Update: The original post contained a data error.
In the interest of digging deeper into the semiconductor oversupply issues, this post continues a series of data gathering on important ratios for companies in the industry. Hopefully the process will provide insight toward the companies better (or worse) positioned to take advantage of the next upturn or weather the downturn.

Yesterday I used Zacks Research Wizard to get the recent Cost of Goods Sold (COGS) and Inventory levels for semiconductor industry participants over the last several quarters. I made some modest limitations on the share volume and market cap, but still ended up with more than 50 names. I used trailing twelve month COGS and the average of the last five quarters (for a beginning, ending and average) of inventory to calculate Days Sales in Inventory.

Higher inventory levels relative to sales indicates a greater likelihood that the company will need to reduce prices, reduce production or take a write-off, all of which would reduce gross profit margin. In this post I compare the current DSI to the DSI in the same quarter one year ago. This should mitigate any seasonal effects, such as ramping inventory ahead of holiday sales, that might distort sequential comparisons.

The companies with the biggest increase in DSI may have the most trouble in the event of an industry downdraft. Even if semiconductor sales remain strong they will need demand to catch up with their current capacity and may not see as much benefit as other manufacturers. The five companies with the largest year/year DSI increase are Silicon Labs SLAB, Applied Micro (AMCC), Zoran (ZRAN), Monolithic Power (MPWR) and Triquint (TQNT).

The companies with the greatest reduction in DSI, by contrast, may be poised for margin expansion as they replenish inventory levels and ramp up production to meet demand. The five companies with the biggest decrease in DSI are Large Cap Watch List (Track at Marketocracy) member MEMC Electronics (WFR), Advanced Micro Devices (AMD - Annual Report), Atheros (ATHR), Conexant (CNXT) and Intersil (ISIL).

The complete list follows.

DSI As Percentage of DSI One Year Ago:

Disclosure: William Trent has a long position in SMH.

Update: The original post contained a data error.
In the interest of digging deeper into the semiconductor oversupply issues, this post will begin a series of data gathering on important ratios for companies in the industry. Hopefully the process will provide insight toward the companies better (or worse) positioned to take advantage of the next upturn or weather the downturn.

Today I used Zacks Research Wizard to get the recent Cost of Goods Sold (COGS) and Inventory levels for semiconductor industry participants over the last several quarters. I made some modest limitations on the share volume and market cap, but still ended up with more than 50 names. I used trailing twelve month COGS and the average of the last five quarters (for a beginning, ending and average) of inventory to calculate Days Sales in Inventory.

The higher the inventory levels, the more likely the company will need to reduce prices, reduce production or take a write-off, all of which would reduce gross profit margin. This first pass looks merely at inventory levels and does not consider strategy or other factors. For example, a fabless company would likely own less inventory than a company that produces chips at its own facilities. In a later post I will consider the trends in inventory (although the historic data I provide below gives some of it away) to determine the companies for which inventory levels are higher than the historic norm for that particular company.

The five companies with the highest levels of inventory relative to their recent sales levels are: Microsemi (MSCC), Lattice (LSCC), Analog Devices (ADI), Micrel (MCRL) and Intersil (ISIL).

The five with the lowest levels of inventory relative to recent sales are: Amkor Tech (AMKR); Smart Modular (SMOD), Large Cap Watch List (Track at Marketocracy) member MEMC Electronics (WFR); Actions (ACTS) and Sirf Technology (SIRF).

The complete list follows.

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.

Having given you our take on the semiconductor sales data yesterday, We had to laugh when we saw this article from Tech Trader Daily - Semis: Feb Sales Data Look Weak; Are We Nearing A Bottom?

The Street this morning agrees on the obvious conclusion of the latest SIA data: it was weak. “Weak February results,” “shipments weaker than typical,” “weakness in both units and pricing,” “data appears generally weak,” “weaker than normal seasonality,” said analysts this morning at J.P. Morgan, Wedbush Morgan, Robert W. Baird, Lehman Brothers and UBS, respectively.But there is also a growing consensus that we are at or near a bottom in semi fundamentals, and that a recovery is just around the corner; it is a theory tied to the notion that the recent inventory correction in the sector is nearly completed.

Oh, really? Here’s a chart we’d like the analysts Eric quoted to look at, which is a total semiconductor sales on a trailing 12-month basis since 1995, based on data from the Semiconductor Industry Association:

So, Christopher Danely, analyst at J.P. Morgan, Craig Berger, of Wedbush Morgan, Lehman’s Tim Luke, and Uche Orji, of UBS: Can you tell me why this looks like a bottom to you?

Disclosure: William Trent has a long position in SMH.

The Semiconductor Industry Association released global semiconductor sales data for the month of February, 2007, and it did not look good.

Worldwide sales of semiconductors of $20.09 billion in February were 6.5 percent lower than January when sales were $21.48 billion, the Semiconductor Industry Association (SIA) reported today. February sales increased by 4.2 percent from the $19.28 billion recorded in February 2006.“While seasonality clearly contributed to the 6.5 percent decline in worldwide chip sales month-on-month, declining unit shipments and lower average selling prices (ASPs) in several key market segments were a factor,” said SIA President George Scalise. “Both unit shipments and total sales of microprocessors and DSP chips experienced sequential declines in February. Unit shipments of NAND flash increased sequentially while total sales saw a double-digit decline, indicating very competitive market conditions.”

