Active Trader Update

Return to Article

Why the Semi Glut Matters

Cody Willard

Since early this year, I've been writing about semiconductor inventory levels, specifically how they've gone from shortage to balanced to glut over the past three or four quarters. The biggest "tell" for the shift from shortage to glut was the commentary on the many semi conference calls that I listen to each quarter. Over the past few quarters, that commentary went from "we can't keep up with demand" to "we're comfortable with inventory levels" to "some excess inventories in the channels need to be worked off."

A few readers have emailed to ask me to explain why the semi-inventory glut matters.

First, picture the same inventory glut with Hot Topic (HOTT Quote) as the end market, instead of Cisco (CSCO Quote), Motorola (MOT Quote) and Apple (AAPL Quote).

Let's say Hello Kitty was the big trend for Hot Topic in 2005. If the retailer ordered a million Hello Kitty T-shirts last spring, but only sold half of them by mid-June, then it has to move a half-million of them into the summer season. So it cuts prices and begins to offer discounts on Hello Kitty products, which finally start moving. The glut works back into balance. If Hello Kitty becomes cool again the next year, the same retailer might find itself in a shortage.

Now let's substitute Cisco (routers), Motorola (cell phones) and Apple (iPods) as the end market instead of Hot Topic (apparel). Broadcom (BRCM Quote) sells into all of those markets, so we'll use it instead of Hello Kitty.

This time last year, Broadcom's customers were finding themselves without enough chip inventory to build all the end products that they could sell. So they ordered as much as Broadcom would sell them, and Broadcom said business was great because it couldn't keep up with demand.

Then Cisco, Motorola and Apple discovered that they might have ordered a bit too much; they have enough chips to last for several quarters. Broadcom started saying that inventories are comfortable.

Then Cisco, Motorola and Apple started working through the excess inventories in the channel. And Broadcom warned, saying it underestimated the supply glut in the channel.

All the while, just as Hot Topic had to move those Hello Kitty shirts as quickly as possible to make room for new trends, Broadcom has to move chips through that channel fast because it has new, improved chips to sell to those same customers. So it cuts prices and hopes that volume picks up and that the inventory glut was just a temporary blip.

That's where we are right now. The question is whether the glut will last just a few quarters or if it will get worse. The tone of the most recent semi-company calls has indicated that the glut is still very much problematic. Ironically, I expect that the glut will work itself out in the next couple of quarters -- probably just in time for analysts and Wall Street to extrapolate the glut out into eternity.

That said, it's certainly possible that this glut is already on the ebb. And maybe the market is already looking past it and into the strong future demand.

Regardless, I remain cautious on semiconductor stocks in general. There are exceptions, including two stocks I'm looking to buy before year-end for the burgeoning and still-doubted Microsoft (MSFT Quote) Vista upgrade cycle. I'll tell you what they are tomorrow.

In the meantime, why fight the glut? Sell semis; buy tech.