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Technology Corner: Is the broad-based sell off in the Semiconductor Sector warranted?

Many Institutional/Hedge Funds are extremely bearish on the semiconductor sector. This investor sentiment largely stems from negative data points across the handset, notebook, and other consumer-related areas. Investors cite inventory build ups in the PC space (gradual quarter over quarter rise in inventories for Lenovo, Dell and HP) and slower demand in China for smartphones. This coupled with higher inventories in both OEM and Cloud has raised some eyebrows. Some investors have pointed to recent TSMC commentary about a handset inventory build, a consumer slowdown, along with used car pricing data starting to roll over. Most investors seem to be waiting for future earnings cuts. This is the highest level of negative sentiment we have seen since the tariffs and the trade war with China.

Congress has been calling to boost U.S. semiconductor manufacturing, but government industrial policy isn’t needed to correct this supply-demand problem. Governments helped create the chip shortage, starting with their lockdowns during Spring 2020. Auto makers reduced orders for new chips as car purchases plunged. They didn’t anticipate how demand for cars would rebound. Meantime, manufacturers pivoted to more profitable chips that power laptops, consumer electronics and data centers. Demand for these chips has surged amid the pandemic and will grow in the 5G era, which will enable artificial intelligence and the Internet of Things (IoT.) Right now, China, Taiwan, Japan, and South Korea account for about 75% of chip manufacturing capacity in part due to their skilled workforce, geographic supply-chain synergies and government subsidies. While U.S. companies make up nearly half of global chip sales, America accounts for only 12% of global chip manufacturing. America’s comparative chip advantage is engineering, and those jobs are high paying. The U.S. accounts for 50% of chip manufacturing equipment and 52% of intellectual property design. If U.S. semiconductor firms that farm out chip production are worried about their supply chains, they and the U.S. government can prod TSMC and Samsung to diversify their manufacturing base out of the Pacific Rim into the U.S.

The Semiconductor Industry Association reported overall revenue/growth of $553 billion (+25.7%) in 2021 and is forecasting revenues to hit $650.2 billion (+17.5%) in 2022E. In 2023, semiconductor revenue growth is expected to plateau to $679.1 billion representing a 4.4% growth rate as capacity builds out to meet current shortages. From a stock perspective, anticipate continued volatility in the semi/semi equipment space until the market starts to refocus on the strong industry fundamentals… opposed to geopolitical events and Fed action.

What can investors conclude after bell-weather semiconductor companies – Texas Instruments, Intel, Advanced Micro Devices, Qualcomm – reported 1Q22 results? YTD the sector is down 33%, while the S&P 500 is down just 20%. Why all the pessimism surrounding the semiconductor sector? One area of concern is global PC shipments that are expected to fall by 10% in calendar 2022. Weakening Chromebook demand and supply issues in China are major headwinds. Data points on PC shipments continue to be negative as lockdowns slow supply. In addition, most companies are calling out supply headwinds from the COVID lockdowns in China.

Intel recently warned that a weaker economy will affect demand and hurt financial performance, this news dragged down chip industry. For Intel, the industry weakness is exacerbated by the fact that the company is losing market share to rivals. According to Mercury Research, AMD gained about seven percentage points of share from Intel in the X86 processor market for the first quarter, compared with the prior year. AMD's high-end server-chip business has been thriving. The company's EPYC server processor revenue more than doubled during the March quarter, AMD said in its latest earnings report. Over the same period, Intel reported just 22% year-over-year growth for its data-center server unit. Intel's latest delay won't help counter this trend.

Top semiconductor equipment maker Applied Materials now sees 3Q sales between $5.85 - $6.65 billion and EPS of $1.59 - $1.95, which is below analyst expectations. The recent downtrodden profit forecast is due to component shortages, the Russia pullout and power supply issues in China, not demand problems. Applied Materials continues to see strong demand and back-log growth.

Despite these dark clouds over the semiconductor group, earnings season kicked off with several other large players reporting upbeat results.

Texas Instruments delivered first quarter revenue of $4.9 billion, which was up 14% YoY. With the increase driven by growth in industrial, automotive, and enterprise. Industrial and auto market revenue were up 20% and communications was up 10%. Management expects second quarter revenue to be in the $4.2 - 4.8 billion range, which was below consensus estimates. The company took a 10% haircut to revenue guidance due to uncertainty around COVID.

