A Tale of Two Semis

It was the best of times (for stocks)
It was the worst of times (for memory chips)
The disconnect between stock & chip prices

The Venn Diagram of Stocks and Chips
Having been involved with semiconductor and tech stocks for a long time there has always been a loose correlation between the fortunes of the industry and the fortunes of the stocks, which varies over time. Right now we are in one of those periods where the Venn diagram has little overlap as the stocks have been on a tear while the industry wallows in the mud. Memory chip pricing and demand has been bad, to say the least and logic demand has not lit the world on fire as the whole smart phone industry has clearly slowed, led by Apple.

You don’t buy equipment when cutting capacity
With Micron cutting back on wafer starts by 5%, they are voting with their feet. A 5% cut back in wafer starts does not correlate to a 5% cut in equipment purchases. Equipment purchases are almost binary. In times of glut, such as we are in now, equipment purchases related to capacity go to zero, while equipment purchases related to technology slow. We doubt that Samsung or other memory makers are spending to build capacity as they also have too much.

A third order derivative market
We have said many times that higher order derivative markets are more volatile than first orders markets and semi equipment is a third order derivative market;

• Smart phone & consumer sales slow – sneezes
• Semi market sees memory crater – catches a cold
• Semi Equip memory sales go to zero – gets pneumonia

Life at the end of the food chain is always more volatile.We saw it in the up cycle and we are seeing now in the down cycle.

The “new normal” is likely lower than the “old normal”
The chip industry went through a “perfect storm” of circumstances that is not likely to be repeated when the industry recovers. The industry, in the last cycle, was driven by moving from rotating media to SSD’s, conversion from 2D to 3D memory, multi patterning due to the lateness of EUV, among others among factors, all of which are one time events that will not be repeated.

This most recent up cycle was higher than normal due to these unique one time events that drove demand to a higher and longer up cycle than we would have otherwise seen.

Although AI, VR, and 5G are on the horizon, its unclear that they will drive the industry to equal the previous unusual high. None of these require significant new technology such as the the 2D to 3D conversion or multipatterning these drivers are primarily just different chips not huge increases in demand or new technology that will force big equipment buys.

Gravitational attraction of realities
The reality of the stocks and the reality of the industry Venn diagrams vary over time but always seem to have a gravitational attraction that brings the stocks back to the “real reality” of whats happening in the market. Right now the stocks do not reflect the continuing weak chip market but sooner or later either the stocks will fall or the chip market will pick up as stocks and the industry will get back in alignment.

Betting on a bounce back
Right now, given the divergence, investors are betting that the industry “bounces back” fairly quickly and will support the overly extended stock prices. We are not so sure of this. We have yet to see any hard evidence of any kind of recovery in the chip market, let alone a quick “bounce back” in the second half of 2019 that many bulls are calling for. It seems a bit difficult to suggest that memory prices will bounce back with Micron cutting production, and Samsung is doing the same. 5G is still a long way off (and not happening at Intel…)and smart phones are certainly slower.

There is no evidence or calculation that can be done to predict when the semi industry will recovery. Each down cycle and up cycle is different in its shape and duration. Any one who claims to be able to predict the cycle is lying. Right now all the talk about a 2H 2019 recovery is no more than hope and conjecture and is about as accurate who said the industry was going to have a “one quarter” air pocket in the summer of last year. That one quarter air pocket is going on about a year now….

Will investors get impatient?
Perhaps the biggest question of Q1 earnings reports is about investor patience. Reports will not likely be very rosy nor particularly upbeat about Q2 or future quarters. Will investors continue to sit on stocks whose price is based on a significant recovery that has no basis in reality. So far, this tear that stocks have been on has lasted over a quarter.
Some of the stocks keep gaining ground and have hit 52 week highs

Whats priced in?
It seems that investors are pricing in a second half recovery and an industry getting back to a similar pace that it had over a year ago. We think this is essentially priced for perfection as its hard to have a lot of upside from those assumptions and there is certainly more downside risk of a slower or lower recovery or both.

The view from the trenches
People in the industry we speak to seem incredulous at the stock prices but are obviously more than willing to accept the benefit. Very simply, business is not as good as the stocks would imply and we would challenge someone to suggest their business has improved as much as their stock has.

Has the China risk gone away?
Also absent in stock valuation in the semiconductor group is discount related to trade issues and potential issues. The March deadline for tariffs set by the white house has come and gone and it doesn’t sound like we have significant confidence of a solid deal. China trade seems to have gone the way of Korean de-nuclearization talks….lots of initial bluster and promises followed by deafening silence.

Maybe this is a good thing for the stocks as ignoring the issue may make it go away…at least as far as stock impact is concerned.

The stocks – Time to take money off the table?
From a high level perspective we find it harder to paint an upside scenario to the stocks from here as opposed to potential downside scenarios. We think the downside beta is higher than upside beta. If we were to take some money off the table in some of the chip stocks that have been on a tear since the beginning of the year we think its a reasonable strategy to lock in some of those short term gains we have gotten.

If we had a more aggressive attitude there are likely some of the stocks that could be shorted here.

Our negative bias is more on memory related companies as that part of the chip market is not getting better any time soon and investors may lose patience here first. Logic and foundry, while not great are in better shape and likely are less oversupplied and have more new drivers.

No matter what, this earnings season is critical given the rapid rise we have seen in the stocks in Q1 and we are at a crossroads that will see volatility.

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