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Semiconductor Industry Rattled by Trade War Fears

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The semiconductor industry is the most dependent on China, both on the production and especially on the sales side because of the rapid pace of technological progress in the country. China today imports 29% of its semiconductors from overseas suppliers (a large percentage of which are American) and the government has the stated goal of reducing that dependence in the near future. It has a comprehensive plan (5-year plans, actually) in place to gradually produce more chips within the country, for which it has devoted considerable resources.

In fact, there is concern among chip makers that the Chinese will produce in the not-too-distant future enough to create an oversupply situation that will lower prices across the industry.

Semiconductors are a focus area for both the Chinese government and the Trump administration, so neither government is going to give up without a fight. As things stand now, this all-important segment has been left out of the trade war. But the consideration may not continue because late last month, the Chinese government lowered taxes for companies manufacturing their semiconductors in China. This could mean that the government is preparing for a showdown that also involves semiconductors.

On the positive side, China still needs the ton of semiconductors it imports because the gap between production and consumption still exists, and without which its growth could slow down. But since the writing is on the wall, U.S. companies need to prepare for the eventuality.

U.S. Government Investigation

The government for its part, has directed the U.S. Trade Representative (USTR) to investigate China’s IP practices to determine whether its acts, policies, and practices (APPs), especially with respect to compulsory technology transfer that China has for long demanded and received, IP and innovation are actionable under Section 301(b)(1) of the Trade Act of 1974. This section allows it the right to take unilateral action against foreign trade practices that are unjustified or unreasonable.

The USTR is also investigating whether any actions of the Chinese with respect to the above are actionable under WTO rules. While it’s hard to appreciate how a coalition of the most powerful nations in the world can somehow push one of its members into agreements against its own interests, the government has been complaining about unfair treatment by the Chinese. It definitely looks like the U.S. took a gamble on China, not expecting it to be smart enough to turn things around so quickly, and now it’s bemoaning the miscalculation. Technology transfer, no matter how bad it hurts, is after all a standard part of these deals, and IP theft is only part of the story.

The USTR report is due by August this year.

Disruption in the Tech Supply Chain

Tech’s dilemma is apparent from the attitude of Josh Kallmer of the Information Technology Industry Council, which represents the who’s who of the sector, including companies like Apple, Google, IBM and Oracle: "We strongly support the administration doing an investigation of Chinese tech policies and practices," adding that tariffs and other penalties are a bad idea.

Similar was the stand taken by John Neuffer, CEO of the Semiconductor Industry Association (SIA): “The U.S. semiconductor industry shares the Trump Administration’s concerns regarding unfair and discriminatory trade practices that put at risk American intellectual property in China," followed by, “We welcome the opportunity to provide input on proposed tariffs, and hope to work with the Administration to avoid tariffs that would harm competitive U.S. industries and their consumers."

Because of the technology supply chain being what it is, the trade war pulls Japan, South Korea and Taiwan (also Hong Kong) into its midst. All these countries are major component suppliers of products manufactured in China for export to the U.S. That includes electronic goods sold by U.S. companies after assembly in China. (The U.S. recently came to an agreement in principle on amendments and modifications to its Free Trade Agreement with South Korea; it reportedly made some concessions in NAFTA negotiations with Mexico and Canada, as well.)

While China was earlier considered a cheap manufacturing location, Apple’s Tim Cook recently said that this was no longer the case. "There's a confusion about China," he said. "The popular conception is that companies come to China because of low labor costs. I'm not sure what part of China they go to, but the truth is China stopped being the low labor cost country years ago. That is not the reason to come to China from a supply point of view, the reason is because of the skill."

So it’s very difficult, if not impossible to pull China out of the equation at this point -- not any time soon, anyway.

End Markets Affected

Most chips are still used in computing and consumer markets, where China plays a big role. While a lot of TVs are currently coming from Mexico, these are generally higher-end. China still supplies the largest volumes. The government has taken measures to make it more difficult for Chinese companies in the communications space. But if Huawei is penalized in the U.S., there’s good reason to believe that Cisco will be hit in China.

Semiconductor Companies with China Exposure

The following table shows semiconductor companies with significant exposure to China. As may be expected, the increased uncertainty is telling on their share prices-

How to Play the Sector

Despite the jitters, this may just be the right time to invest in semiconductor stocks with good potential because post sell-off, the prices are increasingly attractive. So it’s a good time to get back to basics with a quick look at the earnings trends-

From the latest earnings trends report, we see that the broader technology sector, of which semiconductors are a part, has posted 20.7% earnings growth on revenues that grew 15.9%. This compares with earnings growth of 24.2% and revenue growth of 11.1% in the fourth quarter. Both growth rates were better than the S&P 500.Total 2017 earnings for the sector were up +15.8% and 2018 earnings are expected to be up +17.3%.

In the Zacks universe, the semiconductor industry is made up of 15 sub-sectors (including 4 for semiconductor equipment) organized under the Technology sector, which is one of the 16 broad Zacks-categorized sectors.

Similar to the Technology sector, Zacks also breaks down each of the other sectors into groups such that there are a total of 265 sub-sectors or industries. These “X” industries are then grouped in two: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (Click here to know more: About Zacks Industry Rank)

Therefore the Zacks Industry Rank is a good indicator of investment opportunities within an industry at any given time. Moreover, because stocks in the same X industry have certain common positive or negative factors affecting them, it has been observed that there is some positive correlation between them. 

The X industries pertaining to semiconductor stocks have been tabulated below. The list clearly displays the kind of industries likely to have more winners. The last column enlists our picks, which are basically Zacks Rank #1 (Strong Buy) or Rank #2 (Buy) stocks within these industries.

Definition

The Semiconductor Industry serves as a driver, enabler and indicator of technological progress. Developments in the industry determine the way we work, transport ourselves, communicate, entertain ourselves, defend ourselves and respond to our environment.

The emergence of categories like health monitoring devices and home automation gadgets, and the increased automation on factory floors, automobiles and elsewhere have added a new dimension to the industry. Environmental concerns and the need for judicious use of resources have also opened up opportunities in the form of chips reducing power consumption, reducing heat dissipation, capturing solar energy, creating more efficient lighting solutions and so forth.

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