Cracks start to show in the semiconductor industry

Semiconductors have traditionally been a cyclical industry — prone to periods of booms and busts. After going through a significant boom period in recent years, investors worry about what comes next.

Heart of everything digital

Semiconductor chips are (literally) at the heart of electronics, cars and data centers. During COVID, chip demand went through the roof — sending semiconductor stocks higher and higher.

• Growth: In February, semiconductor sales grew nearly a third to $52.5B compared to Feb. 2021 — the highest increase since 2010.
• Shortage: In March, it took an average of 26.6 weeks to deliver the chips from the order date.

Shortages have allowed chipmakers to raise prices — leading to record profitability — with supply expected to remain tight until 2023 (BBG).

All this momentum led to a massive rise in semiconductor stocks:

• The iShares Semiconductor ETF (NASDAQ:SOXX) has been up 93% in the past two years — despite a 22% drop since December.
• Two retail favorites — Nvidia (NASDAQ:NVDA) and AMD (NASDAQ:AMD) — are up 220% and 87% in the same period.

Despite losing a third of their value from all-time highs, their valuations are still above pre-COVID levels and industry averages. While valuations alone shouldn’t scare investors off, here’s what could…

Cracks in the industry are starting to show

Last week, investment firm Truist warned of a “sudden negative shift” in demand from industry sources (SA).

• Their industry contacts see order cuts in the second quarter, but demand remains “robust” for the second half of 2022.
• Truist analyst William Stein is uncertain about the reasons for the fall in demand — which could also be temporary.

In 2020, PC/computer and consumer products made up 43.3% of semiconductor demand. With a sharp fall in global PC shipments in the first quarter and consumer spending showing signs of weakness, this is not a stat investors want to see..

Major chipmakers, including Intel (NASDAQ:INTC), expect new plants to come online next year — bringing more supply into the market. But if the industry isn’t careful, they could find themselves with too much supply.

Worst-case scenario: A drop in demand and a buildup of excess supply could lead to a downturn — common in cyclical industries.

Investors: Enough is not enough

Chipmakers begin reporting earnings in the coming weeks, but they’ll need more than positive news to satisfy investors.

• Analog Devices (NASDAQ:ADI) — a US semiconductor manufacturer — is down 8% since reporting better-than-expected earnings in February.
• $ADI even raised profitability and growth targets on its investor day last week — with little reaction from investors.

Samsung also failed to move the needle after solid earnings. If positive earnings results won’t move stocks, what will?