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Morningstar | We're Maintaining Our Chipmaker FVEs, as We Don't Yet Foresee a Tech Cold War Despite the Huawei Ban

We are maintaining our fair value estimates for the U.S.- and European-based chipmakers across our coverage despite reports from Bloomberg and elsewhere that leading U.S. tech and semiconductor firms, such as Google, Qualcomm, Broadcom, Intel, and Xilinx, have cut off supplying Huawei until further notice. Our valuations imply that the Huawei ban will be used as short-term leverage by the U.S. in ongoing negotiations with China involving tariffs and other trade negotiations. However, our models still assume that the ban won't last in the long term, as it would be highly destructive to technology firms in both China and the U.S., given the complexity and interwoven nature of the tech supply chain. Our valuations don't incorporate a long-term doomsday scenario where Huawei is driven out of business because of its inability to access U.S. components or a potential cold war response from China where U.S. firms might be cut off from China's supply chain, which would likely cripple production of Apple iPhones and all types of enterprise IT equipment.

Near-term chipmaker results may be worse than previously forecast because of even greater uncertainty about end-market demand and future production, likely leading to fewer chip orders. Further, any prior calls for a recovery in China in the second half of 2019 now seem premature, although a bounce-back would be likely if trade issues are resolved. Finally, in the near term, strength in 5G chip demand at firms like Xilinx, Skyworks, Qorvo, and elsewhere, may have been a bit of a mirage, as Huawei has reportedly been stockpiling chips in early 2019 in anticipation of such a ban. Nonetheless, we still see attractive margins of safety in stocks like Intel and Skyworks, while the pullback in Xilinx appears warranted compared with our $90 fair value estimate.

Looking at the direct effects of the Huawei issue, Huawei is the third-largest buyer of semiconductors in the world, according to Gartner, buying over $21 billion of chips in 2018 and lagging only Samsung and Apple. We struggle to see how Huawei can maintain its smartphone business if it were cut off from U.S.-based components, specifically radio frequency chips. According to Gartner, the top four RF chip vendors that make up 82% of global revenue (Skyworks, Qorvo, Qualcomm, Broadcom) are U.S.-based, and we struggle to recall a premium smartphone over the years that doesn't include RF from at least one (if not several) of these U.S. vendors. Such RF design expertise, especially at a global scale, underpins our narrow moat rating on Skyworks Solutions in particular. We're skeptical that non-U.S. RF suppliers (Murata Manufacturing, Taiyo Yuden, MediaTek) can fill in the technology gaps any time soon and provide hundreds of millions of parts to Huawei per year, particularly on high-end phones using spectrum at higher-frequency bands.

In terms of direct revenue from Huawei, Qorvo earned 13% of revenue from Huawei in fiscal 2019 and remains an important customer. Huawei was a 10% customer for Skyworks in fiscal 2017, but not fiscal 2018, so it’s likely a high-single-digit customer today. We would also be concerned about Austrian chipmaker AMS, which counts on Huawei for roughly 5% of total sales, based on our estimates. We believe AMS has design wins ramping with Huawei during the calendar year, but AMS has said that it has no plans to stop shipments to Huawei. If the Chinese firm is unable to secure the other requisite components for its smartphones before burning through its inventory, AMS would certainly be affected. However, we believe AMS supplies illumination products into Huawei’s Chinese competitors, like Xiaomi and Oppo, which may help offset the customer substitution outside of China in the event the ban extends beyond the next few months.

Xilinx benefited significantly from Huawei’s stocking up of chips before the ban. Our fair value estimate of $90 is unchanged, as we had previously been anticipating lumpy and elevated 5G spending as well as the risk that escalating tensions between the U.S. and China could result in a ban of sales to Huawei. In fiscal 2019, communications revenue was 36% of sales for the firm. We assume roughly 20%-25% of revenue is derived from China, with about $300 million attributed to Huawei (also artificially inflated because of Huawei stocking up).

Qualcomm has multiple 10% customers (Apple, Samsung, Xioami), but Huawei doesn’t make the cut because of a combination of in-sourcing more of its chips and the fact that it’s not paying full royalties currently. There could be a risk here that Chinese OEMs don’t buy chips or pay royalties (revenue from China were 67% of last year’s fiscal revenue). Ultimately, we are maintaining our $80 fair value estimate for Qualcomm and expect near-term pressure on its financial results will be at the high end of those affected in the semiconductor space.

