I recently read this article by William Trent of the The Stock Market Beat that mentions Intel (NASDAQ:INTC) and a number of other prominent semiconductor stocks that I follow. I’ve read previous semiconductor articles by Mr. Trent and the theme of the articles revolve around overcapacity and overproduction leading to an inventory glut and an inevitable slowdown in the semiconductor industry.
Much of the analysis that Mr. Trent presents is valid, but I can’t help but mention that I believe he is only seeing half of the picture.
I once worked for the CIO of GMAM and I fondly remember him repeating his views on technology:
“Technology is a tool and nothing more. Technology is an enabler. Technology in and of itself is not a business. Technology cannot succeed without needed applications.”
The required business formula seems to be Technology + Applications = Probable Success.
When reading Mr. Trent’s articles, the statistical information is entirely correct and in the short-term it does appear that there will be an inventory glut. What I believe Mr. Trent has not covered in depth is the reason behind the expansion from companies like Intel, United Microelectronics Corporation (NYSE:UMC) or Taiwan Semiconductor Manufacturing Company Limited (NYSE:TSM). I believe you can’t look at a semiconductor company as an investment without asking yourself:
What is it that the companies are manufacturing?
Why are they manufacturing it?
Answering these questions will validate or invalidate expansion and capacity planning strategies from semiconductor firms. We can look at what lead up to the most recent inventory glut in the semiconductor industry and extrapolate which applications are aging. Standard definition DVD, standard definition TV’s, 2G mobile phones, portable audio players and Microsoft Corporation’s (NASDAQ:MSFT) Windows XP associated computer hardware lead the inventory glut in consumer applications. In the business world we saw networking, security, Windows 2000 and Windows XP server and workstation platforms as the leading applications. New semiconductor processes and technologies were created for an aging consumer and business application cycle. These aging applications are experiencing ongoing declining profit margins and demand.
Currently we are on the verge of a new application cycle that will undoubtedly refresh both profit margins and demand. Anyone who has a difficult time understanding why there is increased demand from semiconductor manufacturers needs only to look at the short-term developments in the consumer electronics industry and the computer industry. There are dozens of potential new applications that could spur technology demand, but I see two that are prominent standouts, high definition DVD standards and Windows Vista.
In 2006 we have seen the introduction of high definition DVD standards and low cost high definition display technologies. We should all be reminded that standard definition DVD was the most successful consumer electronics application of all time. Standard definition DVD’s rapid widespread adoption created technology demand from manufacturers. While it may take a while for high definition standards to emerge, it is undoubted that one of the standards will succeed since all new movies will be released and filmed in a high definition format. If the adoption rate of standard definition DVD was any indication, the shift to high definition DVD will represent one of the most important application cycle shifts of all time.
High definition DVD will have incredible utility just like its predecessor. It will spur demand for related display and audio technologies. The demand will trickle right down to the microprocessors that will power many of the new electronics we will see.
Toward the end of 2006 and in the beginning of 2007, we have the planned introduction of Windows Vista. The new OS contains the most stringent hardware requirements since the introduction of Windows 98. Windows Vista contains a number of productivity enhancing technologies including native OS acceleration from the use of multicore CPU’s. In layman’s terms it means the Windows experience and the applications that run on Windows Vista will be sped up from running a computer with more than one CPU core. For example, Intel’s Core 2 Duo contains 2 cores and the new Core 2 Quad contains 4 cores. None of the previous Windows OS’s contained this type of support.
If we take a look at enthusiast websites like HardOCP that have posted a preliminary performance preview of Intel’s Core 2 Quad processor we can already see tangible benefits from running the CPU on the aging Windows XP platform. Multicore processors will be ubiquitous, since there will no longer be any availability of single core processors in due time. The marriage of an OS that natively supports multicore processors with applications that also take benefit of multicore processors represents a staggering cost-benefit relationship that I believe most consumers and businesses will find hard to ignore.
If you want to experience firsthand why you will need to upgrade in the short-term, simply download the free public beta of Windows Vista RC1 here and download a 1080p Windows HD video here My more than capable Windows XP computer slowed down to a crawl with the combination above.
Once you understand that the application cycle is about to refresh, I believe you will gain some insight into why companies like Intel, Taiwan Semiconductor and United Microelectronics are expanding production in face of a short-term inventory glut. It may take a few quarters for new applications to emerge and for standards to take a foothold. In the meantime I see an opportunity to buy many well managed semiconductor stocks that are still depressed. I believe investors will be richly rewarded in the next year for buying now while the majority is looking elsewhere.
Disclosure: The author owns 1000 shares of INTC purchased at $21.35 and 10,000 shares of UMC purchased at an average price of $3.17.