The following is a reprint of my December 27, 2007 RealMoney column

Recently I expressed concern that there may be more pain ahead for semiconductor manufacturers. The concern was based on recent sales reports from the semiconductor equipment industry and from the semiconductor equipment industry.

I have noticed that semiconductor stocks tend to perform best when the growth for chips exceeds the order growth for chip equipment. This is simple supply and demand stuff - when the chip sales are growing faster than equipment sales, it indicates demand is growing faster than supply. That means tighter capacity and less pricing pressure over the coming months, which is generally good for profits and by extension the stock prices. The reverse is true when orders for equipment are growing faster than chip sales.

Based on the October data, the equipment orders declined 24.7% year/year in September but only 16% in October. My fear was that the orders were not being cut as much as they had been in recent cycles, and therefore that the up-cycle I have been expecting would be cut short.

I did, however, note some cause for cautious optimism - in particular that the semiconductor industry data are sometimes subject to large revisions. And, lo and behold, the October equipment orders were revised down sharply.

Based on the updated report, equipment orders declined 19.9% in October and 19.4% in November. These data are much more supportive of my original thesis that the next year was likely to be a good one for semiconductor stocks.

Better yet, Gartner Group expects all major segments of capital spending to decline in 2008. Worldwide semiconductor equipment spending is now expected to total $40.3 billion in 2008, a 9.9 percent decrease from 2007 spending of $44.8 billion. (Source: Fabtech).

I don’t always believe reports from the industry analysts, because they are often wrong. I like to use the supply/demand model as a gut-check, allowing me to reconcile the unknown (analyst estimates) with what is known (current leading indicators.) In this particular case, I think Gartner is going to be close to the mark.

So what is the upside for investors? I have charted the performance of the SOX index over the last five “excess demand” cycles - with each one beginning the month after semiconductor sales begin to grow at a faster rate than semiconductor equipment orders. I use a one-month delay because the Semiconductor Industry Association reports monthly sales on a one-month lag, so the chart shows the performance starting at the time the data become available.

From the start of the excess demand cycle to the first month of excess supply, semiconductor stocks did very well in three out of four instances - and the bad time was likely a by-product of the Internet bust. (That explanation is also supported by the fact that the periods of excess supply were bad times for the SOX in three out of the last four instances, with the Internet boom being the one exception.)

Sources: Semiconductor Industry Association, Semiconductor Equipment and Materials International, Yahoo!Finance, compiled by William A. Trent

The current period is much more “normal” than boom/bust for tech. Therefore, I think the normal outcomes are likely to prevail.

But perhaps more enticing is that so far in this cycle the SOX is down nearly 16%. Similar (though slightly worse) interim declines happened in two of the previous cycles, and in both cases were followed by rallies of more than 50% over the following six months.

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

Disclosure: William Trent owns shares in the SMH and in Maxim Integrated Circuits (MXIM) and put options on LAM Research (LRCX)

Note: Always read the fine print when signing up for low interest credit cards to avoid hidden costs!

Disclosure: William Trent has a long position in SMH.

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)

Note: Be sure to use real time stock quotes and pick the right stocks for your portfolio.

Disclosure: William Trent has a long position in SMH.

Pension accounting rules permit certain expense items to be smoothed into income. However, the required disclosures allow investors to adjust the income statement to reflect the true underlying economic cost related to pension plans. The economic cost should equal any change in the plan liability other than benefits paid or employer contributions.

Consider the following pension disclosures from KLA-Tencor’s 10K.

The pension obligation increases by 4,175, and benefits paid of $1,519 should be added back to that amount to determine the underlying economic change in obligation. 4,175 + 1,519 = 5,694.

The fair value of assets rose by $1,255. The contributions and benefit payments were a net $789 which should be deducted from this. Notice that in this case the benefits paid figure differs between the asset side and the liability side. It is possible some benefits were paid as a lump sum settlement. At any rate, the net change in assets was 1,255 - 789 = 466.

The net change in the economic liability, then, was 5,694 - 466 = 5,228. Contrast that with the reported pension expense.

The economic change in the value of the pension was $5,228, but the income statement showed an expense of just $2,280. An investor might want to adjust the income statement by adding $2,948 to pension expense, reducing operating income by the same amount. The effect on net income would be smaller due to the tax effects.

For KLA-Tencor, reported operating income was 589,868 in 2007. After this adjustment it would have been$586,920 - approximately half a percent lower. Earnings per share for the year would have been at least a penny lower. In this case, I wouldn’t consider the difference material.

