Chipmakers face a harsh reality after optimism-fueled rally

The latest data from the Semiconductor Industry Association showed total semiconductor sales sank almost 18% in April, while Broadcom cut its full-year sales forecast.

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Semiconductor stocks have climbed in the first half of 2019, as Wall Street looked past last year's harsh fourth quarter and bet that the group would see a rebound in key metrics in the second half of this year.

With the back half of 2019 about to arrive, the optimism that investors had about the group's demand, pricing and inventory levels seems to have almost completely reversed. Industry sales have been tepid, the U.S.-China trade war continues to be an overhang to growth and a source of uncertainty, and tepid outlooks -- including from ON Semiconductor Corp., Texas Instruments Inc., Microchip Technology Inc. and Intel Corp., among others -- have eroded hopes for a recovery.

But even with that more cautious backdrop, the Philadelphia Semiconductor Index has risen more than 25% thus far in 2019, and it remains close to record levels hit in April.

"Chipmaker valuations don't reconcile with the worst-case scenario for 2019 EPS growth," wrote Anand Srinivasan, an analyst at Bloomberg Intelligence. He sees growth prospects "dwindling" for the remainder of 2019 and calculated a drop of 8% in global chipmaker earnings this year.

"Amid macroeconomic weakness and trade disputes," he added, "organic sales growth may be pushed to 2020."

The sector has been extremely volatile as it grapples with an uncertain outlook for both demand and trade, an issue that chipmakers are highly correlated to given that China is both a major market and a key part of their supply chains. The benchmark chip index tumbled nearly 17% over May, its biggest one-month drop since November 2008, but it is up almost 13% in June, its best month since October 2011.

June's rally occurred despite multiple red flags for the sector. The latest data from the Semiconductor Industry Association showed total semiconductor sales sank almost 18% in April, while Broadcom cut its full-year sales forecast in a report so cautious Morgan Stanley wrote that it should squelch expectations for an industry "snapback" in the second half of the year. Micron Technology rallied in the wake of its results earlier this week, but it also gave a forecast that was below expectations, and said it would "meaningfully" reduce its spending in the 2020 fiscal year in order to align increases in supply with demand levels.

The inventory issue is so acute that analysts saw a silver lining in Western Digital's announcement this week of disrupted production at a memory chip plant, speculating it would accelerate balance in the supply and demand levels.

"Capex cuts make us skeptical that the cycle has turned. When we look at shipments and inventories, there are still reasons to be on the sidelines," said Hugo Rogers, head of investments at Deltec International Group, who said in a phone interview that the year-to-date rally in the stocks is "excessive."

"We understand why investors want to call a turn in the cycle, but it won't pay to pick up chipmakers at these prices. We may not see a bottom in inventories until 2020, and think earnings are going to be disappointing for the next couple of quarters."