This article first appeared in The Edge Financial Daily on July 3, 2019

Technology sector
Downgrade to neutral: We downgrade the technology sector to “neutral” from “overweight” following a slew of setbacks that dampened hopes of a recovery in the second half of 2019 (2H19), mainly arising from the trade spat between the US and China. The Semiconductor Industry Association reported a decline in global semiconductor sales for the sixth consecutive month after registering record sales in October 2018. For the year through April, sales fell 11% compared with the same period last year. Recognising the deteriorating outlook for the sector, World Semiconductor Trade Statistics recently revised its forecast for 2019 to a 12.1% year-on-year (y-o-y) decline from an earlier 2.6% y-o-y growth, with memory, sensors and optoelectronics identified to be the causes of the drastic swing.

The tech cold war rages on with no clear winner. Observing the supposedly “final trade talk” on May 10 taking a turn for the worse with further tariff hikes followed by the shocking ban on Huawei, we reckon that a recovery in 2H19 is going to be a tall order. Although the Group of 20 meeting between the US and China last Friday resulted in the lifting of the Huawei ban, the company is still not officially dropped from the US blacklist. The US has indicated that the decision will be dependent on further trade talks with China. While the resumption of trade talks is positive, optimism is partially negated by the absence of a timeline, still leaving many technology companies around the globe in limbo. Companies under our coverage in recent briefings indicated that their customers are taking a wait-and-see approach, holding back on orders in fear of further tariffs.

The US has not been able to replicate its success with Huawei as it did last year with ZTE. Huawei has shown no signs of backing down knowing it controls the largest market share of global telecom infrastructure and fifth-generation (5G) standards. Having the largest presence in China with a population of 1.42 billion (versus 329 million in the US) explains why being potentially shut off from US consumers does not dent Huawei easily. Even the total population of the Five Eyes (the alliance comprising Australia, Canada, New Zealand, the UK and the US), which would likely side with the US, still trails behind China.

China’s population is one of the main reasons that has made it the manufacturing muscle it is today. Apple and many US companies rely heavily on China for its manufacturing and assembly services. Foxconn Technology Group, known for manufacturing the iPhone, hired a million workers during its peak. China’s strength in numbers extends beyond the population count as it narrows the gap with the US in terms of venture capital investment. According to a report by data provider Preqin, China recorded US$105 billion in 2018 with the bulk of it related to technology, compared with US$111 billion for the US. This was quite different from 2010, when China’s numbers were only US$5.6 billion in contrast to US$30.8 billion for the US.

China may have shown tremendous growth but it is still dependent on the US for certain technologies, such as chip-designing software and operating software from industry-leading companies like Cadence Design Systems, Synopsys and Google. HiSilicon, a subsidiary of Huawei, relies on Cadence and Synopsys to build its processors for Huawei smartphones and 5G base stations. Not helping either is the fact that all these processors are built on chip blueprints licensed by Arm Holdings, a UK company, which may be pressured to sever ties with Huawei due to claims that US technology is present in Arm’s designs.

Languishing car sales in key markets like the European Union (EU) and China may likely persist due to weak consumer sentiment, lowering demand for automotive semiconductors. While the EU saw in May its first positive sales growth of 0.1% y-o-y in nine months, it is likely to be short-lived due to tightening EU regulations for carbon dioxide (CO2) emissions where the industry may face fines of up to €33 billion (RM154.48 billion) if requirements are not met. EU carmakers have until end-2020 to reduce CO2 emissions to 95g/km from the current level of 124.5g/km, which experts regard as the most ambitious emission target in the automotive industry.

Instead of increasing research and development cost to battle CO2 emissions from combustion engines, carmakers could sell more electric vehicles (EVs) to lower the emission figures. But carmakers are faced with challenges like: i) lower margins for EVs compared with combustion-engine vehicles; ii) higher selling prices of EVs that may dampen sales during times of weak consumer spending; iii) higher demand for semiconductor content in EVs, which is facing uncertainties over the US-China trade war; and iv) looming tariffs on EU cars sold to the US.

Smartphones are feeling the 4G to 5G transition slump. The annual trend of flagship smartphone launches will still take place, but we expect tepid demand due to a lengthier replacement cycle as consumers may put off purchases in anticipation of 5G. While it was a positive sign seeing 5G-ready phones launched in 1H19, sales numbers are still insignificant due to lack of 5G infrastructure. Prices of 5G phones are still too high to justify a purchase with such limited coverage at this point in time. The Samsung Galaxy S10 5G variant is retailing for £1,099 (RM5,739), £200 higher than the range-topping S10+ model. While the timeline for commercial deployment of 5G is facing uncertainties due to the US-China dispute, we still see Inari Amertron Bhd (hold; fair value: RM1.45) as a potential beneficiary when smartphones transition to 5G on a larger scale. Having expertise in radio frequency chips that are crucial for 5G connectivity in smartphones bodes well for the company.

Key risks to our call include: i) lukewarm demand for end products owing to weak economic conditions; ii) monotonous content growth in underlying products in the absence of innovation; iii) margin erosion in the face of a weakening US dollar; and iv) a worsening trade war between the US and China, specifically relating to technology and intellectual property. If we see further deteriorating outcomes arising from the abovementioned risks, we may downgrade our stance on the sector to “underweight”. — AmInvestment Bank, July 2