Friday, January 11, 2013

Telecom and Semiconductor Industry Analysis for 2013

It’s time to take a look back at 2012 and start to look at which sectors and stocks could do well in 2013. I’m going to start by looking at telecoms and semiconductors. As is often the case their fundamentals ran in tandem this year.  Both were expecting a stronger second half. It never came, although I would argue that telecoms started the year a lot stronger than semiconductors. With that said it’s time to look at the dynamics and throw some light on what could happen in 2013.

It’s More Fun to Compute

It was a disappointing year for the industry, particularly because industry analysts and executives had expected a second half pick up. In order to demonstrate how difficult it has been this year, here is some historical data for 3 month worldwide billings from the Semiconductor Industry Association.

These numbers have been negative since July 2011 so conditions are weak at the moment. It’s easy to get trapped in a viewpoint that this is just a typical cycle but it’s much more informative to actually look at the underlying dynamics. There are some unusual things happening.

First, investment in solar has been dramatically curtailed as part of austerity measures. Second, with every cycle the importance of computing hardware and software seems to be reducing. The IT industry used to salivate at the thought of a new version of Microsoft’s (NASDAQ: MSFT) Windows but it just isn’t a big deal anymore. Indeed, the likes of Dell and Hewlett-Packard (NYSE: HPQ) have reported extremely weak PC sales this year. No one appears to be particularly optimistic about Windows 8. Third, the global economy got weaker as the year progressed and in particular emerging markets (EM) saw slowing growth. This is an issue for consumer electronics because so much marginal growth was expected from EM.

I think these factors won’t change much in the future even if there is some cyclical upswing. There is a lot of uncertainty over China and I’m not that optimistic over PC sales. Windows 8 just isn't that much of a deal anymore. However, there are plenty of other applications for semiconductors and products like smart phones will only increase in adoption. For 2013 I think it is best to keep a close eye on Intel’s (NASDAQ: INTC) gross margins. They are currently guided lower and inventories are rising. Rising inventories nearly always lead into lower gross margins for Intel.


INTC Gross Profit Margin Quarterly data by YCharts

In summary, I think comparisons will get easier and the industry may see some growth, but I wouldn’t expect it to be similar to previous cycles and it is likely to come from different products than in previous cycles. I would take a cautiously optimistic outlook here but delay an overweight view until Intel’s inventories start falling and gross margins are forecast to improve.


One interesting way to look at semiconductors and telecoms is from the perspective of two IT industries that are both seeing the rise in the intellectual quotient as a share of a good’s value. In other words, software is becoming more important than hardware. We can see this sort of thing in the reported revenues of bellwethers like IBM, Oracle and Cisco. This is the year when software trumped hardware and I think this trend will continue. Products and infrastructure are getting smarter and the telco industry is no different.

Over the course of the year we have seen wireless spending increase and wireline spending getting weaker. Moreover, some carriers are jumping straight to 100G infrastructure and the pressure to roll out 4G-LTE is only increasing. These areas have been okay this year but in general telcos weakened their spending as the year progressed. The second half pick up did not occur and while AT&T (NYSE: T) is talking about increasing its spending, the fact remains that the outlook for telco spending is variable at best.

We can see what happened this year by looking at free cash flow for AT&T and Verizon (NYSE: VZ).

VZ Free Cash Flow data by YCharts

Looking longer term, we can see that free cash flow rises for these companies in a recession because they tend to slow spending in investing in their networks.

The unusual thing this year is that we have seen this phenomenon over the last couple of years but we haven’t had a recession! This is as good a sign that corporate are being very cautious with spending in this environment. Irrational melancholy? I think so and perhaps 2013 will see telcos forced to spend?

Pocket Calculator

Having crafted this work it’s time to get out the pocket calculator and hazard a guess as to where things will go next. I must confess I am rather more positive on telco than semiconductors. Telco us seeing increasing strains on networks caused by the rate of technological change with things like smart phones and tablets. Networks need to be upgraded and things like voice over LTE (VoLTE) and network convergence will drive future expenditures at some point.

The cycle does look better for semiconductors too but it’s hard to see a gangbusters 2013 because its drivers are less secular in origin and some end demand is suffering from technological obsolescence rather than benefiting from proprietary changes.

I would prefer telco over semiconductors for 2013 but there is plenty of time before going overweight in either.

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