It reminds us of something we said in February:  Although end demand for semiconductors has experienced fairly steady growth, excess supply has sometimes caused inventory to grow to unsustainable levels. For example, “by 2000 most of the capacity was in place, churning out chips. Since end demand was growing at a slower pace, inventory built up. The falloff in 2001 wasn’t so much a drop in demand, but the fact that the demand could be filled from that existing inventory.” We even backed it up with this chart:

We followed up last week, saying “Next we turn to capacity utilization, which has clearly started to fall. Excess capacity means the potential for even more inventory to be produced, which tends to put downward pressure on prices. Since the majority of semiconductor manufacturing costs are fixed, low utilization means lower profits - either because prices have to be reduced or because the per-unit costs are higher when production is cut.” It sounds very similar to what Scalise described in today’s SIA press release:

“Year-on-year, we see evidence of the fiercely competitive market conditions – across the board unit sales in key products increased, while ASPs declined. Unit sales of microprocessors were up almost 8 percent while ASPs declined 15 percent, and NAND flash units grew by over 40 percent while experiencing a nearly 50 percent drop in ASPs. These products tend to be indicators of conditions in important end markets such as personal computers and consumer devices,” Scalise continued. “Personal computers and consumer products now account for approximately 60 percent of semiconductor sales. Both competitive conditions and product mix issues appear to be affecting revenues of these key components.”

SIA noted that overall capacity utilization declined from 88.9 percent in the third quarter of 2006 to 86.8 percent in the fourth quarter. Most of the decline was in foundry utilization, which fell from 91.5 percent in the third quarter to 80.9 percent in the fourth quarter. The reduction in capacity utilization in the fourth quarter addressed inventory builds in the semiconductor supply chain and selected end markets which are expected to show growth consistent with GDP performance in key world markets in the coming months.

The problem for us is, we don’t see the reduction in capacity utilization as having “addressed inventory builds.” Rather, we see it as the logical conclusion of excess capacity expansion that has built up now for more than a year:

At the time, we said:

The good thing about the downward revision, and also the decline in February, is that it restores some balance to at least the trend in equipment orders relative to end demand for semiconductors. Although supply (chip equipment orders) is still growing much faster than the roughly 10% growth in semiconductor demand, at least the rate at which the capacity is growing is starting to slow down again. Furthermore, the billings (which represent what is actually installed rather than orders, which may prove too optimistic) have been running at a slower rate than orders. The 22% growth of installed equipment is still well higher than what is needed, but has less far to fall.

Unfortunately, today’s release also blows a hole in any hopes we had that slowing orders would restore balance. Since we measure the imbalance as the differential between dollar capacity growth and dollar sales growth, the slowdown in semi demand to 4% year/year from “roughly 10%” means that February’s decline in chip orders did not improve the potential supply imbalance. Things have farther to fall than we thought.

Disclosure: William Trent has a long position in SMH.

According to a recent Forbes.com article, five Chip Stocks are Cheap Relative To Growth.

The stocks of these companies are still reasonably priced relative to expectations for profit growth.The measure here is PEG ratio, calculated by dividing a stock’s estimated price-to-earnings ratio for the next twelve months by its projected long-term earnings growth rate. These stocks have PEGs that are below the semiconductor industry’s average PEG of 1.2, a sign that they might be bargains. All these companies are profitable and carry 12-month forward price-to-earnings ratios below their three- and five- year averages.

We think the article is a good example of why investors shouldn’t take estimates at face value, and of the dangers of quasi-analysis (looking at things without looking into them.) The stocks they name are Analog Devices (ADI), Intersil (ISIL), Microsemi (MSCC), Standard Microsystems (SMSC) and Supertex (SUPX). We’ll just focus on ADI, since we were talking about it anyway.

According to Forbes, ADI is trading at 19x next year’s earnings and is expected to grow at an annualized 20% rate over the next three to five years. Let’s look at those assumptions, and compare them to what ADI has done over the last 10 years, as represented in the following chart.

If you had only this chart to go by, where would you place the dot for 2007 EPS?

1. At $2.06, which is the consensus estimate for next year
2. At $1.84, which is exactly 20% above the current year’s EPS
3. At $1.05, which is where the average for the year following the last two times it was at current levels
4. You would never be so foolish as to guess at such an apparently random number

Given our outlook for semiconductors, we’re going out on a limb with #3, but we’re sympathetic to those who guess #4 as well. It is also entirely possible that #1 or #2 happens but we wouldn’t bet our life savings on it, which is what we’d be doing if we bought the stock based on its low current P/E multiple relative to recent history.

And how about that 20% growth rate for the next 3-5 years? It has certainly sustained such growth in previous 3-5 year periods. It has also declined by 90% over 3-5 year periods, and stayed flat over 3-5 year periods. And all of those 3-5 year periods occurred in the last 10 years. How can anyone dare to invest on such a pinpoint estimate of the near-term growth rate?

Finally, let’s look at the question of whether the “12-month forward price-to-earnings ratio [is] below their three- and five- year averages.” For that, we will look at a monthly chart of the price, along with the P/E range in the lower chart.

And they are right - it is at the low end of the three- and five- year averages. But it doesn’t look cheap when one looks at a longer historical period. The last five years have had elevated P/E multiples due to depressed earnings, and one can hardly hope that they will get the elevated multiple on strong earnings. That was a Y2K/Internet bubble fluke that won’t happen again.

So let’s rephrase the Forbes argument to something that takes into account the whole picture:

• ADI is trading at about its average valuation over the last 10 years.
• Its earnings are at the high end of the 10-year range.
• Its current price likely reflects a multiple of somewhere between 20x and 40x next year’s earnings.
• It will most likely grow somewhere between -30% and 30% annually over the next three-five years.

We’re guessing that investors would buy a lot less paper (both in the form of ADI stock and Forbes magazines) if the outlook were painted in that way. We’d love to hear your analysis in the comments below.

Disclosure: William Trent has a long position in SMH.