North American-based manufacturers of semiconductor equipment posted $1.44 billion in orders in July 2007 (three-month average basis) and a book-to-bill ratio of 0.84 according to the July 2007 Book-to-Bill Report published by trade organization Semiconductor Equipment and Materials International (SEMI). A book-to-bill of 0.84 means that $84 worth of orders were received for every $100 of product billed for the month. According to Solid State Technology Magazine:

The real story is bookings (orders), which slumped more than 10% M-M in July and about 17% Y-Y to $1.44 billion — the biggest monthly decline since Oct. 2006, and biggest Y-Y dropoff since late 2005. It’s also the first month of double-digit declines both M-M and Y-Y since January 2005. “Orders have slowed from the strong levels observed in the first part of this year,” noted Stanley Myers, president/CEO of SEMI, in a statement.

Make that an understatement. Finally, the industry is coming around to the notion that the downturn is more than a short-term blip. Not that I mind - the more people understand there is a cyclical downturn the sooner the stocks can move past it.

Just to double check and make sure that the downturn is indeed well recognized, I skimmed through some recent semiconductor equipment earnings conference calls.

Applied Materials (AMAT - Annual Report) recognizes it.

Steven O’Rourke - Deutsche Bank

Thank you. Good afternoon. A couple of questions. First, I hate to beat a dead horse but are the foundries telling you anything different now than they told you three months ago?

Michael R. Splinter

Well, if you look at our revenue in Q3, we had an up-tick in foundry orders that we delivered in the quarter, had some good turns business, and so we — three months ago we kind of expected that trend to continue throughout the year and it’s not. And so yes, there is a fairly substantial difference between now and May.

(Excerpt from full AMAT conference call transcript)

Lam Research (LRCX) does not.

We expect that foundry shipments for Lam will be weak in the September quarter as a function of the pull-ins to June and we expect that shipments in foundry will strengthen in the December quarter. Shipments for Logic, Flash other and MPU are expected to be flat in the second half compared with the first half.

(Excerpt from full LRCX conference call transcript)

KLA Tencor (KLAC) is still thinking it is a seasonal issue. Note to KLAC: year/year comparisons are not affected by seasonality.

Our September outlook is a little complex this year, as we have a number of factors impacting our results, largely related to recent acquisitions. Jeff will give you more of the details. Given that, our bookings outlook for September is down 15%, with a range of plus or minus 10%. This is on par with the typical seasonality we experience in September.

(Excerpt from full KLAC conference call transcript)

Unfortunately, it doesn’t sound like the downturn is as well-understood as I was hoping.

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Disclosure: William Trent owns put options against the shares of Lam Research (LRCX) and is short put options against shares in the Semiconductor HOLDRS (SMH).

William Trent currently owns put options against the shares of Lam Research (LRCX).

According to Semiconductor Equipment and Materials International (SEMI):

North American-based manufacturers of semiconductor equipment posted $1.65 billion in orders in June 2007 (three-month average basis) and a book-to-bill ratio of 0.94 according to the June 2007 Book-to-Bill Report published today by SEMI. A book-to-bill of 0.94 means that $94 worth of orders were received for every $100 of product billed for the month.

The figures for last month were also adjusted downward, indicating that it isn’t just the forecasts that should be taken with a grain of salt. I noted last month that the tiny upturn was probably a head-fake, and believe that the order growth trend will continue to decline for the highly unscientific reason that it always does.

The good news, of course, is that ordering less equipment will allow demand for semiconductors to catch back up with supply.

Disclosure: William Trent has a long position in SMH.

UPDATE 1-Chip equipment orders seen rising 1 pct this year | Reuters

Sales of equipment used to make microchips are seen rising 1 percent this year to $40.9 billion, cooling markedly from last year’s 23 percent growth, a U.S. industry group said on Monday.The market is expected to grow 7 percent in 2008 and 4 percent in 2009, Stanley Meyers, president of Semiconductor Equipment and Materials International told reporters.

A quick refresher on what these forecasts are worth. In December, SEMI forecast that sales “will grow in the single digits in 2007, and in the double digits in 2008. In 2009, growth is anticipated to be in the single digits with sales expected to hit $50.42 billion.”

I guess technically 1% is “single digits,” or digit anyway. But as I said at the time, and again last month, if the industry group is to be believed the current decline will mark the shortest semi equipment contraction in history. Which is a big part of the reason why I don’t believe it.

The fact is, industry trade groups exist to promote industry trade. Whether the National Association of Realtors or anyone else, the industry forecasts are generally overly optimistic. I look to such groups for their current and past data, not their forecasts.

According to trade group Semiconductor Equipment and Materials International (SEMI):

“Bookings and billings remain at levels above a year ago, and there is relative equilibrium in the book-to-bill ratio, which has remained very near parity for half of a year,” said Stanley T. Myers, president and CEO of SEMI. “We are surveying member companies and will issue a new consensus forecast outlook for capital equipment next month during SEMICON West.”

