .

Also, according to a Friedman Billings Ramsey analyst, capital spending in the DRAM sector is expected to fall by more than 30% in 2008. Leading players in this market include Samsung (SSNLF) , Qimonda (QI) , Hynix (HXSCF) and Micron (MU) .

Together, foundries and DRAM have been responsible for a good deal of the total capex and their caution ahead increases the chances of supply and demand returning to balance.

However, given the current state of the economy and the seasonal factors that should have helped demand in October and November, I'm glad I have my long position in the Semiconductor HOLDRS (SMH) offset by a put option on equipment maker LAM Research (LRCX) .

In general, I favor the semiconductor makers such as Intel (INTC) over the equipment makers such as Applied Materials (AMAT) or KLA-Tencor (KLAC) , because more capex cuts will be needed to restore the supply/demand balance.