Semiconductor inventories: Two takes on the industry and both seem happy

(August 26, 2010) – Chip suppliers are reporting rising inventory, but the swelling stockpiles do not represent a cause for concern at present, with demand on the rise in coming months, according to iSuppli Corp. Inventory levels are now more appropriately aligned with end-market demand, which was necessary given the level of under-shipment across many end-markets since 2HCY09, adds Doug Freedman, Gleacher & Company.

Other coverage of semiconductor inventories.

 

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The builds most bears were looking for transpired in Q2, and a likely flattening of these levels through H2 could cause consensus CY11 EPS estimates to rise as “overshoot” models correct to the upside, says Freedman. 

Freedman continues to believe that current near-trough valuations are not based on sell-side consensus estimates, but rather reflect more ubiquitous bearish buy-side sentiment, which expects a more material inventory correction. In his view, CY11 estimates remain underestimated (including for those names with PC exposure), as imminent sub-seasonal quarters won’t be as draconian as bears are modeling.

Midway through the Q2 reporting period, total chip inventory among the approximately 35 semiconductor component manufacturers tracked by iSuppli climbed to $9.6 billion, up a strong 9% from $8.9 billion in the first quarter — faster than the seasonal average of 3.2%. Post-CYQ2 earnings, Freedman provides an updated snapshot of inventory throughout the electronics supply chain (75+ total companies including up-, mid-, and downstream).

Average days of inventory (DOI) grew, increasing by about four days during the period to 73.2 days, up 6% from 69.3 days — a rate slower than the historical DOI seasonal increase of 9.6%, or 6 days, said iSuppli. Gleacher’s analysis of CYQ2 inventories illustrates that total supply chain inventory days increased 10% Q/Q to 39.1 days (vs. the 5-year seasonal average of +3%). In large part, the elevated levels were most evident across downstream retailers (BBY, ODP) and distributors (IM, TECD), where days are at 5-year seasonal peak levels, reflecting softer end-demand. EMS and PCB (FLEX, PLXS) segments are also at peak seasonal levels. Lastly, while Storage/HDD was up materially (up 6 days to 37.6), MRVL’s recent commentary on inventory correction leaves us bullish looking ahead, said Freedman.

Meanwhile, upstream inventories (61.2 days, only 2% above 5-year seasonal trough) continue to run lean as component distributors, analog semis, discretes and passives/connectors are at seasonal trough levels. However, computing OEMs days are likely better than feared.

All told, the numbers underline a common theme for the semiconductor industry in the second quarter of record revenues, profits and gross margins. Such indicators, along with positive revenue guidance for the third quarter, are providing managers with the confidence needed to increase inventories for the second half of the year, says iSuppli’s analysis. Q2 inventory data across the electronics supply chain illustrates that supply is appropriately catching demand, agrees Gleacher’s report.

The figure shows iSuppli’s forecast of semiconductor inventory value — both in dollar terms and in DOI — starting from the first quarter of 2008 up to the second quarter of 2010.

Global semiconductor inventory value held by chip suppliers (days of inventory (DOI) and millions of US dollars)*
  Q1’08 Q2’08 Q3’08 Q4’08 Q1’09  Q2’09  Q3’09  Q4’09  Q1’10  Q2’10
Average number of days 77.7 79.3 76.2 86.4 78.2 68.1 62.4 67.0 69.3 73.2
% change sequentially   2% -4% 13%  -9% -13% -8% 7% 3% 6%
                     
Inventory value 10,292  10,504  10,759  10,683  8,847 8,145  7,944  8,577  8,864  9,638
% change sequentially    2%  2%  -1% -17%  -8%  -2%  8%  3% 9%

“Across the semiconductor market, management comments in earnings announcements have been extremely positive, citing strong results in various end applications and geographies,” said Sharon Stiefel semiconductor manufacturing researcher for iSuppli. “The solid second-quarter results — based on higher-than-usual seasonal revenues, favorable Average Selling Prices (ASP) and innovative new products — are allowing companies to finally relax their vice grip on inventories.”

INTC, AMD, ADI, LLTC and OVTI: Gleacher

Intel (INTC, $18.41, Buy, PT $30): We feel valuations remain favorable as multiples (corresponding to a conservative $2+ in earnings, in our opinion) remain overly compressed. We continue to favor large-cap INTC for the earnings leverage from favorable ASP mix-shift, server growth, and its lower capital intensity model as 300mm tools are re-used, driving significant manufacturing efficiencies.

Advanced Micro Devices (AMD, $5.99, Buy, PT $16): Our thesis continues to be driven by: 1) likely share gains in notebook, server and GPU (lackluster Fermi launch) through CY10; 2) improving distribution and increasing OEM/ODM partnerships; 3) upcoming leverage, via mix-shift, in CY11 from Fusion, Bobcat and Bulldozer; and 4) Manufacturing (GF). Most importantly, we note that CY11 leverage is likely underestimated as we model 9% of revenue growth to yield 72% of earnings growth.

Analog Devices (ADI, $29.32, Buy, $42 PT): ADI offers investors a rare mix of: 1) robust growth (+8-12% target CAGR, supported by compelling products servicing high-dollar markets); 2) dividends (~3% yield); 3) buy-backs (roughly $90mil remaining); and 4) a solid balance sheet cash (as $8.22 net cash/share could be used for ongoing buy-backs or acquisitions). We believe ADI has runway on further revenue growth with content increases and stable ASPs, while consistent execution (operating expense controls, short lead times, and downside risk protection) makes it one of our favorite analog picks given higher economic uncertainty.

