-Where are we in the chip cycle? Why is it different this time?
-No one rings a bell to indicate the top or bottom of a cycle
-Could the lack of self-awareness lead to a worse downturn?
-Who will weather the cycle better & come out on top
“A cartoon character will not fall until they realize they should be falling”
We wasted too much of our ill spent youth watching cartoons. One of our favorites was Wile E. Coyote. The unique physics was very repeatable, the character in question would find him or herself with no visible means of support but not succumb to gravity until they recognized their position or another character pointed it out to them.
Typically, Wile E. Coyote would run full speed off a cliff but not fall until he noticed his predicament.
This reminds us very much of where the semiconductor industry is today. The industry has been running so fast and focused on speed that it hasn’t yet realized that the basis that supports the industry has gone away, that is that demand has dropped and will see further declines.
We have been talking about the industry being in a down cycle for months now. Memory prices have dropped (usually one of the first signs) inventories have grown, lead times are down. More importantly, demand for semiconductor rich electronic devices is dropping.
However, some semiconductor and semiconductor equipment companies are still reporting great earnings, record breaking earnings in some cases. This makes it very difficult to talk about a down cycle when you are still making big bucks.
The speed at which the industry has been running has driven so much momentum into the industry that gravitational cognizance has been delayed.
Still living on backlog and fear
In many cases the industry is living on backlog or non cancelable orders placed near the height of the cycle despite the fact that product is in inventory or readily available. In other cases, customers are so fearful (like the auto industry) that they continue to order even though they already have enough simply because they don’t want a repeat of the shortages.
Semiconductor equipment is worst in this regard as no one dares to get off the queue waiting in line for litho tools lest shortages start up again.
Realization may hit home when the channel is fully stuffed
In the past we have seen instances where there are crates of semiconductor equipment piling up on the receiving dock because it can’t be installed quickly enough or there’s no room. In one past case there was a parking lot full of crates.
Wafers sit in the channel at OSATs waiting to be packaged and tested. Manufacturers, like Micron, start to hold product off the market to support pricing.
Momentum could cause a huge overshoot of capacity
Given the absolutely huge momentum the industry has had for several years, it is not unreasonable to think that we could wind up with one of the largest cases of excess capacity the industry has seen in many cycles.
A lot has been said about the industry being more conservative in their spending and more cautious than the bad old days of cycles past but the rate of equipment orders over the last year or more has been anything but cautious.
Where is the snowball in the downhill food chain?
We are still at the early stages of a down cycle as not everyone agrees, admits or recognizes reality. We are concerned about processor demand for hyperscalers, data centers and memory in consumer devices but there is not a full fledged capitulation. We have seen virtually no impact in the equipment makers financials other than supply chain issues primarily related to COVID, which have been relatively minor. So we are still at the snowball stage where the issue has not yet grown to snowman size to encompass the entire industry.
Many so called analysts are still very bullish or have a lot of buys or have become even more positive as valuations have slipped. From a stock perspective we have not yet hit, and are still far away from capitulation.
Maybe the bell ringer indicating the bottom of the cycle is the last bullish analyst capitulating (ignoring those who never change their ratings….).
Who will weather the down cycle best?
We think TSMC remains one of the more defensive names in the group of foundries or chip makers in general. They are far and away at the top of the heap and can control and dominate pricing such that they control pricing for every other foundry in the market. Other foundries live under the price umbrella of TSMC.
When TSMC is out of capacity or raises prices enough, chip customers are forced to go elsewhere to get their chips made even though TSMC is always their first choice. The bottom line is that TSMC’s overflow business goes to competitors. When TSMC has excess capacity, a lot of that business will come back to them, leaving those down the foundry food chain with much lower utilization and profits.
In semiconductor equipment , ASML is always the last piece of equipment you would ever cancel given the crazy long lead times. Most process tools, such as deposition and etch tools are more of a “turns” business where you can simply reorder what you have canceled without much delay.
China business is an added “unknown”
Its unclear what the status of tool and chip shipments to China will be given the worsening relations. Given that China has been the biggest customer of most equipment companies means that this is a significant variable that looks to be getting worse in the near term. Though not hugely impactful today it could make a big difference when equipment companies are scrambling for orders or need to find new homes for cancelations or delayed product.
Are there “time bombs” in wooden crates in the field?
Lam had noted that they had several billion dollars worth of unfinished tools that were shipped on an incomplete basis to customers while waiting on parts. This situation is quite different from ASML that shipped completed yet untested tools to get them to customers faster.
What happens when all those tools are completed and installed???
We recall a situation where the Chinese LED industry had a lot of MOCVD tools sitting in crates that were going unused.
The CHIPS act, throwing gasoline on a glut bonfire?
As we have mentioned in previous notes the timing of the CHIPS Act is nothing short of poetic. Micron will likely cut capex in half and Intel has already announced a likely slowing of Ohio and other projects.
Could we get into a situation of “use it or lose it” where chip makers feel forced to spend CHIPS money where they otherwise wouldn’t, through prudent financial analysis. Basically throwing free or cheap money at the industry even though its not needed because we already have excess capacity (although maybe not in the right country).
We may need a redirect of the CHIPS act given that circumstances have changed substantially since the project was conceived
Overall we see a lot more downside beta than upside beta in the semi industry right now. Its hard to come up with some variables that could break significantly to the upside and most of the variables seem to be degrees of downside potential.
We see no good reason to get involved with value traps. The last thing we want to hear is some analyst saying that a stock is trading at a 52 week low with a huge dividend. At this point I am certainly not concerned about a dividend play when my principle is at significant risk , there is no offset benefit.
Certainly macro uncertainty is a big portion of the problem and it doesn’t look like macro issues are getting better soon. Semiconductors remain the tip of the economic spear and will see outsize impact from any macro gyrations.
The other issue is that we don’t have any good sense as to how long or how deep? Could overall demand for chips keep the slow down short lived and minor? Which way will all the variables fall?
Long term demand seems absolutely great but things could get even uglier short term as we have yet to see a bottom in our view.
About Semiconductor Advisors LLC
Semiconductor Advisors is an RIA (a Registered Investment Advisor), specializing in technology companies with particular emphasis on semiconductor and semiconductor equipment companies. We have been covering the space longer and been involved with more transactions than any other financial professional in the space. We provide research, consulting and advisory services on strategic and financial matters to both industry participants as well as investors. We offer expert, intelligent, balanced research and advice. Our opinions are very direct and honest and offer an unbiased view as compared to other sources.