Semiconductor Earnings a Big Head Fake, Not Green Shoots

Semiconductors as Macroeconomic Indicators

Semiconductors are uniquely positioned as leading macroeconomic indicators.

First, they are the most universally common denominator when it comes to products and services: if it doesn’t have a semiconductor chip in it, a chip was used to make it.

Second, as an early component for the manufacturing cycle, semiconductors deliver forward visibility. Apple (Nasdaq: AAPL) orders semiconductor parts months before the product hits the shelves.

To boil it down, today’s semiconductor trends are next quarter’s trends in durable goods, retail, and so on.

Straight From the Horse’s Mouth: A Roundup of Semiconductor Earnings Calls

Given the advance view that semiconductor companies have, what are they saying about current and future demand? I listened to the recent earnings calls.

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The calls were very uniform in terms of sentiment (less bearish), key risks, opportunities (China, autos), and hiring (not until revenue growth accelerates). The general sense is that a bottom is in but the wait-and-see approach to capital and operational expenditures (CAPEX/OPEX) will continue. In other words, a rebound or recovery is nowhere to be seen.

  • No significant revenue growth for 2016.
  • Stability is driving positive sentiment.
  • Everything depends on continued auto and China strength.
  • Continued CAPEX/OPEX controls.
  • EU macro continues to strengthen.

Implications for 2H

Year-over-year (y/y) revenue growth may happen, but it is still based on hope. Also, any upside will be too small to stimulate CAPEX/OPEX investing.

The extreme focus and dependence on China are problematic. Recent data out of China points to a renewed deceleration in growth, which is consistent with the end of the Chinese government’s 1Q stimulus. Mirroring this softening are recent US data points like the Chicago PMI which fell back to contraction levels. The implication here is that the growth seen by semiconductor companies is growth being pulled in from the 2H.

Another area of concern is auto growth. Chip companies expect US auto unit sales to grow only 2%-3%, which is roughly in line with industry expectations. That’s not much. The auto industry has been a major driver underpinning US economic growth and it is plateauing.

Earnings In a Nutshell

The breadth of this increase across our customer base is giving us some comfort that the noticeable weakness we experienced in this market over the past several months is in recovery and that the inventory correction that resulted is behind us. We believe we are shipping to end customer demand and the inventories in the channel and at the OEMs are at least stable, if not lean… However, it is still a fragile market.” -Don Zerio, CFO, Linear Technology (Nasdaq: LLTC)

Some color commentary from the calls. The consistent message: No rebound and no growth without China. (Click images to enlarge)

Moneyball Economics View: Green Shoots AND Head Fake

Last quarter, we said about semiconductors (and by extension about the industrial base):

Possible slight upside: Producers are probably too pessimistic, which is natural given the sharp and sudden pullbacks. There are pockets of growth… And there is potential upside coming from China, even if it will be mild.

A few months later and that was correct: producers were too negative. Now we think they are too bullish.

It all depends on a recovering Chinese demand. The big picture issue is that the Chinese super-cycle is winding down. To choose one important example, China’s infrastructure spending continues to drop. Last year, the government spent 0B on infrastructure projects. Last week it announced a plan to spend 0B over the next three years; an impressive figure and very believable, but a shadow of what it once was.

Following hard on the heels of the slowdown in capital investment comes the second shock: Chinese physical demand for durable goods has also been lower than originally perceived. Various factors contributed to an artificial demand, but the net result is that current and future demand is a lot lower than expected, while supply continues to expand.

That excess supply continues to plague the global industrial base in the form of falling prices and inventory corrections.

Is the demand picture improving? On the semiconductor earnings calls, the repeated message was that a bottom is in, as evidenced by fewer sales contraction and slight inventory rebuilding. Executives reported that their customers were also optimistic.

I question the sustainability of the demand. 1Q inventory growth came from at least three waves. First, pre-booking in advance of the February Lunar New Year. Second, the massive stimulus unleashed by the Chinese government. And last, some genuine demand to replenish stockpiles, but much of the demand is isolated to the auto sector.

In addition to those reasons, the more optimistic among the companies are also the ones more heavily exposed to the thriving auto sector.

The stimulus-triggered demand is helpful because it definitely has boosted positive sentiment, but it remains to be seen whether it genuinely boosted demand or just pulled it in from the 2H. It’s probably just pulled it in. In fact, Chinese production data released this week shows that the 1Q stimulus benefits are already fading. April production slowed to 6% y/y compared with March’s 6.8%. Retail sales slowed as well, barely topping the critical 10% level.

There’s plenty of room to think that the recent semiconductor demand was a head-fake and not green shoots of an impending recovery.

Semiconductor Visibility: Solid 2H Intelligence

Semiconductor sales today are end-user sales tomorrow. Or, more specifically, 1H semiconductor sales reflect 2H durable goods and consumer product sales.

One thing is clear: despite the possible signs of green shoots, semiconductor companies remain in a wait-and- see posture. That means continued restrictions on CAPEX and OPEX. Turned around, semiconductor companies are holding down their spending TODAY because their customers are reporting flat product demand TOMORROW (the 2H).

Semiconductor companies are guiding revenues to be flat, indicating that 2H holiday spending could be a disappointment.

Based on the Semiconductor data, the supply chain is sending out clear messages:

  1. Supply is plentiful, demand less so (pace of demand is stable and not set to accelerate).
  2. Capital spending and business inventories will grow in the short-term for restocking reasons. Long-term CAPEX is under pressure.
  3. Hiring is limited without clear revenue growth.

Semiconductor revenue guidance points to subdued 2H private sector spending. The general trend is that semiconductor y/y sales growth is stabilizing. At the same time, the 1H growth remains largely negative and, further out, the growth acceleration is just a bounce off the bottom. Indeed, expected growth is in a very narrow range. Simply put stability not recovery.

As a proxy for private sector revenue, the semiconductor data is saying:

  1. 2H 2016 private sector spending may be at or slightly below 2015.
  2. 1H 2017 private sector spending will be above 1H 2016’s.

One outcome will be subdued hiring and capital spending. Wage growth will also slow because corporate America can maintain margins and EPS growth only by reducing raises and bonuses.

Semiconductors: Bigger Hit, Bigger Bounce

  1. Consistent: Narrow range of growth. Semiconductor sales point to a narrow range of growth, consistent with a bottoming.
  2. Inconsistent: Semiconductors bouncing up, end-user demand remains soft. Semiconductor guidance is uniformly positive whereas private sector revenue guidance is often negative (based on a random sampling of company guidance).

Semiconductors are recovering from a harder hit.

Semiconductor y/y growth is more positive because these companies suffered deep inventory drawdowns especially in the 2H 2015. The incremental growth they are experiencing is tied more to inventory re-stocking than to incremental sales.

The key here is that semiconductor inventories in the distribution channels remain lean. Distribution channels are the shock absorbers in the supply chain: they are on the front-lines of the demand and will tighten or loosen inventory accordingly. If end-user demand starts to accelerate, it will show up in the distribution channels. As of mid-May, almost halfway through the year, semiconductor companies were reporting no such build-up.

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