Despite these dark clouds over the semiconductor group, earnings season kicked off with several other large players reporting upbeat results. Major themes include continued strength in server and cloud, recovery in auto and industrial, with handsets holding up well. TSMC (one of the world’s largest chip foundries) is expected to earn roughly $17 billion from Apple orders in calendar 2022. This is up from roughly $13.8 billion in calendar 2021. Apple remains a key customer for TSMC as it pushes further at leading nodes. TSMC now expects revenue to grow about 30% in 2022, signaling resilient demand for electronics despite global macroeconomic uncertainty. Sales growth this year should accelerate from 2021’s 24.9%. That’s in line with executive remarks in April that gave an official outlook of topping mid- to high-20% growth in 2022.

Unlike Texas Instrument’s muted outlook. Broad-based chip manufacturer Analog Devices (ADI), which builds chips for a wide spectrum of sectors including auto, industrial, consumer, data center, and communications, reported stellar 2Q results. ADI saw 2Q revenue of $2.97 billion with double digit year-over-year (YoY) growth across all end markets. Further, double digit sequential growth across all B2B end markets. Management stated that “Despite increasing geopolitical uncertainty and ongoing supply chain disruptions, we enter the second half from a position of strength with increased capacity and continued bookings momentum”.

Top CDMA smart phone chip producer, Qualcomm delivered record revenues of $11.2 billion, representing YoY growth of 41%. The QTC segment that produces chipsets served as the growth engine of the company. IoT revenues grew 61% YoY, with strong growth across all three categories. Consumer, edge, and industrial all grew 50% compared to the year ago quarter. While, the RF front-end revenues grew 28% YoY, and handset revenues grew 56% YoY. The automotive design win pipeline is now over $16 billion, up $3 billion since fiscal Q1. Handset revenues of $6.3 billion increased 56% versus a year-ago quarter. Qualcomm is one on the top producers of modem solutions for Apple.

Apple reported a strong 2Q22 despite COVID-related disruptions and silicon shortages in the legacy nodes, and the lockdowns in China, specifically in Shanghai, hurting supply and demand. Despite these hurdles iPhone revenue grew 5% YoY to a March quarter record despite supply constraints. Growth was driven by a strong response to the iPhone 13 and the SE model. Mac revenue of $10.4 billion was a March quarter record despite supply constraints while 15% YoY growth was driven by strong demand for the M1-powered Pro. Wearables, Home, and Accessories set a March quarter record, up 12% YoY. Total iPhone unit shipments for FY21 was 241 million (vs 190 million in FY20) an annual growth rate of 26% YoY. Apple is now planning on maintaining flat production in 2022 targeting 220 million new iPhones. Unit volume is expected rebound at 250 million units for FY23.

The doom and gloom report posted by Intel was offset by a huge beat from one of its largest competitors, Advanced Micro Devices. Advanced Micro Devices (AMD) reported quarterly earnings of $1.13 per share, which beat the analyst consensus estimate of $0.91 by 24.18%. This is a 117.31% increase over earnings of $0.52 per share from the same period last year. The company reported quarterly sales of $5.89 billion, which beat the analyst consensus estimate of $5.52 billion by 6.65%. This is a 70.89% increase over sales of $3.44 billion the same period last year. AMD’s EPYC chip design appears to gaining marketshare from Intel in data center server markets.

Top memory and smartphone maker Samsung communicated that it expects strong server demand in memory through 2022. Memory saw better than expected results due to lower than expected ASP declines in Q1. The company set a record for memory sales into the server market. Memory demand in Q2 for server is expected to remain strong. Management noted an improved availability of components in mobile. For 2022, memory should see continued strong server demand and a second half mobile recovery.

In summary, what can we make of all this information? The semiconductor stocks are trading as if a recession is imminent, and profits will slowdown. However, demand for semis is holding up, with industry sales steadily increasing. So far this earning season, about 86% of chip companies have reported better-than-expected revenue, compared to 74% for the overall S&P 500 Tech sector, according to data compiled by Bloomberg. Bell-weather chip names trade at bargain-basement valuations, like Micron Technology at 7x earnings, Intel at 10x earnings or top equipment makers Applied Materials and Lam Research both trading at just 13x earnings. Maintain a positive view on semiconductor companies exposed to cloud datacenter spending, 5G infrastructure, and gaming. See a bounce back in the auto/industrial space, followed by near-term weakness in the consumer/PC markets as we head into FY22 earnings.

Is the glass half empty or half full? With the overall markets trading in bear territory, it is often difficult to see a silver lining. However, there are many signposts that point to fundamental strength in the semiconductor sector. But each investor will have to sort through the tea leaves and make their own determination!

Written by Daniel Morgan, Senior Portfolio Manager

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