Soaring inventories at U.S. chip companies are likely to worsen as the U.S.-China trade war casts a shadow over the future of the once red-hot industry and threatens the broader U.S. stock market, according to a recent Morgan Stanley report entitled "Micro Meets Macro: Underweight Technology and Cautious on Semis." The Wall Street firm is negative on semiconductor stocks, arguing that the Street’s estimates remain too high.
Headwinds Facing Chip Stocks
- Trade tensions not discounted by the U.S. equity market
- Semiconductor industry viewed as a proxy for global growth and is “tightly wrapped into the debate on tariffs”
- Weak end demand in nearly every semiconductor end market
- Earnings recession already upon us
- Weaker tech capital spending outlook
- Near record inventory levels at some companies weighing on margins
Source: Morgan Stanley
Risks Are Not Reflected in Equity Prices
"We stress that our bigger picture strategy view is largely aligned with our semiconductor view. Even looking through the 3rd round of tariffs, the overall macro picture is not the type of environment that will lead to a re-acceleration of semiconductor shipments in the second half," says Morgan Stanley. Analysts add that a pickup in shipments in the latter part of the year has already been priced into stocks.
Additionally, while U.S. stocks have fallen about 5% in recent days in light of macro-trade uncertainty and escalating trade tensions between two economic powerhouses, analysts do not view the heightened risk as fully reflected in the U.S. equity market. Morgan Stanley says tensions could exacerbate an already weak earnings outlook, foreseeing EPS growth to decline to 0% in 2019 from 21% in 2018.
Semi Revenues Slated to Fall 4.4%
The semiconductor space is “viewed as a proxy for global growth” and is “tightly wrapped into the debate on tariffs,” noted Morgan Stanley. If a 25% tax is imposed on all of China’s exports, likely sparking retaliatory measures by Beijing, this could have major ramifications on supply chains and inventory levels for chip stocks already struggling with waning demand.
"We continue to see very high inventories on semiconductor balance sheets and in the channel, weak end demand in nearly every semiconductor end market, a once-in-a-generation magnitude of memory oversupply, and capital spending that hasn't adjusted enough to feel comfortable with all of that,” wrote Morgan Stanley.
Analysts recommend that investors reduce their positions in semiconductors, citing an “earnings recession that is already upon us.” Meanwhile, the median days of inventory for semi companies has increased 18% YOY to 114 in the first quarter, compared to the long term median of 88. Some firms are struggling at median days of inventory between 120 and 150, and at or near peak levels, they added. With no near-term reversal in sight, analysts expect excess inventory to continue to depress growth and weigh on margins.
For the overall chip sector, Morgan Stanley is modeling for gross margin and operating margin to fall 30 bps and 120 bps YOY respectively on a 4.4% decline in revenue.
Companies slated to see revenues fall further include Cypress Semiconductor Corp. (CY), Western Digital Corp. (WDC), Skyworks Solutions Inc. (SWKS), Nvidia Corp. (NVDA), and Micron Technology Inc. (MU).
Despite an overall bearish outlook, analysts at Morgan Stanley note that things could turn more positive for semis if certain scenarios play out. First, if demand comes in above expectations, inventory levels would decrease and support the “snapback narrative” of a second half of the year recovery.
“Other items which could tilt the favor toward the bull camp include meaningful progress on U.S.-China trade, muted inflation, dovish Fed policy and wage growth deceleration,” read the report.
Moving ahead into 2020, Morgan Stanley expects gross and operating margin for semis to rebound by 50 bps and 150 bps respectively on a 6.6% increase in revenue.