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Global Semiconductor industry set to grow

The outlook for the global semiconductor industry appears upbeat, despite gloomy earnings outlooks and potential slowdown in consolidation.

To date, trade tensions between the U.S. and China have infiltrated the semiconductor space, spurring fears about companies’ future financial prospects.

Uncertainties over China’s production capabilities and dependency on high-end chips have risen, for example, along with jitters about protracted feuds and tariffs between the world’s two dominant economies.

Tammy Kiely of the Goldman Sachs Investment Banking Division recently noted that as “trade tensions continue to intensify, semiconductors, one of the world’s most important and complex industries, have emerged as a key point of contention.”

These frictions raise the stakes for an industry that has received heightened attention from a regulatory perspective, and Kiely said that given the size of the sector, as well as “its importance from a technology and military perspective, many countries are very focused on their semiconductor assets.”

Indeed, trade-related uncertainties appear to have increased risks related to the global supply chain, as well as international product sales, while generally posing a threat to the recent wave of consolidation in the industry.

South Korea’s Samsung Electronics, for example, saw its stock shed around 3% intraday Tuesday after it unleashed a profit warning for the fourth quarter of 2018. The company released relatively rare expectations of a quarterly operating profit decline of roughly 29% year-on-year, as well as a sales decline of about 11% over the same period.

The news followed hot on the heels of U.S. tech giant Apple’s (NASDAQ:AAPL) downwardly revised earnings guidance earlier in January, including around 10% less revenue than initially expected. The alert, which was the firm’s first in almost twenty years, was largely a casualty of U.S.-China trade relations.

Apple CEO Tim Cook noted that while the company anticipated “some challenges in key emerging markets, we did not foresee the magnitude of the economic deceleration, particularly in Greater China.”

In fact, the majority of Apple’s revenue shortfall to its guidance, and over 100% of its year-over-year international revenue decline, occurred in Greater China across iPhone, Mac and iPad.

Cook said that as China’s economy began to slow in the second half of 2018 – marked by the second lowest GDP growth during the September quarter in the past 25 years – was impacted by rising trade tensions with the U.S. He added that as “the climate of mounting uncertainty weighed on financial markets, the effects appeared to reach consumers as well, with traffic to our retail stores and our channel partners in China declining as the quarter progressed.”

Meanwhile, other factors for Apple’s downbeat guidance included foreign exchange headwinds. as well as some supply constraints due to the introduction of several new products. These constraints included sales of the Apple Watch Series 4, iPad Pro, AirPods and MacBook Air.

Dave Novosel, a senior analyst at corporate bond research service firm Gimme Credit, noted that the U.S.-China trade disputes “have not helped,” although the U.S. has not imposed tariffs on smartphones from China. He suggested the tensions will likely pose potential future pressure on sales as well.

Gimme Credit expects Apple’s full year revenue will drop by around 1.5%, and that margins will continue to weaken as they have over the past couple of years.

Novosel said that part of the margin erosion may come from lower pricing as Apple strives to maintain its market share, with EBITDA likely to fall by US$2.5bn or more. He added that “amazingly enough, since debt is not likely to change, leverage will remain at 1.4x.”

The U.S. oversees overseas threats

In addition to earnings scares, the U.S.-China trade disputes have also thrown a wrench into M&A deal-making – notably after U.S. President Donald Trump prohibited Qualcomm (NASDAQ:QCOM) in March 2018 from completing its proposed US$117bn merger with Singapore-headquartered semiconductor supplier Broadcom (NASDAQ:AVGO).

The decision came after President Trump issued an executive order in mid-March citing “credible evidence” that Singaporean domiciled Broadcom, along with its partners, subsidiaries, or affiliates, “might take action that threatens to impair” U.S. national security through exercising control of Qualcomm.

As such, he quashed the proposed takeover of Qualcomm and sent the chipmaker a presidential order to immediately and permanently abandon the deal.

Amid ongoing trade negotiations between the U.S. and China, Semiconductor Industry Association (SIA) CEO John Neuffer said that his organization “welcomes” Trump’s and Chinese President Xi’s de-escalation of tensions.

Neuffer noted that over the next 90 days and beyond, “the U.S. semiconductor industry will be monitoring the progress achieved on important aspects of China’s trade practices as highlighted in USTR’s Section 301 Report, including findings of forced tech transfer, intellectual property theft, industrial subsidies, data localization measures, and discriminatory cybersecurity rules.”

Reversing course

In the meantime, while the industry has undergone a bout of deterioration, recent developments between the two world powers seem to have helped the PHLX Semiconductor Sector (SOX) reverse course.

Asbury Research chief market strategist John Kosar, for example, observed in late December that broad market weakness had pushed the market-leading SOX below 1150 support. Although a test of 1020 appeared to be the next step, the index had retraced some of those losses, gaining around 7.35% since December 24.

Moreover, growth in the semiconductor industry space is likely to continue, despite gloomy earnings outlooks and potential slowdown in consolidation.

According to Moody’s Investors Service, Chinese tariffs, for example, would have only a small impact on US semiconductor equipment makers.

Moody’s analyst Richard Lane recently said that “China’s tariffs and/or trade restrictions would have only a limited impact” on Applied Materials (NASDAQ:AMAT), Lam Research (NASDAQ: LRCX) and KLA-Tencor (NASDAQ:KLAC) given that indigenous Chinese customers represent only 6%, or US$1.8bn, of their annual aggregate revenue.

Among the three rated semiconductor equipment makers, Moody’s noted that Applied Materials is the most exposed to the Chinese market. Including equipment, services, spare parts and flat panel display equipment, the firm currently derives about 7% of its revenue from indigenous Chinese customers. Including equipment, services and spare parts, Lam Research generates an estimated 5% and KLA-Tencor 4% of revenue from China.

However, these companies’ stocks have not been immune to the fallout from trade feuds. Over the past 52-weeks, Applied Materials has seen its shares shrink by about 46%, Lam Research’s equity plunged roughly 48% and KLA-Tencor is down around 35%.

Despite the material losses, Applied Materials’ earnings have been decent.

In fiscal 2018, Applied grew its net sales by 19% to US$17.25bn, with gross margin of 45.3%, operating income of US$4.8bn, and earnings of US$3.23 per share.

Applied Materials CEO Gary Dickerson noted that each of the company’s major businesses delivered double-digit growth “despite challenging conditions in the second half of the year.” He added that while “near-term market headwinds remain, overall industry spending remains robust, and we are focused on positioning Applied Materials for the long term, expanding our role in the A.I.-Big Data era and winning the major technology inflections ahead.”

Indeed, it appears the overall outlook for the semiconductor industry remains rather upbeat.

In fact, World Semiconductor Trade Statistics (WSTS) expects the global semiconductor market to grow nearly 16% in 2018 to US$478bn, with growth anticipated across all geographic regions. The organization said its upbeat outlook reflects growth in all major categories, with “extraordinary growth” from Memory at 33.2%, followed by Discretes with 11.7% and Optoelectronics with 11.2%.

WSTS added that for 2019, all regions are expected to grow, with the overall market up 2.6% to US$490bn.

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The analysis in this material is provided by Interactive Brokers for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by Interactive Brokers to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Steven Levine

Steven Levine is a Senior Market Analyst at Interactive Brokers, (IBKR), which provides online trade execution and clearing services to institutional, professional and individual investors for a wide variety of electronically traded products including stocks, options, futures, forex, bonds, CFDs and funds worldwide.

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