Linear Technology (LLTC, $29.32, Buy, $40 PT): Value proposition remains compelling driven by: 1) consistent and near flawless execution; 2) a VERY sound operating model (gross and operating margins); and 3) share gains through continuous shipments into under-shipped high-dollar end-markets despite extended lead-times towards 8-10 weeks (though below most competitors). Leverage in the model should be driven by: 1) ongoing mix-shift focus towards Industrial and Communications (driving ASPs and units), as channel inventories remain lean and under-served, 2) improvements in the cost structure, and 3) capitalization of share gain opportunities.

OmniVision Technologies (OVTI, $20.67, Buy, $27 PT): In our view, the next leg up for OVTI’s share price is when margins exhibit a material uptick (nearing or crossing 30%), which will likely transpire once volume ramps at high-MP BSI sensors and helps yield improvement (likely in the October quarter). We remain constructive as we believe longer-term earnings leverage (FY12) is underestimated. We note our $1.80 estimate in FY12 largely reflects increasing ASP trends (we model +18% in FY11 and +16% in FY12 Y/Y), improving yields, underestimated TAM (units) and technological leadership.

Considering the onslaught of negative data points surrounding PC builds, Gleacher is particularly encouraged to see only modest builds at the computing OEMs (HPQ, AAPL, IBM, DELL). While inventory days increased 14% Q/Q to 19.5 days, we recognize this is off a low-base impacted by supply constraints, as current levels are 7% below the 5-year seasonal average. In our view, this is all the more important given heightened (and we believe misguided) fear of stocking on increasing sea shipments.

Given the quick rise in demand, semiconductor suppliers are finding it difficult to restock to pre-recessionary levels. Products being shipped are intended to meet current orders, iSuppli has determined, and not meant for placement into inventory.

As a result, the current backlog is driving many semiconductor suppliers to increase capacity, although conservative capital spending appears to be the norm. Instead of committing to long-term capital investments for new facilities, suppliers often are investing cautiously in equipment to relieve constriction points in production. The exceptions to the rule are the large corporations — entities such as Intel Corp. and Samsung Electronics Co. Ltd. — with enough cash to invest, the economic downturn notwithstanding.

Recent stock market price compression could be a result of a liquidity squeeze. There is a lack of incremental income to buy stocks as "newer" allocation has placed greater emphasis on cash. Recent stress on valuations could be nothing more than a change in asset allocation, says Freedman.

Semiconductors remain undervalued trading at 10.7x in CY11 (vs. S&P at 11.6x) given operating expense flexibility across most models, strong product cycles (touch, back-light application, server supported applications, virtualization, and computing mobility), and improving ASP trends (helped in part by integration). Investors are reluctant to overpay for semis. In fact, the SOX index is no longer used as a forward indicator to future earnings power. Currently, we are at a peak NTM EPS average ($1.53) between the selected companies, while the SOX index is trading towards the low-end of its 8-year range.

Overall, however, the increase in inventory reflects a justifiable build, and iSuppli is not concerned over an inventory bubble. Expect no material changes from here in CYQ3, and Q3 builds to be only moderate, says Freedman. And with the market now less volatile, semiconductor companies gradually will be returning to more normal operating conditions and inventory levels over the next few quarters, iSuppli believes.

Backwards looking Q2 inventory days growth was substantial (driven mostly by the downstream); however, Gleacher believes builds will likely stabilize from here, as the imminent sub-seasonal quarters ahead are not as bad as most suspect (largely reflecting caution on the macro). Consequently, better than feared results (possibly even including mild estimate cuts) could lift compressed multiples. CY11 estimates, which allow for sub-seasonal quarters in the 4Q10-2Q11 timeframe, remain highly achievable across Gleacher’s semi companies. The majority of Gleacher models account for an overshoot scenario, as they model sub-seasonal quarters beginning in CYQ4. Declines through CY1Q11 are even steeper than consensus (Gleacher at -8% vs. Street at -5.8%).

Learn more about the current state of chip inventory with Stiefel’s latest Inventory Insider, entitled: Inventories Are Rising but Do Not Raise an Alarm Yet, http://www.isuppli.com/Pages/Market-Research-Search-News.aspx

Upcoming Sandy Bridge and Fusion should alleviate concerns through sub-seasonal quarters. In Gleacher’s view, the softness (sub-seasonal) in PC builds (builds at +7% in Q3 vs. 3-year average of +20%) is the "calm before the storm" ahead of compelling CPU+GPU offerings from INTC (Sandy Bridge, Q4) and AMD (Fusion, Q1). Additionally, the sub-seasonal nature through Q4 will result in leaner inventories across downstream retailers, as favorable reviews for Sandy Bridge and Fusion alike will help drive a replenishment cycle. For CY11, catalysts for AMD/INTC remain CPU+GPU integration and enterprise client refresh. Current AMD/INTC CY11 estimates will prove to be safe, as bearish sentiment is simply overdone.

Follow Solid State Technology on Twitter.com via editors Pete Singer, twitter.com/PetesTweetsPW and Debra Vogler, twitter.com/dvogler_PV_semi. Or join our Facebook group

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