What next for IC markets?

Short-term outlook: all bad
Long term outlook: still bright

This has been a difficult year for IC manufacturers and their suppliers. After setting records in 2000, equipment and IC sales fell fast and hard, threatening to make 2001 one of the worst years in history. After several months of pessimistic news, the semiconductor equipment book-to-bill ratio has begun to rise, but only because equipment shipments are still falling while orders remain flat. DRAM prices have been sliding all year. The telecommunications sector is still struggling under painfully high debt loads and inventory levels.

And that was before hijackers flew two planes into New York's World Trade Center on September 11. The attack closed financial markets for a week, inspired wholesale cancellations of airline reservations, and sparked expectations of lengthy military action in the Middle East and Central Asia. In the immediate aftermath, the Dow Jones Industrial Average fell 14.26%, suffering its worst week since the Great Depression. The broader S&P 500 and NASDAQ indexes were down 11.6% and 16.1%, respectively. Airlines announced layoffs of nearly 100,000 employees. Semiconductor equipment bellweather Applied Materials announced it would layoff 2,000 employees, accounting for 10% of its global workforce.

Short-term outlook: all bad

At SEMI's New England Breakfast Forum (Burlington, MA) last Wednesday, industry analysts struggled--and mostly failed--to find signs of positive near-term economic performance. Ali Irani, from CIBC World Markets, noted that redundant computer systems and offsite storage are likely to surge in the coming months as companies guard against both terrorism and more mundane disasters. Fred Wolf, from Adams, Harkness, and Hill, suggested that cellular phone sales are likely to jump as consumers try to make sure they can stay in touch in emergencies.

Still, none of the panelists expected these bright spots to offset the macroeconomic impact of the hijackings. Beyond the airlines themselves, reduced travel will affect many more jobs throughout the economy. Consumer spending, already anemic, is likely to stall. Until the details of the US response are known, both consumers and investors are likely to hold their collective breath.

Byron Walker, of UBS Warburg Equity Research, noted that Treasury bills, one of the most conservative of all investments, jumped sharply as investors ran for safe havens. An unprecendented surge of liquidity from the Federal Reserve Bank and its global counterparts failed to stem the negative tide.

If there is any good news, it is, as Irani explained, that demand shocks and business disruptions tend to be short-lived. While business results for the third quarter are likely to be disastrous, the third quarter may also represent a trough point for the current business cycle. No one expects record breaking holiday sales, but Irani expects that holiday sales will help the fourth quarter deliver at least a mild uptick. Economic conditions are likely to remain weak at least through the first half of next year, depending on geopolitical events. If investors have now resigned themselves to the likelihood of recession, they may be more willing to take a longer term view, Irani said. Companies with poor short term results are less likely to disappoint investors who are already prepared for bad news.

Wolf agreed that short term bad news is now expected. Investors are likely to begin looking for stocks with low valuations that offer the potential for long term gains.

Still, as Theodore O'Neill of C.E. Unterberg Towbin pointed out, valuations of semiconductor equipment stocks are still historically high. At the last cycle bottom, in 1998, Applied Materials traded at double its book value. That metric would give a stock price of $26 now. Applied Materials closed at $33.12 on Tuesday, the day before O'Neill's presentation, and at $29.24 on Friday. O'Neill also noted that chip volume fell 10% during the Persian Gulf War in 1990-91. If the hijackings and the US response have a similar impact, O'Neill expects 2002 will be another down year for chips.

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Long term outlook: still bright

For the longer term, the forum participants agreed that the outlook for integrated circuits remains bright. As Walker pointed out, Moore's Law continues to increase functionality per dollar. Falling costs drive demand for existing applications and make new applications possible.

Irani observed that US per capita consumption of chips topped $200 in 2000, compared with only $38 in the rest of the world. Increasing global penetration of integrated circuits offers substantial growth opportunities. Developing economies tend to spend a disproportionate share of disposable income on electronics, Walker said. Computers and communications give individuals and communities substantial leverage for a relatively small investment. Just one PC and one cell phone can transform a rural village into a global exporter, for example.

Inventory overhang has smothered IC markets all year, Wolf said. This "slack" in the supply chain makes it difficult to measure true demand. As the year wears on, more and more inventory--of both chips and capacity--will become obsolete. Walker expects companies to absorb substantial writeoffs to clear their balance sheets at the end of the year. Irani agreed, noting that a long slow recovery will make chip makers more willing to delay new capacity purchases and retire old capacity. He believes the breakeven point for DRAM manufacturing is now the 0.15 micron technology node. A slow recovery makes it likely that older technology will never be profitable again, so there's no reason for companies to continue to maintain older fabs.

On the other hand, new technology is expensive. Many IC makers can't afford major investments. Consolidation and increasing reliance on joint ventures are likely. Irani expects consolidation in the equipment market as well. Larger companies with broad product lines have insurance against weaknesses in any one product line. Larger companies are also more able to support a global infrastructure.

Walker concluded by warning that timing the semiconductor and equipment cycle is risky. While the long term prospects are bright, it's too soon to identify a bottom. Wolf suggested that the most serious risk for investors is that people will get tired of waiting for the next upcycle and will abandon the sector entirely. As long as people believe an upturn is coming, stocks should continue to hold much of their value. Semiconductor and equipment suppliers have seen cyclical downturns before, and know how to manage them.