Recently I wrote in this space that "Intel (Nasdaq: INTC) lives and dies by semiconductor inventory cycles, which are brought on by supply and demand issues dictated by business spending, production capacity, and a myriad of other factors. Intel has weathered a number of peaks and valleys over the last decade. It should be evaluated by looking at its performance through a complete inventory correction." OK then, Mr. Lebor, let's do just that.
Before we do, however, I should correct myself and rephrase that last sentence to read "through a complete semiconductor cycle." Now all we need to do is define a semiconductor cycle. It starts with demand and like all cycles it ends where it starts. The semiconductor cycle is not unlike many other business cycles that are dictated by supply and demand. In fact, the latest period of rough sledding experienced by the semi industry is similar to the battles in Cisco's (Nasdaq: CSCO) backyard with the networking market.
It's also likely that Nokia (NYSE: NOK) will experience these cycles in the wireless handset and infrastructure markets. Up to now, first-time customer growth, strong demand, and upgrades to 2.5G and 3G equipment have been fueling healthy growth rates, but once these markets mature and saturation levels pick up, Nokia is sure to have its own staring contest with Mr. Business Cycle.
The cycle looks like this: End users get juiced about the latest electronic gizmos and the strong consumer demand is sniffed out by manufacturers and retailers. That gets manufacturers worked up about their production capacity and output. If capacity is there, the manufacturers simply pick up the pace. If current production capacity can't meet forecasted demand, new facilities are built or, at a minimum, architects are called on to draw up plans for new facilities. But building a multi-billion manufacturing plant is not an overnight job, so a temporary supply shortage results and prices go up thanks to the laws of supply and demand. After a while, the same forces of supply and demand drive production capacity toward equilibrium and Adam Smith is proven correct once again.
But even the new fangled inventory and supply-chain management systems can't spot the inevitable shift in demand fast enough, so when demand fades, a supply surplus is the result. Inventories build up, margins erode and the surpluses must be sold at fire-sale prices. The resulting drop in prices and decrease in demand is a double whammy for the income statement and can distort the financials. For example, from Q4 2000 to Q1 2001, Intel's gross margins dropped from 62.9% to 51.7% and its operating income dropped from $2.6 billion to $0.6 billion. Eventually, excess inventories are depleted and it starts all over again. It's a vicious cycle, but it's an economic reality.
Many analysts and investors measure the semiconductor cycle by the book-to-bill ratio (BTB). BTB is the dollar of orders booked by U.S. semiconductor capital equipment makers divided by the dollar of products shipped (and billed). A ratio of 1.25 means that 25% more semi equipment was ordered than was shipped in a three-month period. Therefore, a ratio greater than 1.0 indicates demand is growing.
Semiconductor Equipment and Materials International (SEMI) releases a monthly survey of U.S. manufacturer's book-to-bill ratios. Not surprising, the BTB hit its most recent peak in March 2000 of 1.46 and has been on a drastic slide ever since, culminating with an all-time low of 0.42 in April 2001. (May numbers are to be released on Thursday.) That's a drop of over 70% in a year.
Assuming 0.42 is at or very near the bottom of this cycle and looking back to the most recent low in September 1998 of 0.57, Intel has fared relatively well over that period. Below are some key financial measures for the quarter ended just prior to the BTB bottoms (in billions):
Qtr Ended
6/98 3/01
Stock Price $18.53 $30.91
Market Cap 130.90 213.20
Revenue 5.90 6.70
Net Inc 1.10 0.50
Gross Margin 48.90% 51.70%
Cash & LT Inv 9.70 12.40
CF From Ops 0.40* 1.20
Cap Ex 1.10 2.70
* prior 3 qtr avg was $2.6B
From trough to trough, Intel improved its cash position (without taking on debt), slightly increased gross margins, and still was able to spend $15.2 billion on capital expenditures. While much of the competition is battening down the hatches to ride out the storm, Intel is gearing up for clear skies. As Rich pointed out last week, thanks to its highly profitable microprocessor business, Intel continues to produce sufficient cash flow from operations to fund capital expenditures.
Elizabeth Schumann, Director Industry Research and Statistics for SEMI summed up the situation best with an article titled "Two Steps Forward, One Step Back?" She points out that even though the semiconductor market is expected to contract in 2000, revenues will still be the second-largest in the industry's history. She offers this commentary and advice: "...the growth trend of this industry has always been a 'two steps forward, one step back' kind of movement. The growth is attractive; the cyclicality is difficult to manage. The bottom line is that the long-term outlook for the semiconductor equipment industry is still highly favorable."
This is the atmosphere in which Intel breathes. Like the surface of Mars, one moment the temperature can be 40 degrees F, and before you know it a dust storm roles in, the sun is blocked out and the temperature drops to -200 degress F. Weathering these cycles is matter of fact for Intel and so far Intel's space suit, (read: business model) has held up well.
Todd Lebor has never missed a putt from inside three feet to win a major. He owns share of Cisco, Intel, and Nokia. Todd's other holdings can be found online, along with the Fool's complete disclosure policy.
