Thursday, November 19, 2009

Semiconductors: Cycle stalls; Downgrading sector view - Merrill Lynch/BAM

Merrill Lynch/BAM is out with a rather significant Semicondutor sector downgrade, downgrading 4 large players to Neutral and 4 to Underperform:

Firm notes they are downgrading their view on the sector given unfavorable indications from our cyclical framework suggesting a modest inventory correction, even in the face of improving electronic demand and a more constructive outlook for the global economies. They are also downgrading shares of INTC, TXN, MRVL, and LSI to Neutral, and MXIM, NSM, POWI and MCHP to Underperform. Merrill now rates a modest 5 stocks (BRCM, XLNX, ALTR, ADI and LLTC) as Buys within their coverage group (19 stocks in total).

In particular, Merrill's industry model suggests that following a normalization of semiconductor IC shipments to “true” consumption levels, inventories in the supply chain are approaching a level suggesting a modest overshoot vs. equilibrium levels, even after accounting for above consensus global GDP growth, and a smart recovery in global electronic systems sales into 2010. Thus, barring a sharp upturn in the global economy, their indicators point to the potential for an inventory correction, thus rendering the risk-reward associated with ownership of chip stocks unattractive.

In some ways, the firm thinks the current backdrop reflects a striking contrast to the conditions that prevailed at the time of Merrill's upgrade. Specifically, at the time, supply chain inventories were at abnormally depressed levels, economic forecasts were poised to improve but as yet depressed, and indications of an inflection in electronic demand had just started to manifest themselves. Fast forward two quarters, and the picture looks completely different. To wit economic growth forecasts have trended higher, as have expectations of electronic demand growth, and supply chain inventories are perking above what they’d consider to be a normal equilibrium level. Last but not the least, sentiment around growth prospects for the group has also seen a marked improvement. Simply put, the ideal mixture of investor skepticism coupled with the potential for sharp upward revisions – which served as potent fuel for the semiconductor rally – no longer prevails. This then begs the question: What is the incentive to own chip stocks, esp. on the heels of a spectacular move up (SOX +83%) over the last 12 months?

For those looking for real world confirmation of the potential inventory adjustment being forecasted by Merrill's industry model, the firm would point to indications from the Asia PC supply chain suggesting a material downward bias to desktop forecasts in the near-term. In particular they note that their Taiwan Hardware analyst Tony Tseng is now projecting ~flat Q/Q growth in PCs (desktop motherboards and notebooks included) into Q4. Merrill notes that it represents a sharp downward revision (esp. on the motherboard front) vs. just a month ago, in turn suggestive of slowing momentum in the PC space – the lynchpin for semiconductor industry growth. Serving as further corroboration of waning momentum are resale trends out of Asia distribution suggesting recent monthly sales trends that have been solidly below seasonal. Importantly, they’d note that above seasonal trends in the distribution data in late 2008/early 2009 had served as a harbinger of the cyclical upturn, thus, in Merrill's view, underscoring the importance of the data.

Last but not the least, for those looking for a smoking gun, Merrill has one: namely, foundry utilization. Using TSMC utilization as a loose proxy for trends in overall foundry utilization rates, they’d note that a sale of the SOX every time TSMC’s utilization rates hit 100% would have put you on the right side of the trade in short order. As counterintuitive as this might sound (after all isn’t tighter capacity great for chip ASPs etc.?), the fact is that there is such a thing as too much of a good thing. When it comes to foundry utilizations, 100% seems to be the magic number, simply because “sold out capacity” – esp. in the face of an improving perception around the economy and by extension end demand – is often a catalyst for double/excess ordering in the supply chain. After all who wants to be caught short on semiconductor parts, which average a paltry $1.00-1.50 in ASPs, when demand is improving?

Will it be different this time, and will the backdrop allow for an extended period of rationality in the supply chain despite tight supply? Perhaps. Then again recent history suggests that this has ultimately never been a bet that worked out in favor of the chip investor.

Notablecalls: So, Merril Lynch/BAM is joining the Anti-Semi group today (call was out last night) after Morgan Stanley downgraded the Semi Equipment sector last week.

The call makes perfect sense and is backed by FBR Capital this morning. According to FBR, recent checks into 4Q PC builds with the top five notebook ODMs and top four desktop motherboard makers are worse than their month-ago checks. Overall, the firm forecasts 4Q PC builds to decline –1.5% QOQ, worse than their month-ago forecast of +5% growth QOQ.

It's kind of surprising to see this kind of action ahead of Q4 numbers but I guess this can be explained by recent rumours of double and triple ordering that has been occuring over the past months. The Intel's and Dell's of the world have enough components to work with and are paring back their future orders.

Good thing no real production capacity was added, which makes the upcoming decline somewhat easier to handle.
How to play it?

I'm not a big fan of shorting INTC here down 3-4% in the pre mkt. Too much of a battle, given how WDC/STX performed following the Merrill downgrade yesterday.

The Merrill call is good for context but not for actual trading, I think.

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