The big question with semiconductor stocks at the moment is simple. Is the chip industry still cyclical? The gains in chip stocks starting in early 2016 came in part due to a belief that they weren’t. The recent pressure on the space is coming from investors who believe times haven’t really changed.
On Thursday, Goldman Sachs gave its opinion, and, with one key exception, it was mostly bearish. The firm sees a cyclical downturn on the way — and it’s not alone. Chip stocks have sold off steadily of late. The iShares PHLX Semiconductor ETF (NASDAQ:SOXX) has dropped 10% in the last month. Advanced Micro Devices (NASDAQ:AMD) is off 15% over that period, and Nvidia (NASDAQ:NVDA) has dropped 12%. Intel (NASDAQ:INTC) and Micron (NASDAQ:MU) already were tumbling heading into October; both are threatening to hit eight-month lows.
There is a case that, particularly from a long-term perspective, the selloff is overdone. But Goldman only adds to the chorus calling for the cyclical downturn that supposedly wasn’t going to happen anymore.
Near-term pressure seems likely to continue. There is one notable “buy the dip” case in the sector, however — and it’s one on which both Goldman and I agree.
Why Semiconductor Stocks Would Stop Being Cyclical
As I’ve pointed out before, the relatively high valuations given to stocks like NVDA, AMD, NXP Semiconductors (NASDAQ:NXPI) and Mobileye (before its acquisition by Intel) are somewhat unusual. Historically, semiconductor stocks have tended to be cheap.
The reason why is pretty clear. Chip manufacturing is a tough business. The product has to get better every year — while prices typically come down over time. On top of all that, the industry usually is cyclical — across end markets. Shortages emerge and competitors race to fill orders at higher prices. Oversupply follows, and prices — and profits — plunge. (Micron’s experience in the memory market is a particularly exaggerated form of this cyclicality.)
Of late, however, investors argued that the days of the cycle were over. Key trends like Internet of Things (IoT) and connected automobiles would create demand that rose continuously. In both those categories, in particular, chips didn’t need to be great. An internet-connected coffeemaker doesn’t require a cutting-edge semiconductor — it just needs to work.
More demand and less need for R&D suggested that a rising tide would lift all boats. And so the SOX index (on which the SOXX ETF is based) doubled between early 2016 and late 2017.
Cyclical Concerns Return
That optimism is starting to fade. Goldman analyst Toshiya Hari wrote, “We foresee a cyclical correction approaching and recommend investors to stay selective in Semis.”
Hari pointed out that units manufactured were well above trend, with the gap at historically high levels. That, in turn, suggests a sharp increase in inventories at manufacturers. The only way for chip companies to move excess inventory is to cut prices, which will pressure earnings in the fourth quarter and into 2019 at least.
It’s essentially an argument that this time isn’t different. The semiconductor industry still has cycles, like always. And, interestingly, Goldman sees pressure as highest in the traditionally cyclical categories that benefited most from recent optimism. It downgraded two analog chipmakers, Analog Devices (NASDAQ:ADI) and Maxim Integrated Products (NASDAQ:MXIM), to “sell” — a rare rating from Goldman (or any other Street firm).
And the firm noted pressure in automotive, in particular, which actually makes some sense. While investor eyes have been on the benefits of autonomous driving, near-term auto sales actually may have peaked. Adding pressure from Chinese tariffs and other macro concerns, and that key end market very well may be oversupplied.
Goldman makes a good case, and it’s one that looks correct at the moment. Inventories are high, pricing isn’t what it used to be and external factors have turned negative. This looks like a good old-fashioned cyclical downturn. And that’s bad news for a number of chip stocks, including equipment manufacturers Lam Research (NASDAQ:LRCX) and Applied Materials (NASDAQ:AMAT).
… Except for Nvidia Stock
Goldman did upgrade a couple of chipmakers, but it saved its highest praise for NVDA. Goldman added the stock to its “Conviction Buy” list with a $305 price target, suggesting 32% upside from current levels. (That upgrade hasn’t helped much; the NVDA stock price is down 4% in Friday trading as of writing.)
As Barron’s noted, Goldman argued that Nvidia’s tailwinds — in datacenter and visualization, in particular — insulate it from the coming cyclical correction. I think the firm is right on that front — because I made the exact same argument just this week. The semiconductor cycle can turn and NVDA can still rise.
Pretty much none of Nvidia’s markets have real cyclical exposure. The gaming segment, which remains the company’s largest, could take a hit if U.S. macro trends turn down. Presumably, unemployed gamers would have less money to spend on higher-end rigs in that scenario. But it’s not as if there’s going to be a glut of graphics cards (particularly with cryptocurrency mining fears largely worked through at this point).
The same is true in datacenter (where growth should be explosive for years) and visualization. After that, autonomous driving starts to contribute in full next decade.
Bottom Line on Nvidia Stock
So it’s not contradictory to call for weakness in chip stocks and strength in NVDA stock. In fact, it’s kind of the point. Nvidia is an outlier – as a company, the best semiconductor play out there. Yet Nvidia stock is selling off like it’s just another chip play. Investors in other stocks can debate the cycle. NVDA stock should rise from here no matter what happens elsewhere.
As of this writing, Vince Martin has no positions in any securities mentioned.