Why Chip Stocks' 17% May Selloff Will Only Get Steeper

Stock investors stunned by the drastic decline in price of major chip stocks such as Intel Corp. (INTC), Texas Instruments Inc. (TXN) and Micron Technology Inc. (MU) in May, due to heightened trade war fears, had better get their crash helmets on. Even if trade conflicts ease, chip stock are likely to fall further as memory prices plunge, according to several Street bears, as outlined in a detailed Barron’s report.

Semiconductors Face Headwinds

  • iShares PHLX Semiconductor ETF dips 17% in May
  • Demand conditions deteriorating in nearly every important end market
  • Guidance reduced for major chip makers like Nvidia, Texas Instruments, for second half
  • High inventories on semiconductor balance sheets
  • Memory chip prices in free fall
  • Downside from Trump administration war against Huawei not priced into stocks

Source: Barron’s

The iShares PHLX Semiconductor exchange-traded fund (SOXX) jumped an impressive 35% in the first four months of 2019, outpacing the broader S&P 500’s recovery after a dismal Q4, which closed out the market’s worst year in about a decade. The rally was driven in large part by optimism regarding a revival in chip demand, as well as confidence in a U.S.-China trade resolution.

Now, however, both of those hopes look short-lived as data points to weaker than expected demand for semis and the Trump administration ups its rhetoric on trade wars with China and now other global players like Mexico.

Chip Expectations Go Lower

Headwinds in the chip space and broader market turbulence led the iShares PHLX Semiconductor ETF to drop approximately 17% in May, with many major players posting declines over 20%. By comparison the S&P 500 was down roughly 7% over the same period.

While this may look like an overreaction, some bears, including Bernstein's Stacy Rasgon, think that the dip is justified and better reflects expectations for chip makers. He argues that management’s guidance offered at the start of 2019 was overly optimistic for many chip companies.

“Anytime I hear companies talking about big back-half ramps, I get nervous. In practice they have no visibility on what actual customer end demand is really doing,” said the Bernstein analyst. “There were some expectations for the second half that were built into the industry coming out of January earnings that we felt were overly ambitious. That has become apparent.”

Deteriorating Demand

As companies lower expectations for the second half of the year, demand conditions in nearly every important end market, such as cloud computing, enterprises, and China, offered disappointing commentary in the last round of earnings, per Barron’s.

Last month, Nvidia Corp. (NVDA) slashed its full year guidance, citing low visibility in the data center market. The announcement, which dragged down shares in the double digits, followed disappointing guidance from Intel and a warning from Texas Instruments on “choppy” demand in the communication infrastructure space back in April.

Falling Memory Prices

As lower chip demand in important end markets spooks investors, falling prices also threatens to eat into revenues. Memory chips, a key component in tech products across every end market and geography, have been in free fall.

The price of a benchmark eight-gigabyte memory module fell a whopping 40% through mid-May, according to Nomura Instinet. In June, industry research firm TrendForce said it was forecasting continued declines for semiconductor players this month, thanks to rising inventory levels at major suppliers.

Meanwhile, big data center clients like Microsoft Corp. (MSFT), Alphabet Inc. (GOOGL) and Facebook Inc. (FB), all reported capital expenditures below expectations in the first quarter.

“Cloud guys are not necessarily going to come back and rebuild inventories,” said Susquehanna Financial Group’s chip analyst Mehdi Hosseini. “They are going to be systematic.”

All of these negative forces could significantly drag down chip makers, regardless of how the trade war materializes.

“We continue to see very high inventories on semiconductor balance sheets and in the channel, weak end demand in nearly every semiconductor end market, [and] a once-in-a-generation magnitude of memo,” explained Morgan Stanley analyst Joseph Moore.

Looking Ahead

While chip makers have suffered in the recent month, the sector actually remains up from October lows as fundamentals have deteriorated and trade wars have intensified.

“Investors need to be patient and be able to have more visibility before we can consider the recent pullback as a buying opportunity,” said Hosseini, adding that the Trump administration’s war against Huawei Technologies poses another big risk to chip makers, and is not yet fully reflected in prices.

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