MarketEye: Passive Components: Market Outlook for 2009

Passive Components: Market Outlook For 2009

Introduction:

This article is not a pessimistic one. In fact, it takes a broad swipe at pessimism in general. Pessimism, which can be defined as “a general disposition to look on the dark side and to expect the worst in all things,” is pervasive in all financial related media as I write this. By the time you read this (in November), it will undoubtedly have reached a pitched frenzy. I say this with great certainty there should be no unhappy faces as you gaze upon the screen. It is important to look on the current market conditions as a time of great opportunity and not one of unfolding disaster. Why would I say such a thing? Well for certain, and because of the ubiquitous nature of passive components and the financing of the vendors of these parts, I am directly exposed to some of the greatest financial minds in the world from Hong Kong to Frankfurt to Tokyo to Manhattan. Subsequently, I am exposed to radically different thought processes on the subject. Those with whom I speak are not retail or commercial bankers. The are the largest private equity firms in the world. They attract the greatest minds in the world- those who are too busy studying and investing to have the time to espouse new adjectives in print or media. One lesson from all this should be that broadcasters and financial writers should be limited in their use of adjectives because in many instances this breeds bias. Certainly adjectives are tools in the creation of a culture of fear. This makes us tune in to the message of woe, typically followed by a commercial for mood enhancing or anxiety reducing prescriptions. To summarize, a headline that currently reads: “U.S. Markets Suffer Largest Downturn Since September 2001,” could easily have been written as “Best Time to Invest in U.S. Markets Since 1929.”

Solace in Asia: The 20-Year Outlook

I find great solace in my friends in Asia. They maintain such a long-term view of markets (at least 20 years or more), and they remain calm as usual, seldom showing their emotions. For the first time I have seen an almost childlike giddiness in attitude because they are positively excited about what is going on in this global re-adjustment of value. The best and brightest of them are employing counterintuitive thought processes that many of us can learn from. They absolutely believe that now is the time to invest in capacity expansion, especially in mass produced product lines such as MLCC, chip resistor and chip inductor. When the market turns, and it will, those that expand now will absolutely crush the competition later on. A thought process like that takes some intestinal fortitude, but historically such investment timing has proven to be the correct course of action for obtaining share.

Europe: Stop Buying Parts and Start Hording Cash:

In Europe, from where I’ve just returned, having given my speech on the global passive component market outlook in Helsinki, Finland, I note the Europeans in attendance were absolutely bleak in their outlook. This was the exact opposite to the Asian sentiment, and is more in line with the American sentiment on the current world economic crisis. When markets worsen, and when media outlets shout out increasingly more obtuse adjectives, the European consumers literally stop buying. In fact they opt for storing cash in their homes as oppose to in their banking institutions. In fact, one person “in the know” from a major German passive component’s manufacturer told me about how the paper factory serving the money printing industry in Europe is operating on triple shifts to get paper to the banks so they can help in liquidating the electronic assets of the continent.

United States: Can’t See Past the Next Quarter:

In the United States, where I am well in tune with the financial institutions on a daily basis on both coasts (and Omaha in between), media is king. The negative adjectives have reached new bounds, as if the correlation between finding a way to communicate bad news is directly proportional to success in the ratings. This constant bombardment of adversity has taken a toll on the best and the brightest in the financial sector, who seem to call me to get calmed, and then proceed with rolling up every bad bit of information they have heard into one long litany of exasperation, punctuated by a few swear words, long sighs and reminiscing about better days. They cannot see the forest for the trees and live quarter-to-quarter. They tend to perk up when I note how their Asian counterparts seem to be in better control of their emotions, and how it is uncontrolled emotion that leads to panic, and panic leads to disaster. I try to quote Eisenhower during the Battle of The Bulge, which tends to put their current quarterly insanity to the test of time, “now is a time of great opportunity.”

Why Passives are Somewhat Insulated:

I was at the Apple Computer store at my local mall yesterday trying to get past all the customers to make a purchase, and just could not get it done. I’ll go back during the week when the buying frenzy there slows down. Not even to mention the amazing reporting results from Apple computer for the third quarter of the calendar year, but also to look at Intel’s reporting as well is reason for optimism in passives, because what is good for Intel is good for passive components. This is not to say that all things are rosy, certainly anything related to credit is in for a rough ride. And yes, it is true that the automotive companies in the United States and Europe have stopped buying parts as have many of the large home appliance manufacturers, but alas this only affects about 15% of the total buying for capacitors, resistors and inductors combined. Credit is becoming all too important and we look to the immediate cash reserves of the top 20 passive component manufacturers and “red flag” those whose cash reserves have dropped below 10% of annual revenues. Still, it is not as bad as one might think, with only four of the 20 at cash reserves below 10% (and with Rohm Company of Japan leading the pack with an astounding 100% of cash to annual revenues. Kudos to AVX and Vishay as well for having large cash reserves- not in marketable securities). Also, the Christmas buying season is upon us, and this usually results in a cyclical bump for the passive component manufacturers worldwide, followed by a first quarter that drops off, so logically, the first quarter of 2009 will be the absolute bottom, and I do not know a financial analyst anywhere who thinks otherwise.

