Semiconductors: Maintain 2.5 Stars “Neutral” as we await a better entry point

• After an incredible rally over 2020 and 2021, semiconductor stocks have fallen by close to -22% year-to-date, underperforming the broader S&P 500 Index. 

• While most chipmakers have reported strong earnings, many have guided for a slowdown in earnings growth and are planning to reduce their capex spending after observing a reduction in demand. 

• With sales growth falling and lead times levelling off, the chip industry is likely to be in the early stages of a down cycle.

• Future down cycles are likely to be milder than those in the past as there are now numerous semiconductor applications than before. 

• While we have decided to maintain a 2.5 Stars “Neutral” rating for the semiconductor industry for the time being, our long-term view on the industry remains overwhelmingly positive. 

Chipmakers have underperformed the broader market year-to-date

After an incredible rally over 2020 and 2021, the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) has fallen by close to -22% year-to-date, underperforming the broader S&P 500 Index which delivered returns of -10% over the same period (Figure 1). The muted performance is in line with our view that the share prices of chipmakers will be challenged by tougher economic conditions as well as a potential supply glut.

Figure 1: Semiconductor stocks have posted negative returns year-to-date

During our previous update back in January, we warned that the semiconductor industry could go into a down cycle, as the massive increase in capex spending by chipmakers might lead to a supply glut. Coupled with the gradual normalisation of demand, the industry is likely to experience a period of lower sales growth, leading to a down cycle. And with the valuations of chipmakers on the higher end, share prices have less room to appreciate and are more likely to see a correction in the near-term. 

Related Article: Semiconductors: Chip drought? It’s time to start worrying about a chip glut

Fast forward to today, signs of an impending down cycle have become even more visible, with sales growth falling and lead times levelling off. After rising throughout the most part of 2020 and 2021, semiconductor sales growth have started to lose momentum, declining for three consecutive quarters since 3Q21. As of 2Q22, semiconductor sales have risen by only 18.1% year-over-year, much lower compared to the growth rate of close to 30% in 3Q21 (Figure 2).

Figure 2: Semiconductor sales growth is losing its momentum, having declined for three consecutive quarters since 3Q21

Semiconductor sales soared during the pandemic, as a severe shortage of chips led to several rounds of prices hikes that benefitted chipmakers. But as we head further into 2022, there are signs that the shortage is starting to ease. Lead times, the duration between placing an order and taking delivery, is currently at 27 weeks, basically unchanged over the past three months (Figure 3). This is a promising sign that supply is starting to catch up with demand.

Figure 3: Lead times have started to stabilise  

Earnings results and revised guidance points to softening demand

Aside from the macro data, the latest earnings results and forward guidance from a few well-known chipmakers also point to softening demand in the near future. While most companies have reported positive results for the most recent quarter, a number of them have cited mounting headwinds, and have guided for lower earnings in 2H22 while making revisions to their capex plans, a sign that business conditions today aren’t as rosy as they were compared to the beginning of the year. 

For instance, executives of TSMC (NYSE:TSM), the world’s largest foundry and industry bellwether, warned that an inventory correction may be on the horizon, due to softening demand from smartphones, PCs, and other consumer market segments. As inventory levels along the supply chain become increasingly bloated, the company expects its customers to start reducing their inventory, and for this adjustment to last throughout the first half of 2023. 

Aside from a looming inventory correction, TSMC is also battling greater inflationary pressures with the cost of raw materials, wages, and even electricity rising. In light of the more uncertain environment, the management said that capex for 2022 would be closer to the lower end of the previously guided range of between USD 40-44 billion. 

When asked about the company’s plan to spend USD 100 billion over the next three years, which was announced back in April, executives responded with “We're not going to talk about the $100 billion today. We're not going to comment on capex beyond 2022”. Although the response does not exactly paint a positive picture of the industry’s outlook, TSMC is not alone. 

Memory makers SK Hynix and Micron (NASDAQ:MU) are also reportedly considering making sizable cuts to their capex spending after observing a significant reduction in demand. Similar to TSMC, both companies noted that the demand for chips is expected to worsen as the global economy slows.

