Note: Professor Fleckenstein provides his commentary every Wednesday evening for educational purposes - his insights are not intended as investment advice. You can find his daily comments at www.fleckensteincapital.com.
If I Could Fly, I Wouldn't Need a Car
Overnight equity markets were quiet, but the currencies were under pressure as the dollar enjoyed a bounce. Preopening, we found out that the trade deficit for last month was not as ugly as anticipated -- only $46 billion, vs. $48 billion -- though that was pretty much ignored by the equity market. The early going saw a bit of strength in tech and mild greenness all around, but nothing worth commenting on. Over the course of the day, we had a rather quiet flop-and-chop around the opening levels, in trading that produced one of the smallest net changes I've seen in some time. Whatever strength could be found was in housing stocks, which bounced a percent or two. Otherwise, it was a really dull day.
Lustrous Loss as Par for the Course
Away from stocks, as I noted, the dollar enjoyed a bounce, with the dollar index getting back to around the 88 level. Oil was modestly lower, as was fixed income, somewhat surprisingly. Precious metals were under pressure, with gold down $8 at one point, and silver down 25 cents, before closing down $6 and 15 cents, respectively.
These moves in the precious metals are fun on the upside, and less fun on the downside, but they just kind of come with the territory, as anyone who's been paying attention must understand by now. I'm not surprised that we have seen a setback after the recent run. How much deeper it will go is unknowable, but I don't anticipate a humongous break from these levels.
Groping for Growth in the Land of Andy Grove
As everyone knows, Intel reports tonight, and I thought I might put in perspective what all the big flap is about regarding Intel's inventory. (Since I've often discussed Intel's macro problem, i.e., PC saturation and the competitive threat from AMD, I won't go into that now.) The company is expected to report sales for the last quarter just shy of $8 billion, and about 10%, plus or minus, more than that for the third quarter. What's germane to this discussion is not the absolute level of sales, but the level of sales growth. Given that Intel's sales were also about $8 billion for the first quarter of 2000, the company has shown no sales growth in four years -- yet it's valued at 5.5 times sales and has a P/E of 27, plus or minus, depending on what you think it will earn in the next 12 months.
What's likely to be a problem is the fact that as of last quarter, Intel had inventory of about $2.8 billion on its books, vs. only $1.5 billion of inventory at the end of Q1 2000. So, Intel is carrying roughly twice as much inventory now as then, with the same level of sales. It's been building inventory for four quarters, and one might ask why, in the absence of any apparent need. The reason why a high-fixed-cost company such as Intel would build inventory is to help keep margins up. It gets to spread its high fixed costs of production over a larger number of parts.
At the End of the Day, Profits Astray
If Intel were to have sold those parts instead of building them, two things would have happened (assuming that there is no real demand, which is why the parts went on the shelves): First: extra parts would put pressure on pricing. Second: The cost of those parts would also flow through the income statement, ergo, we'd have pressure on margins. Now, the problem has built to the point where Intel's got roughly 35% to 40% of a quarter's worth of sales on the balance sheet, and we don't know if it's built even more parts this quarter.
If demand slows, as I suspect, Intel will have to cut prices to move the inventory, and at some point probably need to cut production. That will wreak havoc with earnings per share. Again, when you're in a high-fixed-cost business like Intel, after you get past your break-even, essentially all the profits flow to the bottom line. When that process goes in reverse, small drops in revenues can have a disproportionate impact in driving declines in earnings. Finally on the subject of revenues, I think that folks' expectations for what Intel can do in the third quarter are far too high, based on unrealistic comparisons with last year, which saw a big surge in notebooks and Centrino-related sales.
That's the story in a nutshell. Intel has always been slow to recognize problems and take remedial action. Whether it does anything aggressive right here and now remains to be seen. But I expect that before we get through the third quarter, it will be forced to take serious action. That will impact the stock price and psychology in the chip sector generically. As I've been noting, there has been no shortage of inventory issues all through the sector. It will face real problems if end demand slows down, as apparently seems the case.
MU Waxes Poetic on IF
Of course that doesn't stop companies from engaging in wishful thinking. This morning, a headline passed on Bloomberg that "Micron Expects Stronger Fiscal Fourth Quarter." And why might that be? Said Mike Sadler, VP of Worldwide Sales: "We're expecting a stronger fiscal fourth quarter than fiscal third quarter because we will have pretty significant output increases." (Read: Micron is going to make more parts.) Sadler concluded: "And, as long as [my emphasis] we sell all the production output, it should result in stronger fourth-quarter earnings." In other words, we're going to make a whole bunch more stuff, and as long as pricing holds, and if we can sell it, things will be wonderful.
Micron has basically said the same thing every quarter for the last five or six years, and it hasn't worked out. (I note that this morning's bold proclamations were sort of lost on the tape, as that stock was only up about a nickel in the early going.) Of course, Micron has no idea of what end demand will be like, since its position is at the back of the food chain. Again, it's not that Micron matters so much. It just happens to be a good example of the ever-optimistic nature of semiconductor executives. They never, ever see trouble coming, and when it hits them in the face, they're always forced to slam on the breaks. Yet, folks still act like these are wonderful companies that deserve large multiples.
If they could always sell their product, they would in fact make lots of money. But that fantasy can't withstand the fact that there's no barrier to entry in most facets of chip land (especially memory manufacturers), and that capacity additions ensure that pricing stays under pressure. So, for these chip companies to continually contend that they'll keep making parts, and if things get better they'll do better is a little bit like saying: If I could fly, I wouldn't need a car.
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