HAS THE TECH RUN TOPPED OUT?

Courtesy of The Pragmatic Capitalist

Merrill Lynch downgraded several semiconductor names this morning citing unfavorable cyclical trends and a normalization in inventory restocking. The semis are tanking 3.5% on the report and many investors fear the inventory restocking that has powered much of the fundamental strength in the sector could be slowing. The Merrill analysts wrote:

“We are downgrading our view on the sector given unfavorable indications from our cyclical framework. In particular, our industry model suggests that following a period of rapid replenishment of inventory and normalization of semi shipments to true consumption levels, inventories in the supply chain are approaching a level suggesting a modest overshoot versus equilibrium levels. While we see limited risk to near-term estimates, we think the longer this persists the greater the risk of a correction in the supply chain. Barring a sharp upturn in the global economies, this, in our view, renders the risk reward associated with ownership of chip stocks unattractive.”

Notable Calls has more details:

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?