Japan technology stocks looking vulnerable near term

This week we focus on technology stocks but as usual, through a Japan lens. We have been mostly negative on the sector since early summer as their shares seemed overbought after having followed their US peers higher, and leading Japan’s big market rally. However, since the last earnings season in July, the group have struggled for performance, giving back some of their relative gains to Japan’s financial and cyclical names, areas where investors are mostly chasing stocks that trade at a discount to their book value. 

Among Japanese technology names that we follow closely, inventory adjustments seem to be taking longer than previously hoped, as end demand volumes remain anaemic and hopes that AI will plug the value gap anytime soon seem to be deflating.  We think this has provided some compelling near-term shorting opportunities, particularly among Japan’s semiconductor production equipment and material makers.  

Also, ARM’s coming IPO whose value range was set significantly below the initial lofty estimates could be a good litmus test for future listings as it doesn’t seem to have a significant value exposure to AI chips. Reports that the IPO is many times oversubscribed is not surprising given that the size of the listing was fairly small, precisely to keep initial demand firm and allow Softbank to borrow against its remaining 90% stake.

What will be more interesting is how ARM’s shares perform after the listing given that even at $50bn we think its valuation premiums seem rich considering that TSMC, which practically owns production of AI chips, trades at forward PE of less than mid-teens. This modest valuation comes despite Taiwanese foundry’s notable lead in scale of its cutting-edge lines and its chip packaging capabilities which provide half its revenues.  

Moving on, we think geopolitical risks in technology stocks could also prove disruptive. Huawei’s unveiling of its new high-end smartphone seems to have caused a storm as teardowns suggest it comes equipped with China’s SMIC processor that is close to utilising the cutting-edge nodes. This has renewed calls among US lawmakers for tighter export restrictions of manufacturing tools. 

We also suspect China reinforcing its ban on the use of iPhones among workers of government bodies and agencies doesn’t seem a coincidence having come soon after Huawei’s unveiling. More importantly, it may be an early warning sign that China is turning less friendly to Apple which dominates the high-end smartphones market in the country thanks to Huawei disappearance. Indeed, China may want to revive the brand as its national champion of high-end handsets. 

We have also argued that export bans do not seem to go far enough in disabling Chinese chip makers from producing cutting edge semiconductors, mainly by utilising multi-patterning techniques on older equipment which have had no export license requirements. Although there were some talks of US further broadening its export bans, including disallowing high margin maintenance of existing equipment in China, nothing has materialised yet. 

However, the Biden Administration seems to have now launched a new investigation in China’s chip making capabilities. Moreover, with US presidential race edging closer, pressure to act tougher on China could intensify again. We thus think we will likely see tougher sanctions on Chinese semiconductors possibly before the year-end. Incidentally, this may also impact sentiment regarding ARM which derives over a quarter of its revenues from China. 

But with Chinese chip makers having hoarded volumes of manufacturing tools in anticipation of these broader restrictions, it may be too late to stop them shrinking geometries nearer to most advanced nodes, even if their manufacturing efficiencies are not as high which is somewhat irrelevant to this technology cold war.

Come what may, we think the likely fall in equipment sales and orders from China from here onwards (especially as the first set of restrictions have now kicked in) could provide heavy earnings headwinds for tool makers next year as most of those we follow have seen their China bound deliveries surging in the past few quarters. Unless semiconductor capex recovers elsewhere next term, the overall picture is not looking encouraging.