Chips Require Further Negative Developments

Chip investors have had a tough year. Things may need to get worse before they get better, but there is hope on the horizon.

‍
Micron's disappointing fiscal first-quarter results late Wednesday added more pressure to the already struggling company. The PHLX Semiconductor Index slid more than 4% on Thursday, and is now down 36% for the year. This follows three years of strong performance, where the index averaged a market-trouncing gain of 51% annually.

‍
But as is typical in cyclical industries, stocks turned down well before the actual numbers did. By the end of June, the SOX was down 35% for the year, while global semiconductor sales for the first six months were showing a 23% gain over the same period in 2021, according to data from the World Semiconductor Trade Statistics trade group. Experienced investors understood that the shortages sparked early in the pandemic wouldn’t last, and would in fact drive up inventories that would sooner or later spark a slowdown in sales.

‍
Micron's inventory increased by 26% during the most recent quarter, reaching a record high of $8.4 billion. This is the largest sequential jump in inventory that Micron has seen in nearly a decade. Chief Executive Officer Sanjay Mehrotra said that the industry is currently experiencing the most severe imbalance between supply and demand for memory that it has seen in the last 13 years.

‍
The key question now is: when will chip stocks hit bottom? In his initiation report on the industry last month, Chris Caso of Credit Suisse noted that “historically two-thirds of the pullback in semi stocks occurs before the first bad news hits the tape.” He went on to say that most times they reach a bottom just a few months later.
However, he also acknowledged that the current cycle is atypical, as certain chip sectors such as analog and automotive have yet to experience a downturn. Many buyers who were affected by the shortage have taken precautions to avoid being caught off-guard again, building up larger amounts of inventory.

The four largest chip companies serving these markets—Texas Instruments, CXS, Microchip and Analog Devices—averaged 24% year-over-year revenue growth in their most recent quarters. Companies in the semiconductor industry will likely have to start showing weakness before investors become positive on the category again. This may take some time. In a report from December 14th, Chris Rolland of Susquehanna noted that while lead-times have come down from record highs over the past few months, the analog and MCU chip categories are still two to three times their prepandemic levels from November.

‍
Investors who wait too long to jump back into the chip stock market may be taking on unnecessary risk, according to Mr. Caso of Credit Suisse. He says that chip stocks have a tendency to rebound before fundamentals do, and has given a positive rating to Micron for that reason. In a note to clients Thursday, he wrote that "in a cyclical space such as memory, we're more inclined to be constructive when suppliers sound this bad." This suggests that chip investors may need to start buying before chip makers run out of stock.