Related Article: Semiconductors: Downgrade to 2.5 Stars “Neutral” on lofty valuations and greater near-term risks

With interest rates rising and inflation sticking around longer than expected, consumers have been forced to tighten their belts. Naturally, this reduces the appetite for chips in end markets that are most exposed to consumer spending, such as smartphones and PCs. After a bumper year, smartphone and PC shipments are expected to decline by -3.5% and -8.2% respectively, according to forecasts from IDC (Figure 4). 

Figure 4: Smartphones and PC’s shipments are expected to decline in 2022 

While the economy is not officially in a recession yet, it is definitely on a much weaker footing today compared to the start of the year. And if the Fed continues to tighten monetary policy aggressively, it could very well put the US on the path towards a recession. In the event that a recession does occur, chip demand is likely to fall even further, which will ultimately lead to a larger decline in sales growth. 

Related Article: Maintain 2.5 Stars on US equities: Aggressive rate hikes might put the US on a recessionary path

With both the macro and micro level data pointing in the same direction, we think that the industry is already in the early stages of a new down cycle which could last for several quarters (Figure 5).

Figure 5: Data suggests that the semiconductor industry is in the early stages of a down cycle  

Source: iFAST

Long-term growth story still intact with the wider range of end use products 

Despite the bleak near-term outlook, investors should bear in mind that down cycles should not be feared, but instead should be embraced as they represent an opportunity to pick up shares at a discount. 

Since the early 2000s, the semiconductor industry has started to experience softer down-cycles. While the duration of the down-cycles has more or less remained the same, the magnitude of the sales decline was nowhere near as large as before. We believe that this is due to the structural changes that have taken place in the semiconductor industry, and we expect the trend of softer down-cycles to be the norm going forward.

In the past, the semiconductor cycle was mainly driven by changes in PC demand as it was the dominant end-use market at the time. But with the world becoming increasingly digitalised, the number of semiconductor applications has and will continue to increase. 

Today, the widespread proliferation of semiconductors in modern technology has created a multitude of end-use products (e.g. IOT, cloud computing, self-driving vehicles), thus minimising the impact changes in demand from a single product would have on the chip cycle, resulting in milder down-cycles. 

Even if a downturn does materialise, it is very clear that in the longer-term semiconductor sales will eventually recover to higher levels than before (Figure 6). Thus, it is not a question of whether a recovery will occur, but a question of when will the recovery take place. As such, we remain confident that the semiconductor industry will be among the best performing industries over the next decade.

Figure 6: Semiconductor sales should eventually recover to higher levels than before

Maintain 2.5 Stars “Neutral” as downside risk still outweighs upside potential

As we are still in the early stages of a down cycle, share prices will probably fall further once earnings misses and negative revisions starts to surface. Moreover, there is a real risk of a recession especially if the Fed chooses not to take its foot off the tightening pedal. 

Under these conditions, semiconductors, which is widely considered a growth industry by many, could also experience a compression in multiples, thus limiting the room for share prices to appreciate. Taking all these factors into account, we think that share prices of chipmakers are likely to see further downside before a recovery takes place. 

Based on a fair PE multiple of 20X, we project an upside potential of 16% for semiconductor companies by 2024. While the valuations of semiconductor companies are certainly more attractive than before following the sell-off this year, downside risks remain. We await a better entry point. As such, we have decided to maintain a rating of 2.5 Stars “Neutral” for this sector for the time being. 

Table 1: Valuations are still not incredibly cheap in the near-term

Figure 7: In the long run, share prices are driven by earnings

Even though we hold a neutral stance in the near-term due to the downsides risks as mentioned above, we would like to reiterate that our long-term view on the semiconductor industry remains positive and our position has not changed. While chipmakers are still far from incredibly cheap, we acknowledge that their valuations have indeed become more attractive courtesy of the recent sell-off.

While we do expect more price volatility ahead as the industry works its way through a down cycle, investors should be ready to pick up shares once valuations start to look attractive.  

We will continue to monitor this sector closely and provide timely updates when the opportunity arises. Our recommended product for the semiconductor industry is still the VanEck Vectors Semiconductor ETF (NASDAQ:SMH).

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities. The analyst who produced this report holds a position in the VanEck Vectors Semiconductor ETF.