Semiconductors and Macro Trends - Interview With Dan Niles (BBY, RIMM, AKAM, AAPL)

Dan Niles, co-chief investment officer at AlphaOne Capital Partners, was nice enough to grant Benzinga an exclusive interview. Dan manages a concentrated, multi-sector long-short equity fund at AlphaOne. In April 2006, the AlphaOne Satori Fund which he managed at Neuberger Berman, was awarded the "Best Newcomer" by MARHedge during the U.S. Performance Awards in New York. Prior to managing money, Dan was a noted Wall Street research analyst. He was named multiple times to Institutional Investor magazine's "All-America Equity Research Team" in the semiconductor and PC hardware/IT hardware categories.

Our conversation was wide-ranging and covered his macro outlook, the European debt situation, the housing market, the semiconductor sector and some specific stocks. Dan is quite bearish and believes that we are headed for a double dip recession. He said the current situation could potentially be analogous to what occurred in the wake of the 1929 stock market crash. During the crash, stock prices declined by 48%. The market then rallied 48% off of the bottom all of the way back to around 22% below its all-time high. Over the next two years, the market then proceeded to decline 80% from those levels. These events bear some resemblance to what we have seen in the last couple of years.

The S&P 500 hit all-time highs in October of 2007, before falling 57% to the lows of March 2009 and then rebounding 80%, which put the index within 22% of its peak. This is quite similar to the rally that occurred after the crash of 1929 and preceded another large decline in the stock market. While not necessarily predicting a decline of this magnitude, Dan said, "we are going to see how bad this gets."

This interview is also available as an episode of the Benzinga Podcast

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Q: Dan, we saw you on CNBC's Fast Money recently and you were bearish on the semiconductor space as well as some of the macro trends in general. Could you outline your thesis on semiconductors and then talk a little bit about your macro outlook?

A: I would like to reverse the questions. It is really the macro that is driving into the semiconductor complex. Semiconductors are a very ramped up reflection of whatever is going on at the macro level. If the macro picture is getting worse, semis will collapse and if it is getting better, they will explode to the upside. Where we are today is sort of the culmination of things that we have been going through since the late 90s. If you go back to 1998, there was the Asian currency crisis. The Federal Reserve cut rates and that enabled companies to take out a lot of debt, specifically in the telecom sector.

You had companies taking out over $10 billion in debt and then promptly going bankrupt. When the tech bubble burst in 2000, the Fed went ahead and cut rates again. When they cut rates this time, policy makers encouraged people to go out and buy houses, thereby increasing the consumer's burden of the debt load. When consumers ran out of their ability to borrow and the housing market rolled over, governments around the globe stepped in and said "ok, we will take on the debt." In order to stem the financial crisis, and make up for the lack of consumer spending, governments have run up huge debts and spent money that they don't have. What you are seeing today with the headlines out of Europe is that as governments run out of the ability to borrow money, who is going to take on their debt? The answer is nobody. The government is the last resort. The issue today is that unlike the past year where you have had nothing but stimulus pumped into global economies, now you are having the capital markets enforce discipline on governments who spent money that they don't have.

This is similar to what happened to telecom companies such as Global Crossing back in the 2000 period and consumers who shouldn't have been buying homes and were burned by the housing collapse. Now if you look at the size of some of these European countries individually, they may not seem that big. For example, Portugal is the 37th largest country in terms of GDP. But if you look at the PIIGS in total, which is Portugal, Italy, Ireland, Greece and Spain, they make up about 7.6% of global GDP. China, to put it in perspective is about 8.6%, so they are not that far behind. Put another way, if the PIIGS were one country they would be the fourth largest in terms of GDP. The 27 countries that make up the European Union account for about 28% of global GDP. The United States is about 25%. Europe has now gone from spending money that they don't have in order to stimulate their economies, to implementing austerity measures. On top of that, the cost for them to borrow money has now gone up. That is an awfully big weight that needs to be dealt with. It is also bringing up some questions in the U.S. about how long we can continue to spend one and a half trillion dollars a year that we don't have. These are the issues we are facing from a big picture macro perspective.