If the industry group is to be believed, the one-month semiconductor equipment sales decline in April will mark the shortest semi equipment contraction in history. Which is a big part of the reason why I don’t believe it.

The other part is that I’m hearing about more and more order pushouts of exactly the type I have been predicting here for over a year.

Don’t get me wrong - I think this is exactly what their customers need to be doing, which is why I have taken neutral to bullish outlook toward the semiconductor stocks.

Disclosure: William Trent has a long position in SMH.

The Semiconductor Industry Association (SIA) released the monthly industry sales report for April, saying:

Worldwide sales of semiconductors of $19.9 billion in April were 1.6 percent higher than the $19.6 billion reported for April of 2006, but 2.1 percent lower than the $20.3 billion reported for March 2007, the Semiconductor Industry Association (SIA) reported today. Total sales for the first four months of 2007 are up 3.7 percent compared to the same period of 2006.

The 1.6% year/year growth in semiconductor revenue comes despite 10% growth in unit sales. The excess capacity that has been building over the last year is now taking its toll in the form of more competitive pricing. But don’t take my word for it:

“A very competitive semiconductor market, with declining average selling prices (ASPs) in major industry segments, contributed to a sequential decline in worldwide chip sales,” said SIA President George Scalise. “Several of the largest segments of the semiconductor market – microprocessors, DRAMs, and NAND flash – are all experiencing ASPs that are declining more rapidly than historical patterns, offsetting growth in unit shipments.”

The good news is that, for the second consecutive month, semiconductor manufacturers have ordered new capacity at a slower rate than their own sales growth. Over time, this is the action that will restore balance between supply and demand.

Disclosure: William Trent has a long position in SMH.

Panel Of Analysts Bearish On The Chip Gear Industry:

Three well-known market watchers, speaking on a Silicon Valley panel Wednesday night, said the chip gear industry is headed for a downturn that could be steep.”I think we’re heading to the worst semiconductor equipment downturn — perhaps ever,” said James Covello, a Goldman Sachs analyst. “We’re starting to see the first signs of that.”

Actually, as my readers well know, the “first signs” that there would be a severe downturn were clearly visible a year ago. At the time, orders for semiconductor manufacturing equipment had grown faster than sales of semiconductors for three consecutive months. Those first few months were about making up for a year of under-investment in 2005. But as I predicted at the time, and as should be obvious from the history, semiconductor demand and semiconductor equipment demand are rarely at equilibrium.

I am working on an update to my semiconductor supply/demand model, including some refinements that will hopefully help better identify entry and exit points.  It will obviously continue to be art as much as science, but one thing seems sure - waiting for the sell siders to identify it is likely waiting too long. Applied Materials (AMAT - Annual Report) topped out in January 2006 - (coincidentally?) the first month that would indicate future oversupply. It still hasn’t broken above the January 2006 high. I’ll admit I might have missed the bottom last year - but to “forecast” the decline now seems particularly late unless last year’s rally was really just a head-fake.

We’ll know the answer to that soon enough.

Disclosure: William Trent has a long position in SMH.

Trade organization Semiconductor Equipment and Materials International released the April book-bill figures for semiconductor equipment orders:

The three-month average of worldwide bookings in March 2007 was $1.60 billion. The bookings figure is over 12 percent higher than the final March 2007 level of $1.42 billion and even with the $1.60 billion in orders posted in April 2006.The three-month average of worldwide billings in April 2007 was $1.60 billion. The billings figure is over 11 percent than the final March 2007 level of $1.44 billion and almost 11 percent higher than the April 2006 billings level of $1.44 billion.

“This year, several large integrated device manufacturers are believed to be investing a substantial part of their capex in the first quarter. This is one reason that the April book to bill report shows strong gains in both billings and bookings for new semiconductor equipment from North American based suppliers,” said Stanley T. Myers, president and CEO of SEMI. “Updated figures also show relative equilibrium of orders and shipments over the past few months, reflecting continued market stability for North American providers of chip making equipment.”

Although SEMI says year/year bookings were “even” with last year, my spreadsheet calculates “even” as down 0.6%. This is, of course, the beginning of a quite natural correction after the recent extended period of overordering, as depicted in the chart below.

What I have described over the last year as a “building imbalance,” SEMI calls “relative equilibrium” and Citi calls “bleeding to death.” A rose by any other name, I suppose. The good news (for me, anyway) is that with the downturn now widely accepted I can continue to be contrarian but take a more bullish stance on the sector - and being bullish is usually more fun.

Disclosure: William Trent has a long position in SMH.