Commodities Prices Impact on EBIT:

I went to the gas station here in North Carolina on my way back from the Apple store, and when I got out to pump my gas I heard such phases as “yeah baby” and “great, just great” coming from other motorists. Fuel prices have dropped by $1,00 per gallon in the past 25 days here in the United States, which is a reflection in the drop in the price of oil per barrel (now at $71.00 USD). This is very good for EBIT margins of passive component manufacturers for two reasons: One is that the “fuel surcharge” which was appearing on many bills of ladling will now go away, but also that mining costs for the raw materials used to make dielectric, resistive and inductive elements are also coming down (fuel can be as much as 40% of the costs to extract ore). So the timing is good as well as most raw material contracts are signed in January of the calendar year, I expect better prices for aluminum, titanium, niobium, nickel, copper, palladium, ruthenium and silver; as well as better prices for polypropylene and polyester film (which are petroleum based products). I still think that tantalum prices will remain high because of impending changes in that supply chain, which are unique to that supply chain. Since engineered raw materials can account for 25% to 60% of the cost of goods sold in passive components, the new contracts should be much better in 2009 then they were in 2008, so this is another reason to be optimistic.

Currency Valuations:

The other somewhat hidden cost factor in cost of goods sold was the rising costs of local currencies in 2008. Many manufacturers of passive components have production plants in low-cost locations such as Brazil, Mexico, Southeast Asia, India and Eastern Europe who made a large percentage of their fixed cost purchases in local currencies. The rising costs of these local currencies to the yen, euro and dollar had a significant impact on EBITs in 2008. The rapid decline in these local currencies in the fourth quarter of 2008 will have a positive impact on cost to produce in CY 2009, which is also positive news for the passive components industry.

Research and Development: The Bright Spot

One thing that I am watching very closely right now is for an increase in spending on research and development over the next six months. Since many passive component manufacturers are shying away from investing in marketable securities because of the volatility of these markets, and the potential for greater upheaval in stocks and mutual funds in the coming months, the logical place to invest money now is back in the business through increased spending on research and development. Spending on R&D offers CFOs a place where they can control spending with a logical return on investment. This one bright spot from all this financial mess may be some new and interesting component products with lower ESR, tighter tolerances, high capacitance values, or integrated passive functionality much sooner then anticipated.

Summary and Conclusion:

In terms of investment strategy, the Asian financial giants have it correct. A 20-year analysis of the passive component industry by component type reveals a constant upward trend in both volume and value, which is the true testament to the continued assured growth of the high tech economy. These upward trends are punctuated by hard times that last for a short time. Also, the current crisis and its impact on the passive component markets is very similar in fact to the Asian financial crisis of 1998. This is a good model for recovery (remember that the financial crisis of 1998 was followed by a huge upturn in demand in late 1999 and 2000, followed by a real deep crisis in the industry in 2001-that is what the reader truly has to look out and plan for). I expect now that there will be massive investments in capacity expansion, especially in China in the short term as savvy companies take advantage of lower costs to invest in capital equipment. Revenue growth will undoubtedly slow overall in 4Q 2008 an 1Q 2009. This will be emphasized by end-markets that depend upon large credit to move end products, such as automotive and large home appliances. Other markets, such as handset, computer and CATV will still grow. EBITs will remain stable or even improve on better commodities prices and more realistic currency valuations. Overall, the best investments now will be counterintuitive to the negative adjectives being touted throughout media outlets. The age-old investment principal of buying when the market is low and selling when it is high is of keen importance now. Also, increased spending on research and development, not only at the passive component houses, but throughout the entire high-tech supply chain is quite logical. Such spending can be controlled and the outcome more is more certain as should money be invested in marketable securities. The majority of the top passive component houses retain large cash reserves that are NOT tied to marketable securities, which is encouraging, and have plenty of cash to weather the current crisis for many months to come (some for many years to come). So there should be no sad faces in the room. Now should be viewed as a time of great opportunity.