RealMoney Silver - Semis' Recovery Seems Back on Track

Semis' Recovery Seems Back on Track
By Bill Trent
RealMoney.com Contributor
12/27/2007 4:49 PM EST

Recently, I expressed concern that there may be more pain ahead for semiconductor manufacturers. The concern was based on recent sales reports from the semiconductor makers and the semi equipment industry.

I have noticed that semiconductor stocks tend to perform best when the growth for chips exceeds the order growth for chip equipment. This is simple supply and demand stuff -- when the chip sales are growing faster than equipment sales, it indicates demand is growing faster than supply. That means tighter capacity and less pricing pressure over the coming months, which is generally good for profits and by extension stock prices. The reverse is true when orders for equipment are growing faster than chip sales.

Based on the October data, the equipment orders declined 24.7% year over year in September but only 16% in October. My fear was that the orders were not being cut as much as they had been in recent cycles, and therefore that the up-cycle I have been expecting would be cut short.

I did, however, note a cause for cautious optimism -- the semiconductor industry data are sometimes subject to large revisions. And, lo and behold, the October equipment orders were revised down sharply.

Based on the updated report, equipment orders declined 19.9% in October and 19.4% in November. These data are much more supportive of my original thesis that the next year was likely to be a good one for semiconductor stocks.

Better yet, Gartner Group expects all major segments of capital spending to decline in 2008. Worldwide semiconductor equipment spending is now expected to total $40.3 billion in 2008, a 9.9% decrease from 2007 spending of $44.8 billion (source: Fabtech).

I don't always believe reports from the industry analysts, because they are often wrong. I like to use the supply/demand model as a gut-check, allowing me to reconcile the unknown (analyst estimates) with what is known (current leading indicators.) In this case, I think Gartner is going to be close to the mark.

So what is the upside for investors? I have charted the performance of the Philadelphia Semiconductor Index (SOX) over the last five "excess demand" cycles. Each one begins the month after semiconductor sales begin to grow at a faster rate than semiconductor equipment orders. I use a one-month delay because the Semiconductor Industry Association reports monthly sales on a one-month lag, so the chart shows the performance starting as the data become available.

From the start of the excess demand cycle to the first month of excess supply, semiconductor stocks did very well in three out of four instances, and the bad time was likely a byproduct of the Internet bust. (The periods of excess supply were bad times for the SOX in three out of the last four instances. The Internet boom is the one exception.)

SOX Performance
During Periods of Excess Demand

Click here for larger image.

Source: Semiconductor Industry Association, Semiconductor Equipment and Materials International, and Yahoo! Finance; compiled by William A. Trent

The current period is much more "normal" than boom/bust for tech. Therefore, I think the normal outcomes are likely to prevail.

But perhaps more enticing is that so far in this cycle, the SOX is down nearly 16%. Similar (though slightly worse) interim declines happened in two of the previous cycles; both such declines were followed by rallies of more than 50% over the following six months.

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.