China Trade war is accelerating with First Blood in Chips

China didn’t wait around for the US to announce more tariffs or export restrictions, instead it went on the offensive and put an injunction in place to prevent Micron from shipping product into China. Although our view is that Micron will see little impact from this action, the headlines caused the semiconductor sector stocks to sell off biggly.

The prohibition was very thinly veiled as an injunction in an alleged court victory in China between UMC and Micron. Anyone who for a minute believes that this was a true and fair verdict in which Micron infringed upon UMC’s IP and not part of the escalating trade war between China and the US, also believes in Santa Claus and the Easter Bunny.

It also reinforces our view that although China can’t go toe to toe with the US on tariffs due to the trade imbalance, there are many other ways to fight the trade war and inflict damage. There also isn’t a simple retaliatory reaction that the US an respond with as it can with tariffs, so its a smart move by the Chinese.

As we have stated several times over the past months, the “headline” risk to chip stocks due to China trade issues is large and accelerating by the day. There is no de-escalation on the horizon and we feel it will gets worse before it gets better so the stocks still have more downside risk.

Rather than announce technology export restrictions to China as originally planned on June 30th, the administration punted and kicked the can down the road to congress, suggesting congress enact legislation that would enhance CFIUS or something similar. We all know that congress can’t do anything in less than a decade, so that effectively killed the movement to restrict technology exports to China. China on the other hand had no such compunction and effectively shut down Micron in China.

Not much long term impact on Micron
While the injunction against Micron makes headlines and is good PR for China the actual impact is less so. The chip memory market is a giant zero sum game commodity market very similar to the oil market. If Micron can’t sell product in China, it can sell it elsewhere in the globe. Samsung can sell memory in China to make up for it and Micron can serve the customers Samsung gives up to sell to China.

Imagine if the US stopped importing Iranian oil, it would have zero impact on the Iranians as they could sell it to other global customers and the US would import more from other sources…a giant zero sum game of a commodity product. However it would still rile the oil markets and make headlines.

Its unclear if the ban is enforceable anyway
If Apple wanted to use Micron memory in its Iphones made in China will China really stop Foxconn from making Iphones and put one million Chinese workers who assemble Iphones out of a job? Probably not. The collateral damage is very far reaching and we doubt that anyone has taken the time to figure out the ramifications.

Its Deja Vu all over again….
We have seen a smaller version of this movie before with Veeco of the US and AMEC of China as the previous actors. Veeco sued AMEC for infringing, AMEC countersued in China, and won of course, effectively shutting down Veeco in China even though AMEC started the infringement.

UMC ripped off Micron’s IP in Taiwan yet UMC sued in China and won….surprise, surprise. I don’t think there is any court in China that would rule in the favor of a US company on IP infringement if they valued their lives. Basically the courts in China will always rule against the US so using the courts in a trade or IP conflict will always get the desired result.

This should come as no shock to most in the industry as we have seen it before in other countries. AMAT got put in the penalty box by Samsung for going after a little Korean company that had infringed on Applied’s IP.

The moral of the story is you an’t protect your IP in court, you have to prevent it from being ripped off in the first place by tightening security.

The secret recipe
A couple of years ago we had several discussions with a number of people in the industry saying that China would never get anywhere in the chip business as they had no recipe to make memory chips and no one was willing to license it to them. Its clear now that they can get into the chip business simply by stealing the IP much as they got into the fighter airplane business by ripping off US companies that make fighter planes. The chip business is just as important, perhaps even more important than fighter planes so it should come as no surprise that any effort will be made to get the IP by whatever means.

The only bottleneck is the tools
Even though the Chinese can steal the recipe for chips they can’t make them without the tools, especially litho tools. The Japanese and others can sell China tools to make chips but they simply can’t make competitive chips without US manufactured tools. Stopping the export of US semiconductor equipment tools is the only truly effective way of shutting down the Chinese chip industry and sooner or later the administration will figure that out and impose export restrictions. Sooner or later equipment companies will get dragged into the trade war wether they like it or not.

The storm will grow to suck others into the war
We also assume that other companies will get sucked into the trade war. Intel has a fab in China and will undoubtably get involved…though not willingly. The US could stop Intel from exporting technology to be used in its China plant which could be easily copied. Other companies will also get drawn into it

Is Taiwan the next Crimea?
Much as the Soviet Union “annexed” Crimea, so will the Chinese “annex” Taiwan. After all, Taiwan is a rogue “run away” province of China and China underscored that fact by having airlines change Taiwan’s name to be part of greater China. When (we say that because its not “if”) China annexes Taiwan, they will get TSMC and become the dominant leader of the semiconductor industry with no need to steal it. UMC , also of Taiwan , is obviously already part of China as it was the actor that ripped off Micron.
If the US does indeed try to slow down China’s entry into the chip business, China could turn around and accelerate it through Taiwan. We are not sure that the US will come to the aid of Taiwan as we didn’t do a lot over Crimea.

The stocks
We continue to see lots of risk in semi stocks as there is no resolution on the horizon or anywhere else for that matter….it only gets worse by the day. All chip companies are at risk in one way or another. The stocks, if not immediately impacted, will have the sword of Damocles over their heads waiting to get sucked in to the fray or be collateral damage.

The other issue we have is “death by a thousand cuts”. That is that the news continues to flow out in a continuous negative stream that nibbles away at stock valuations day after day.

All in all we are not happy with any of these possibilities and as such see no reason to go against the flow and buy into the group. We would still continue to be light or short the group and the sox index in general.

We still think Micron remains cheap and the sell off was an over reaction but its very hard to “fight the tape”.

Have a happy fourth of July and watch out for continuing fireworks in the chip industry…!!!!

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