Waiting For A Chip Rebound
By Tom Smith
The semiconductor industry is experiencing one of the sharpest, deepest downturns in the 40-year history of the business. The big question is: When will the group's earnings and revenue turn around?
Recently, some major research shops have made bullish calls on the turn of the semiconductor cycle, while others maintain a bearish stance. The nub of the dispute is how long the group languishes near cycle-bottom levels of revenue and earnings. The group could remain at low levels of fundamental performance for several more quarters, depending on the strength of the economy and end-market demand for chips.
Executives at many semiconductor and semiconductor equipment companies remain optimistic about long-term prospects for the business. This optimism is characteristic of the chip group as a whole, which has gotten used to down cycles that come and go about every four years. During downturns, companies in the chip sector typically cut costs, keep steadfast R&D efforts, make acquisitions and restructure their businesses.
BECOMING MORE BULLISH. Standard & Poor's has been gradually upgrading our favorite names in the group since the spring. On Aug. 1, 2001, we upgraded a handful of issues, indicating more bullish stance. Going up to a 5-STAR buy recommendation were Texas Instruments (TXN ), a big-cap maker of DSP and analog chips, and Vishay Intertechnology (VSH ), a mid-cap maker of passive components and discrete semiconductors.
Going up to 4-STAR accumulate recommendations were Analog Devices (ADI ), which is another top name in analog and DSP chips; Altera (ALTR ), a programmable logic device maker; LSI Logic (LSI ), a maker of ASIC chips and storage systems; and Novellus Systems (NVLS ), a supplier of deposition equipment for semiconductor manufacture.
We believe that fundamentals for the semiconductor group are presently about as bad they can get. Here are several measures that indicate that the chip group has hit bottom.
1. The book-to-bill has bottomed. The trade association Semiconductor Equipment and Materials International (SEMI) reported the June book-to-bill ratio for North American-based semiconductor equipment suppliers at 0.54 (preliminary). That means that $54 of orders were booked for every $100 of shipments made. A book-to-bill ratio below 1.0 implies a contracting industry, and a number above 1.0, or "parity," marks an expanding industry.
One key point of interpretation is that the ratio has ticked up for two consecutive months since hitting a cycle low of 0.44 in April 2001. This should mark the end of the freefall part of the downcycle. A second key point is that both bookings levels and shipment levels were still falling. However, bookings fell only by 1% in June 2001 over May 2001, which implies the beginning of stabilization of orders, albeit at a surprisingly low level. We expect orders to continue to stabilize for a few months, and then move higher. An upturn in orders, whenever it comes, will be an important statistical landmark in defining the bottom of this cycle.
Stocks in the group are likely to jump to a higher plateau when orders start to rise, as this is a prime early signal that a recovery has started. The next landmark to watch in the series would be the book-to-bill surpassing 1.0. Toward the top of the next cycle, the ratio is apt to be higher than 1.3.
2. Chipmakers report an end to order cancellations. During the companies' earnings calls in July, semiconductor makers generally reported that the wave of order cancellations seen in the spring had slowed or stopped. Again, this appears to mark a low bottom for order levels, but does not indicate whether orders start to rise again sooner or later.
3. Capacity utilization is at cycle-low levels. The total integrated circuit wafer fabrication plant ("fab") utilization rate as monitored by the Semiconductor Industry Association (SIA) for the first quarter of 2001 was 83.7%. That's down from 92.8% in the fourth quarter of 2000, and from 96.4% in the third quarter of 2000, which stands as the prior cycle high. We expect total fab utilization measures to drop further in the second quarter of 2001, probably falling below the prior cycle low utilization rate of 80.8% set in the third quarter of 1998.
Looking back further in history to a truly nasty down cycle, total fab utilization fell to just above 40% in 1985. It is worth noting that utilization rates for only the big chip foundries fell below the 40% level in the June 2001 quarter. Overall, we conclude that fab utilization is near rock-bottom.
NOT IF, BUT WHEN? So, if orders and fab utilization can't get worse, then the next step is to see improvements. However, the timing of an upturn in orders remains uncertain.
Another question is, what categories should do especially well? Reviewing the SIA's June 2001 forecast for worldwide chip sales can reveal some chip categories that should see above average growth over the course of the next up cycle. In the table below are some selected categories and the total percentage change in sales from 2000's actual sales number to SIA's estimated worldwide sales for 2004.
Smith is a semiconductor analyst for Standard & Poor's