Approximately 50% of Broadcom’s revenue comes from sales to distributors, OEMs, or contract manufacturers in China, though the end customer may not be in China. Based on its customer concentration, we think Huawei is at least a 15% customer, which would imply about $3 billion in sales from Huawei. The firm reports in early June, and management will likely provide revised full-year guidance (Broadcom no longer provides quarterly guidance). That said, we maintain our $300 fair value estimate, as we don’t think the Huawei ban will be long term. Broadcom competitor Marvell also counts Huawei as a customer for networking switches and PHYs as well as chips for 5G base stations. We believe direct sales account for roughly 5% (or approximately $150 million in fiscal 2020 revenue based on our full-year outlook) and we are maintaining our $21 fair value estimate based on our view that this is a temporary headwind.

Intel had about 27% of its revenue derived from China, though Huawei is likely below 10%. Intel probably sells an assortment of processors to Huawei, spanning the data center and networking segments. Out of our large-cap semiconductor coverage, we think Intel will be relatively less affected by a ban on Huawei, thanks to its scale, broader diversity, and lack of non-U.S. alternatives. Worth noting is AMD’s joint venture with various Chinese entities (public and private): Tianjin Haiguang Advanced Technology Investment, which licenses x86 technology to China. The initial processor was launched in 2018 and is a variant of AMD’s EPYC processor. Nonetheless, for many high-end and specialized workloads, we think Chinese customers will still require Intel Xeon processors, and thus we are maintaining our $65 fair value estimate for the wide-moat chip titan.

Also supplying products for devices is Corning, whose Gorilla Glass adorns the surfaces of several Huawei smartphones, laptops, and wearables. However, we believe the Huawei-related sales account for a low-single-digit percentage of revenue at Corning. Other firms that could be affected with a similar severity are NXP Semiconductor (NFC chips for payments and transit), ON Semiconductor (sensors for flat-panel testing), and Cypress Semiconductor (Wi-Fi and Bluetooth modules). Under the assumption that this ban is temporary and does not extend beyond the next few months, we are maintaining our fair value estimates for all of these firms. However, interface designer Synaptics could be sorely affected if the Huawei ban is anything but short term, as it supplies touch and display solutions into several of Huawei’s devices. We estimate sales to Huawei account for more than 10% of Synaptics’ revenue.

In storage and memory, we believe both Seagate and Western Digital have counted Huawei as a customer, with Seagate supplying storage products for enterprise data centers and Western providing flash for a variety of applications. According to a report from Nikkei Asian Review, the latter has already suspended supplying Huawei. However, we believe Huawei accounts for just 2% of Western’s total sales. We estimate Seagate’s exposure is more elevated, closer to 5%, or roughly $500 million dollars, but we are maintaining our fair values of $63 for Western Digital and $40 for Seagate based on our outlook for the ban.

The indirect effects of the Huawei issue could also weigh on U.S. tech firms in the near term while negotiations drag on, and perhaps longer if no deal is reached soon. First, Apple's China business could continue to suffer—perhaps modestly and organically if Chinese consumers no longer favor buying U.S.-branded phones, but perhaps drastically if the Chinese government were to retaliate with some sort of action that might cripple Apple's ability to manufacture iPhones in China, regardless of where they are sold across the world. Apple derived 20% of revenue from Greater China in fiscal 2018. The firm has been negatively affected by weaker iPhone demand in China (for a host of reasons, including lower switching costs and Chinese nationalism). We had previously expected iPhone sales in China to be down nearly 30% this year, which could be lower if Apple tries to pass on the cost of tariffs to end customers (or lower margins if Apple maintains prices).

Second, chip demand paused in the fourth quarter of 2018, as customers were reluctant to build new manufacturing facilities or expand production in China. The latest bout of trade tensions around Huawei and the day-to-day tactics of the negotiations will likely lead to another bout of caution that could weigh on June quarterly results and perhaps the September forecasts for many chipmakers. A broad-based slowdown might be negatives for analog and microcontroller firms like ADI, Maxim Integrated, Microchip Technology, Texas Instruments, NXP, and others.

Third, regardless of the outcome of these negotiations, we expect more-aggressive chip investment and development in China, as there are some gaps in the tech supply chain there that the country simply can't fill organically. Such ramifications would initially weigh on the memory space, though even this dynamic is a few years away from materially affecting the likes of Samsung or Micron. We don’t think domestic Chinese manufacturers will be able to encroach on TSMC or Intel’s leadership anytime soon.

On the bright side, the U.S. Department of Commerce ban on ZTE in May 2018 was crushing to the Chinese tech firm, which we suspect helped lead to a relatively swift resolution (the ban was lifted in July 2018). Huawei's placement on the U.S. Entity List might be crippling, too, perhaps leading to a similarly swift resolution. The ZTE setback was relatively immaterial to many of the chipmakers we cover, serving as no more than a blip to quarterly results last year. Huawei is certainly a larger firm and a more important customer, but we still see potential for the U.S. ban being another blip for chipmakers rather than a roadblock.