The second part of the question was what do I think of semiconductors? IT spending is highly correlated to GDP growth. If you see that pulling back, it is natural to expect that you will see some signs of slowing. Best Buy BBY reported its quarter not too long ago. The issue is when you look at the numbers, out of the five segments that they have, four out of five decelerated from February year/year to May year/year. Within that, we are focused on the electronics category because that is a big driver of semiconductor demand. In November of 2009 that segment grew at 8% on a year over year basis.

In February 2010 it grew at 4% and in May it was flat. In addition, days of inventories were at 71 days which is the highest in 7 years. This leads me to believe that business slowed in the quarter. If consumer electronics slowed, whether it is PCs or handsets, etc., semiconductor demand will begin to deteriorate as well. Most of these semiconductor companies are saying that demand is great and that they are feeling very good about business. The problem is that semiconductor companies, in a lot of ways, are the last companies to see the slowdown. What happens is, Best Buy BBY maybe does not sell as many cell phones. Then maybe the cell phone manufacturer has an issue of its own.

Then that company's management sits down and realizes that they don't need as many chips as they originally thought because they don't need to build as many phones. It is a food chain effect. It always takes the semiconductor companies a lot longer to see these issues. I think that you have to link the food chain all the way from what is going on in Europe with their debt problems down to end demand at a Best Buy or Nokia NOK and then to what semiconductor companies may potentially see three to six months from now.

Q: You were named to Institutional Investor's "All-America Equity Research Team" in the semiconductor and PC hardware/IT hardware categories. Can you give us some insight on what the analysts who are bullish on technology in general and semiconductors specifically are focusing on and where maybe they have it wrong?

A: The easy way to think about it is the following. If you are following semiconductors you are two steps removed potentially from the end-market consumer. Lets say that a cell phone manufacturer is having trouble selling their phones. The distributors may see it first or a Best Buy may see it first. Then they are going to turn around and tell the phone manufacturer that they don't need as many phones. Orders change all of the time, so it is nothing to get that concerned about. It could be a couple of months before the phone or PC manufacturer hears that sales are slowing down and distributors don't need as much stuff.

Then it may take the manufacturer a month or two to realize that a trend is developing with regard to lower demand for devices. It is at this point that the manufacturer turns around and cancels orders with the semiconductor companies. This time lag has been exacerbated because for the last year, semiconductor companies have not been able to supply as many chips as their customers want. So, the customers have been doing something called double ordering. They have been ordering twice as much stuff as they actually need. They aren't going to cut back until they are absolutely certain that their suppliers can give them everything that they want.

So the lag that you would normally see between, lets say a Nokia having issues, and them turning around and telling their suppliers that they don't need as many parts is going to be a little longer because Nokia wants to be certain that they can get things exactly when they need them. It is always very difficult for analysts to go out and say "the company is saying everything is wonderful, but based on what we are seeing this is what we think is going to happen three to six months from now." It's much easier for an analyst to say, "I just talked to the company and business sounds great."

Q: I don't think any conversation about technology is complete without talking about Apple AAPL. You are long Apple shares. Do you view this just as a company specific story given your general bearishness on the sector?

A: I think it really is. Apple is a type of stock that I don't like to like. Everyone seems to like Apple. It's not that controversial, unlike the semiconductor sector. The reason I think Apple is interesting, however, is fairly simple. About 1.3 billion phones are expected to be sold this year. Apple expects to sell about 40 million phones. Forty million is obviously a very small number, its roughly 3% or so, of the 1.3 billion total estimated phone sales. There is still a lot of market share up for grabs. This is particularly true as people shift to smartphones which have multifunctional uses. Furthermore, the iPhone is really setting the standard in the smartphone segment. The PC market reveals a similar situation. This year we think that 13 million Macs will be sold versus estimates of 370 million PCs that are going to be sold. Again, Apple still has a very small market share and there is significant room for it to grow. In addition, an argument could also be made that they have created an entirely new category to some extent with the iPad.

This is not a full transcript. In order to hear Dan's take on companies such as Research in Motion RIMM, Akamai Technologies AKAM, and Netflix NFLX be sure to check out the podcast. He also elaborated on where he thinks the economy is headed (think double dip) as well as the markets (much lower). His views are highly recommended and offer an extremely cogent counterpoint to the perma-bull, sell-side analysts on Wall Street. For investors who are looking for candor and honesty in these uncertain times, listening to this interview is a must.

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