Excess Chip Inventories Could Spell Trouble for the SOX

Witawat (Ed) Wijaranakula, Ph.D.
Mon Aug 17, 2015

The PHLX Semiconductor Sector index (SOX), a modified capitalization-weighted index composed of semiconductor companies, slid 0.6% to close at 631.04 on Friday after Applied Materials [NASDAQ:AMAT] announced its fiscal third quarter revenues below Wall Street expectations and forecast this quarter below consensus as well. Shares of Applied Materials, a SOX constituent, traded as low as $16.24 a share, down 4.75%, after the report. 

In the third quarter of fiscal 2015, Applied Materials said its revenues came in at $2.49 billion, up 10% year-on-year, missing the consensus estimate of $2.54 billion as sales in the U.S., Europe and China sagged. The company reported adjusted non-GAAP earnings of $0.33 per diluted share, up 18% year-on-year, in line with the consensus estimate.

For the fourth quarter of fiscal 2015, Applied expects net sales to be in the range of flat to down 7% from the previous quarter, and non-GAAP adjusted diluted EPS is expected to be in the range of $0.27 to $0.31. The midpoint of revenue guidance is below the consensus estimates of $2.43 billion, while the adjusted EPS range is in line with analysts’ estimates of $0.29. 

The company said that major chip foundries are focusing more on the bleeding edge, such as 10-nanometer technology, while taking a pause in capacity additions as their foundry customers are worried about excess chip inventories.

The SOX index is down over 8% year-to-date, underperforming the NASDAQ composite's 6.6% gain for the year. Most of the gains in the SOX index earlier this year came from the speculative thesis, “Who’s next in a tech merger?”, after the announcements that Intel [NASDAQ:INTC] was buying Altera [NASDAQ:ALTR], and that Avago technologies [NASDAQ:AVGO] will acquire Broadcom [NASDAQ:BRCM]. 

The chip sector itself is fundamentally shaky, as Philly SOX bellwethers, including Intel, Taiwan Semiconductor Manufacturing Co. [NYSE:TSM] and Qualcomm [NASDAQ:QCOM] either cut their outlooks or gave guidance below Wall Street estimates. China’s slowdown and yuan devaluation could spell trouble for the semiconductor sector as it has already seen a decline in demand, leading to higher inventories and lower revenues. 

Bill Fleckenstein, the president of Fleckenstein Capital, told CNBC earlier this month, "I'm short semiconductor stocks because there is an inventory correction at a minimum, and there might be saturation,".

From our technical viewpoint, the SOX has been moving in a bearish ascending wedge chart pattern since July-August of last year. The index broke down the trendline support of the ascending wedge in late June and has pulled back about 16% from the all-time high at 751.21. The death cross, where the 200-day SMA breaks above the 50-day SMA, has now emerged. Hence, there is a major downside risk for the index, to the 545 and 540 levels, if the trendline support of the descending wedge can’t hold. 

Disclosure: No position in AMAT or any other stocks mentioned.

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