My December 4, 2007 RealMoney article:

Recent data points are shaking my confidence in the near-term outlook for semiconductor stocks.

After being bearish for more than a year I had turned cautiously bullish earlier this year because it looked like potential supply (which I measure as orders for new semiconductor equipment) was coming back in line with demand (which I measure as the year/year change in semiconductor revenues. Unfortunately, the latest data show this trend weakening faster than I thought it would.

On Monday, the Semiconductor Industry Association (SIA) released their sales report for October, saying worldwide semiconductor sales rose to $23.1 billion, an increase of 5 percent over the $22 billion reported in October 2006 and 2 percent higher than the $22.6 billion reported in September of this year.

That 5.0% sales increase year/year was a slight decline from the 5.8% year/year growth reported a month ago but was still the second-best growth reported since January. Taken alone, I wouldn’t consider this report troubling in terms of the supply/demand balance as it shows stable if not slightly improving demand trends.

However, on November 15 Semiconductor Equipment and Materials International (SEMI) released their October book/bill report for semiconductor equipment orders and sales. The bookings figure was flat with the final September 2007 level of $1.24 billion and 16 percent less than the $1.47 billion in orders posted in October 2006.

The fact that demand growth (up 5%) was greater than supply growth (down 16%) is generally supportive of positive performance for semiconductor stocks. The performance of the SOX index during the last five periods in which such conditions prevailed is presented below.

Sources: SIA, SEMI, William A. Trent

In each of the periods other than 2001/2002 the excess demand growth relative to supply resulted in positive returns for the SOX. Unfortunately, the current period to date most resembles 2001/2002. That similarity is also noticeable when looking at the size of the relative peaks and troughs in supply/demand balance.

Sources: SIA, SEMI, William A. Trent

As the chart illustrates, there is typically a fair degree of symmetry between subsequent peaks and troughs, which is only natural because over time one would expect balanced supply and demand.

That 2001 peak in excess demand, however, occurred quickly and was shallow relative to the long, drawn-out period of excess supply that preceded it. So far in 2007, the chart is looking very similar. If the relationship continues to hold, it could be some time before semiconductor stocks again experience the normal cyclical upswing.

There are still some reasons for cautious optimism. For one thing, the semiconductor industry data are sometimes subject to large revisions. With that in mind, I’m not going to get too hung up on the data released in a given month.

Furthermore, recent forecasts have continued to show a cautious approach to adding capacity. Gartner Dataquest forecast that 2008 capital investments by the four largest foundries will decline 9.6% year-on-year. The largest foundries are Taiwan Semiconductor (TSM), United Microelectronics (UMC), Chartered Semiconductor (CHRT) and Semiconductor Manufacturing International (SMI).

Also, according to a Friedman Billings Ramsey analyst, capital spending in the DRAM sector is expected to fall by more than 30 percent in 2008. Leading players in this market include Samsung (SSNLF), Qimonda (QI), Hynix (HXSCF), and Micron (MU - Annual Report).

Together foundries and DRAM have been responsible for a good deal of the total capex and their caution ahead increases the chances of supply and demand returning to balance.

However, given the current state of the economy and the seasonal factors that should have helped demand in October and November, I’m glad I have my long position in the Semiconductor HOLDRS (SMH) offset by a put option on equipment maker LAM Research (LRCX).

In general, I favor the semiconductor makers like Intel (INTC - Annual Report) over the equipment makers like Applied Materials (AMAT - Annual Report) or KLA-Tencor, due to the fact that more capex cuts will be needed to restore the supply/demand balance.

Disclosure: William Trent is long SMH and holds put options against LAM Research (LRCX)

Disclosure: William Trent has a long position in SMH.

Lest you think we were going soft, we hereby balance our earlier enthusiasm for semi stocks with our more customary caution. The five reasons to avoid semiconductor stocks right now include:

1. The fundamentals will get worse before they get better. While supply indications grew slower than demand in April, the turn followed 16 months of too much capacity being ordered. As that capacity comes on line, the inventory situation will worsen and margins will get hit more. It is not at all certain that estimates reflect this.
2. It is May. Sure, sell in May and go away is a cliche. Things often become cliches for a reason.
3. Demand? What demand?
4. Valuations are too high because investors are hoping for more premium buyouts. They will happen, but not to every name in the sector.
5. The last bear may no longer be standing.

Food for thought.

Disclosure: William Trent has a long position in SMH.

A reader complained yesterday that we have been too negative. While we aren’t going to go crazy and have a whole positivity day, we will take the time to outline the bull case for the industry on which we have been most negative: semiconductors.

1. The bad news is known. When we started harping about oversupply, it was the farthest thing from anyone’s mind. Like Heisenberg’s uncertainty principle, the act of observation can alter the experiment.
2. The market is ignoring the fundamentals. Related to point 1, the market knows about the bad fundamentals and doesn’t care. Often this means that the bad news is sufficiently well known to be priced in. This is of course the weakest reason, as the market ignored the fundamentals in 2000 as well.
3. Demand may be ready to pick up. Double-digit growth from a tech distributor for the first time in a long time should not be ignored. The Vista hoopla has passed, now the nuts and bolts work may be beginning.
4. Supply and demand will soon realign. For the first time since 2005, orders for new equipment grew at a slower rate than semiconductor end demand. The longer this situation continues, the healthier it will be for future industry sales, pricing and profit margins.
5. The game has changed. Forget private equity buyers. For the first time a semiconductor management team decided it was more important to take capital out of the industry than to add more. This is a sea change in semiconductor management-think, and the strong positive reaction from investors ensures that the wave will continue to build.

There. That wasn’t so hard, was it? Stay tuned for our five reasons NOT to buy semiconductor stocks today.

