Semi Nervous: China Trade Battles Sink Chip Stocks

The Trump administration announced plans today for a stronger security review process of foreign investors acquiring American technologies that would rely on existing laws, taking a step back from previous gestures indicating it would specifically block Chinese investments.

This move is perceived as more economically friendly to global investors who were concerned the U.S. Treasury was about to create a virtual blockade of firms with at least 25 percent Chinese ownership from buying U.S. companies with "industrially significant technology."

“Such legislation will provide additional tools to combat the predatory investment practices that threaten our critical technology leadership, national security, and future economic prosperity,” Trump said in a statement.

Instead of creating new executive powers, the Treasury Department recommended that Trump use the Committee on Foreign Investment in the United States (CFIUS), a 1980s law which already gives the executive branch the power to review foreign investments seen as a national security risk.

Loose WH Lips Sink Chips

Part of the volatility for global stock markets the past few months has been due to the unpredictable rhetoric from the Administration. With no less than five voices besides Trump's -- including Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, US Trade liaison Robert Lighthizer and economic advisors Larry Kudlow and Peter Navarro -- all speaking to the media, many apparently "official" statements are later retracted or modified.

In the end, any meaningful action on the Chinese threat to US intellectual property is probably a good thing. But it's the short-term uncertainty about how it evolves that has both investors and technology companies on edge.

Caught in the middle of the White House "America First" agenda are a number of big US companies who complain that the tariffs penalize them for their globe-spanning supply chains. And the Semiconductor industry may be the most vulnerable right now.

Global supply chains for Semiconductor manufacturing and equipment are probably some of the most complicated. Tariffs will definitely throw a wrench in the works.

Chips are often designed and produced in the US, sent to China for packaging or testing and then returned back to the States. The chips would now be subject to tariffs on the return trip.

Earlier this month, a spokesman for the Semiconductor Industry Association made their views clear...

"Tariffs on semiconductors would harm, not help, U.S. semiconductor companies, their workers, and American consumers."

In the video that accompanies this article, I go over the last few week's of "trade battle" rhetoric that have led to a 9% sell-off in the Philadelphia Semiconductor Index (SOX), and individual declines (from their June peaks) in these 5 popular investments...

Lam Research (NASDAQ:LRCX) : -17%

Applied Materials (NASDAQ:AMAT) : -14%

These first 2 companies are wafer fabrication equipment (WFE) makers for the actual chip makers like Intel (NASDAQ:INTC), Samsung (KS:005930), Micron and even NVIDIA.

Micron (NASDAQ:MU) : -13.5%

NVIDIA (NASDAQ:NVDA) : -11%

Alibaba (NYSE:BABA) : -11.5%

Wait -- Alibaba isn't a chip stock. Why did I include them?

Because I can't believe this "Amazon (NASDAQ:AMZN) of China" is a victim in this trade war. I explain in the video with my thesis on why you buy BABA as the premier gateway to the world's largest middle class.

The Threat of "Made in China 2025"

I also explain the motives of the Trump administration and what threat(s) in particular they are combating. This excerpt from a June 15 Wall Street Journal article gives some good background...

White House officials said the goal of the tariff fight is to protect high-tech U.S. companies from pressure they face in China to transfer their technology to Chinese partners. Tariffs are necessary, the officials say, to force Beijing to change the way it does business.

"We're going to stop, we hope, their transfer of technology -- their forced transfer of technology," U.S. Trade Representative Robert Lighthizer said on Fox Business Network.

What is "Made in China 2025?" It's their long-term strategic technology plan, issued by Chinese Premier Li Keqiang and his cabinet in May 2015, to comprehensively upgrade Chinese industry.

The goals include increasing the domestic content of core materials to 40% by 2020 and 70% by 2025. The plan clearly focuses on high-tech fields including the pharmaceutical and semiconductor industries to which China has largely depended on US and European companies for advanced technology.

The Council on Foreign Relations has said it believes the plan is a "real existential threat to U.S. technological leadership."

And so it was no surprise when, on June 15, the Trump administration unveiled a lengthy tariff list mainly focused on the products included in the Made in 2025 plan, including IT and robotics related products.

The War to Protect WFE -- And Its Costs

Intel, Samsung, Micron and Taiwan Semiconductor Manufacturing (TSM) have always been big customers for WFE. “But Chinese chip makers are starting to write some large checks as well," according to Dan Gallagher of the Wall Street Journal.

Applied Materials CFO Dan Durn in his company's quarterly earnings call last month confirmed this sentiment from their business...

"China is emerging as a spender. Their strategic intent is clear, and the financial resources they have are clear.“

But as Dan Gallagher wrote in his June 25 article Chip-Equipment Makers in Crosshairs of Trade War...

“Wars are generally good news for arms dealers. In the burgeoning trade war with China, the semiconductor-equipment industry may turn out to be a notable exception.

“To be sure, China isn't the only driver of growth for the chip-equipment sector. Strong spending in memory and process-node upgrades at the major chip makers are also fueling increased spending on equipment. But Krish Sankar of Cowen & Co. estimates that China accounted for about 14% of trailing 12-month revenue, on average, for the eight semiconductor-tool companies he covers.

"That means the loss of future sales could be significantly more. War is hell.”

While I have believed that we are in the midst of a Technology Super Cycle (email Ultimate@Zacks.com to get a free copy of my December 11, 2017 special report) driven by exponential data and memory demands, exponential mobile and connected/IoT device growth, artificial intelligence, and automation including ADAS vehicles, it looks like the "war on China" is throwing a big wrench in the works after all.

But I still think it will set up terrific buying opportunities in all these companies as the pessimism peaks this summer. Here’s to a short battle with China instead of an all-out war.

Disclosure: I own shares of NVDA, AMAT, MU, and BABA for the Zacks TAZR Trader portfolio.

Kevin Cook is a Senior Stock Strategist for Zacks Investment Research where he runs the TAZR Trader service. Click Follow Author above to receive his latest stock research and macro analysis..

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