Time to Start Worrying About Chip Stocks?

All good things eventually come to an end. Summers, baseball seasons, James Bond TV marathons ... and semiconductor booms as well. And while the semiconductor boom that's sent many chip stocks off to the races over the last year isn't over just yet, I think we're now getting some clear signs that we're much closer to the end than we are to the beginning.

At first glance, this might seem a strange time to predict a downturn for the semiconductor industry. After all, chip companies just delivered a stellar round of earnings reports in July: Sales and earnings generally beat consensus estimates, while healthy short-term guidance led analysts to boost their forward estimates for chip giants such as Intel (Nasdaq: INTC  ) , Texas Instruments (NYSE: TXN  ) , Broadcom (Nasdaq: BRCM  ) , and SanDisk (Nasdaq: SNDK  ) , as well as many smaller names. But taking a closer look at both industry and company-specific data turns up some clear warning signs, such as the following:

Chip sales have been looking a little too good.
The Semiconductor Industry Association (SIA) reported earlier this month that global semiconductor sales were up over 50% annually during the first six months of the year, to $144.6 billion – a figure that's backed up by the scorching revenue growth reported by the likes of Broadcom and SanDisk. While it's normal for chip companies to see their revenues outpace those of their customers during a boom cycle, as prices firm and customers rebuild inventories, a revenue difference on that scale for such an extended period of time suggests that sales have gotten overheated, and are due for a contraction.

Accounts receivable are rising.
Another sign that sales growth has gotten out of hand is when a company's accounts receivable, which shows the amount of money owed to the company by its customers for products and services that they've been billed for, starts growing. In the case of the semiconductor industry, growing accounts receivable is often a sign that customers have been buying more chips than they need, and are at risk of returning shipments and/or pushing out future orders. Here's a look at how some major chipmakers saw their net receivables rise in the second quarter:

Company

Q1 Net Receivables (Millions)

Q2 Net Receivables (Millions)

Sequential Growth

Broadcom

$607.2

$688.2

13.34%

Linear Technology (Nasdaq: LLTC  )

$161.5

$184.2

14.06%

Maxim Integrated Products

$470.4

$560.2

19.09%

Sandisk

$278.1

$440.6

58.6%

Texas Instruments

$2,082.0

$2,281.0

9.6%

Xilinx (Nasdaq: XLNX  )

$363.9

$457.5

25.7%

Source: Yahoo Finance. Net receivables is both accounts receivable and deferred tax assets.

The fact that this surge in receivables is happening at a time when many chip buyers have been struggling with component shortages and soaring lead times for needed chips is an additional warning sign. It's been a common practice over the years for chip buyers to respond to conditions like those by ordering more product than they need, just to play it safe. And this usually leads to chipmakers feeling a major case of heartburn once the component shortages evaporate and lead times fall, leading their customers to pare back orders.

Capital spending has been soaring.
Chip manufacturers have responded to growing demand by ramping their capital spending on manufacturing equipment from the likes of Applied Materials (Nasdaq: AMAT  ) and KLA-Tencor. Industry trade group Semiconductor Equipment and Materials International (SEMI) is now expecting chip equipment sales to grow by a jaw-dropping 104% in 2010. As with chipmakers, it had to be expected that 2010 would be a good year for chip equipment manufacturers, considering how bad much of 2009 was. But the parabolic growth being reported by the industry suggests that chip manufacturers have gotten ahead of themselves when it comes to adding capacity, and that all this excess capacity will come to bite the industry in the form of oversupply and dropping prices.

Memory prices are beginning to weaken.
No part of the semiconductor industry has fared as well during the boom as memory manufacturers. Following a brutal market crash in 2007 and 2008, demand for DRAM and flash memory chips began rebounding last year, and the good times have kept rolling in 2010. The SIA reported that memory sales were up 82% in June, propped up by an unusually strong pricing environment. But now we're getting the first signs of softening DRAM and flash contract prices, thanks in part to slackening demand. As a commodity business in which pricing is a direct result of supply, demand, and customer inventory levels, the memory market often acts as leading indicator for the semiconductor industry as a whole.

Recent weakness in some well-known chip stocks suggests that Wall Street is starting to get nervous about the future outlook for the semiconductor industry. And considering the red flags now appearing, I think it has good reason to feel that way. Business might still be booming for chipmakers, but for many of them, the party doesn't have a lot of time left.

Fool contributor Eric Jhonsa mysteriously stops watching James Bond marathons around the time that Roger Moore appears on the screen. He has no position in any of the companies mentioned. Intel is a Motley Fool Inside Value pick. Linear Technology is a Motley Fool Stock Advisor recommendation. The Fool owns shares of and has written puts on Intel. Motley Fool Options has recommended buying calls on Intel. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.


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