Disclosure: William Trent has a long position in SMH.

We have been talking about oversupply of semiconductors for some time. Now, in the last two weeks two research firms have cut forecasts according to Semiconductor Fabtech:

IC Insights has drastically cut its semiconductor growth projections for 2007 citing severe pricing pressures in the NAND flash memory market as well as the continued decline in microprocessor prices. However, the market research firm has added that a major DRAM price collapse has also started and will also affect market growth this year. As a result, the firm has lowered its forecast to 2 percent growth compared to its previous forecast of 7 percent growth for 2007.Only two weeks ago, Semico Research lowered its semiconductor forecast for the second time this year citing poor prices even though unit demand remained strong, and now projects only 1.8 percent growth for 2007. In March, Semico had projected growth of 5.8 percent compared to a projection at the beginning of the year that the semiconductor industry would grow by 7 percent.

While everyone plays catchup we will refer you back to our October 2006 comments, which have not needed any revisions:

The chart below shows the year/year growth rate in semiconductor sales for each month going back to 1998. Data is courtesy of the Semiconductor Industry Association (SIA).

This tells us a few things:

• The semiconductor sales growth rate has been more consistent since 2005 (in the mid-high single digits.)
• The forecast calls for that to essentially continue for two more years.
• The chart tells us that is pretty dadgum unlikely.

Sales growth is likely to be either much higher or much lower than 8.6% next year. The million dollar question (or however much you may have at stake – for us it’s more like a couple thousand) is which direction. We’re betting it is lower.

For one thing, this is the longest the semi industry has ever gone without a year/year decline. By itself that doesn’t mean much – due to the fabless/foundry model and general tech industry maturity sales growth should be less volatile.

However, when you combine low volatility in sales growth with huge orders for new manufacturing equipment you end up with oversupply. Oversupply in a cyclical industry means sharper than normal price reductions. If the prices fall faster than unit demand rises – you get a decline in sales.

The other reason we expect semiconductor sales to be less than the industry predicts next year is summed up in the following chart, which tracks the total sales (rather than growth) over the preceding twelve months. There has been a definite change in the overall growth rate, going back to about 1995 or 1996, depending on where you want to draw the lines. For simplicity, we’ll just use the last 10 years (September 1996 – August 2006). Over that time frame, the average growth rate has been 6.3%. However, it is easy to see that that rate is toward the top of the new range (the trendline represents resistance in this case.)

So, given overcapacity, volatility and resistance we think 8.6% growth in 2007 is on the optimistic side. Perhaps even the wildly optimistic side.

We’ll have to wait and see how much of a shakeup there is in 2007 before we’d be willing to comment on 2008.

Disclosure: William Trent has a long position in SMH.

When Semiconductor Equipment and Materials International (SEMI), the industry trade organization for semiconductor equipment makers, reported the January book to bill ratio for chip equipment, we were concerned.

Unfortunately, just when it looked as if things might be set to turn the semiconductor companies re-accelerated their pace of equipment orders over the last two months.

Until orders for semiconductor equipment start growing at less than the roughly 10% growth in demand for semis, there will continue to be the brutal pricing environment we have seen recently. The decent guidance and calling of bottoms are pipe dreams.

But now it appears there could be another reason for the datapoint we found so strange. According to Reuters.com:

Global sales of microchip-making equipment in February rose 16.6 percent from a year earlier on demand for tools to make and process silicon wafers, an industry group in Japan said on Friday.Sales of gear used to make semiconductors rose to $2.72 billion in February, the Semiconductor Equipment Association of Japan (SEAJ) said.

The group also restated sales figures for January, saying sales rose 17.2 percent year-on-year to $3.49 billion, instead of a previously stated rise of 34.5 percent to $4.01 billion.

A member of Semiconductor Equipment and Materials International, a California-based industry group, had given the wrong sales numbers, the SEAJ said in a statement.

Then SEMI reported adjusted figures. Here is what the numbers looked like in February as originally reported:

And here is the new and improved data:

The March numbers will be reported Thursday. Given that the supply/demand imbalance is the main contributor to our bearishness, a continuation in this trend would mean we are much closer to adopting a neutral/bullish outlook for semis. We can’t wait for Thursday’s release to find out.

Disclosure: William Trent has a long position in SMH.

When we saw predictions of a second-half rebound for DRAM prices, we said:

Or, more likely, vendors hope demand will kick in later this year. Furthermore, with all the new supply being added it is unlikely to be absorbed even if demand does pick up. We don’t think prices will rebound in 2007, although the stocks may bottom this year ahead of the bottom in industry fundamentals.

But perhaps we were misinterpreting. Perhaps by “propping up” prices they meant that prices would fall more slowly. Alas, even that may be a premature hope, according to DRAMeXchange:

After experiencing a temporary rebound, the DRAM spot price has started to weaken again. Amid the national holidays in the Hong Kong and Taiwan markets, minimal transactions were seen. The DDR2 512Mb 667MHz chip price stayed near the USD 2.9 level, while the DDR2 eTT slipped to USD 2.65.

Oh, and we already covered the New Year Holiday myth so we won’t go there again.

According to iSupply, the top DRAM producers (exposed stocks) are:

1. Samsung (SSNLF.PK), 27.8 percent
2. Qimonda (QI), 16.9 percent
3. Hynix (HXSCF.PK), 15.8 percent
4. Micron (MU - Annual Report), 10.6 percent
5. Elpida (ELPDF.PK), 10.2 percent
6. Nanya, 6.6 percent
7. Powerchip, 4.8 percent
8. ProMos, 4.5 percent
9. Etron, 0.9 percent
10. Winbond (WBEMF.PK), 0.6 percent

Caveat emptor.