Will Weak Demand Ruin This Earnings Season?

by: Spencer Knight

Weak demand is associated with a slowdown in spending, manufacturing miscues, inventory backlogs, and a loss of market share to name a few thoughts that come to mind. After a particular company or number of companies within the same industry report weak demand, it is common for stocks that have not reported weak demand to suffer downward movement.

This scenario has recently came to fruition as RF Micro Devices (RFMD), Standard Microsystems (NASDAQ:SMSC), QuickLogic (NASDAQ:QUIK), Measurement Specialties (NASDAQ:MEAS), Juniper (NYSE:JNPR), and Texas Instruments (NYSE:TXN) have reported weaker than expected revenue due to weaker than expected demand from their respective customers.

Moreover, this situation opens up two possibilities for investors and traders as the major earnings season approaches. The first possibility is that several of the major technology players, specifically in the semiconductor industry, will follow suit and report weaker than expected demand; which will cause a downwardly revised forecast as well as lower than expected earnings which will cause the respective share price to tumble.

The second situation is that traders and investors have been given a golden opportunity to pick up solid gains. Due to several technology stocks reporting weak demand many semiconductor stocks have slipped; which means if this weakness is not an industry and sector wide phenomenon these stocks have a strong upside possibility. I will discuss this in more detail later.

For now, however, it is important to note four of the companies that reported weakness are small cap technology stocks. This brings up a possible reason regarding the reportedly weaker than expected demand. Since smaller companies reported weakness, it is possible the larger firms -- that have not reported weakness -- may be expanding their own market share at the expense of the smaller firms. If this is the case, the upcoming earnings season will be fantastic for larger semiconductor companies such as SanDisk (SNDK), Broadcom (BRCM), Marvell Technology (NASDAQ:MRVL), and Skyworks Solutions (NASDAQ:SWKS).

Therefore the question that remains is whether investors should open long positions or short sell technology and more specifically semiconductor stocks before the upcoming earnings season? Along with the four large firms listed above, two other semiconductor firms that have the potential to report stronger than expected earnings are Nvidia (NASDAQ:NVDA) and AMD. Both stocks have been sliding due to the much talked about weakness in the chip industry; therefore a weak earnings report is likely priced into the share price. Which means any positive indicators will cause a slightly higher increase in the share price than expected.

It is more difficult to discuss stocks to short because a weaker demand scenario has been priced into many of these stocks already. Therefore severe downside (-7% or more) movements will not occur; unless, of course, an extremely downward forecast is given. Also, the weaker companies have reported they will miss analysts' expectations already, therefore during the major earnings season investors will not see many surprises. This means the best stocks to short are those that have historically missed earnings.

One of these, Oclaro (NASDAQ:OCLR), reported revenue above what analysts were expecting. This does not mean investors should expect a perfect earnings report from Oclaro. Since Oclaro’s management "expects four of the five flood affected product lines to have restarted commercial output at Fabrinet's Pinehurst facility by the end of January" the company's future guidance will need to be strong. This may prove to be the weak point in Oclaro's conference call. And after Wednesday's surge in the share price, many traders may find Oclaro a stock to short.

This brings me back to the question of weak demand. The most obvious reason for weaker demand is because businesses are not spending to buy new products. Two primary reasons cause a business not to spend. The first is the particular business may not be receiving enough sales to entail buying more supplies for new products. The second reason is these same businesses have purchased too many parts in the past and have an inventory backlog. The latter scenario is better for the economy because this indicates that once the inventory glut clears we will see normal levels of demand.

However the former reason is not a good economic indicator because if consumers are not spending the economy will not improve at a healthy rate. And if businesses are not spending for products, it is likely consumers are not buying new products from the firms; which also causes the business to avoid hiring new employees. With those ideas in mind, how can investors decide if the reported weakness is a general economic problem, an industry and sector wide problem, or a case by case problem?

By looking at the overall industry it appears the weakness is a case by case issue. Even though semiconductor and chip stocks have faced weakness together, many of these fears are overblown. Two companies that indicate the industry is not facing severe weakness are JDS Uniphase (JDSU) and Cirrus Logic (NASDAQ:CRUS).

JDSU announced during the December conference call that the firm is seeing "significant improvements in customer's inventory levels;" which indicates that JDSU’s business partners and customers are beginning to see strong demand; which will give JDSU higher sales as well. Cirrus Logic also stated the firm is seeing signs that indicate demand is robust. Therefore it appears the so-called industry wide demand shortage is dependent upon each company.

Nevertheless at the end of the day the broader semiconductor industry is all over the place. Some stocks are flying high with demand increasing while others are struggling with demand dwindling. Because of this volatility it will be difficult for traders and investors to make perfect picks as to which companies will beat analysts' expectations and which will miss this earnings season. But it appears three of the strongest/safest bets are SanDisk, Broadcom, and JDSU. Keep in mind JDSU is a wild card pick. However based upon the company's fiscal first quarter report in November 2011 investors will see strong earnings this time as well, and with the share price still depressed there is a bit of room to run.

Three stocks to be on your toes about are Spreadtrum (NASDAQ:SPRD), Oclaro, and Texas Instruments. Texas Instruments is a stock to be wary of because the company reported a lower forecast, yet the share price has climbed higher than prior to the announcement. Therefore Texas Instruments' share price has a serious downside risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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