The trade conflict between the U.S. and China seems to intensify a little more each day. After announcing tariffs would go into effect on July 6, China threatened to impose its own tariffs on a number of U.S. exports, to which President Trump responded by saying he would just add to the list; in fact just two days ago he directed the U.S. Trade Representative to prepare new tariffs on $200 billion in Chinese imports – more than five times the $36 billion that are scheduled to go into effect next month. Not surprisingly, China is promising to follow suit. And so the cycle continues.
Digging into the tariffs that are scheduled to go into effect next month shows that the Trump administration isn’t differentiating between “native technology” – what might have been designed and manufactured in China – and what might be designed by U.S. firms, but who have then outsourced production to Chinese factories. That means that a number of U.S. companies are liable to get hit with tariffs from their own government as Trump tries to tighten down on what it has long alleged to be runaway intellectual property theft.
The Trump administration has even begun using more and more incendiary language in its descriptions of the issue. Secretary of State Mike Pompeo called China’s claims of globalization and openness “a joke” and pointed to one of the core arguments for U.S. actions, which relates to intellectual property theft. “Everybody knows China is the main perpetrator,” he said. “It’s an unprecedented level of larceny.” So much for diplomacy-speak!
The intellectual property question is a thorny one, since the U.S. alleges that China has benefitted from decades of co-opting, and even simply copying, U.S. technology. At the same time, some of the biggest companies in the technology sector, including semiconductor manufacturers such as Intel (INTC), Texas Instruments (TXN), and Nvidia (NVDA) have long outsourced fabrication and production of their designs to China. The question also effects companies that provide the capital equipment to produce semiconductor chips like Applied Materials (AMAT) and Lam Research (LAM), who rely on China for a major portion of their revenue.
AMAT and LAM, in particular have seen their stock prices each tumble more that 20% since the beginning of March, when tariffs were first announced. And while that kind of price decline could prompt a bargain-hunting investor to start thinking about making an investment in U.S. companies with terrific fundamentals, this is also a case where geopolitical issues could continue to cast a cloud over these companies for the foreseeable future.
Applied Materials Inc. (AMAT)
Current Price: $48.58
As of the company’s last earnings report, China accounted for approximately 25% of AMAT’s $4.57 billion in revenue for the quarter. The company also forecast lower revenue for the upcoming quarter that was below the market’s expectations. While management attributed most of the downbeat forecast to a slowing smartphone market, which prompted semiconductor companies worldwide to spend less on capital equipment, and mostly downplayed China’s impact on their business, the truth is that a long-term environment of 25% tariffs on Chinese imports, along with likely additional Trump-imposed controls on U.S. exports of sensitive technologies to that country, could dampen their prospects even further.
The stock hit an all-time high in early March at $61.61 before retreating to its current levels. It’s price activity since that point is also following a classic downward stair-step technical pattern that any technical trader would refer to as a downward trend. That trend is now moving well into its third month and is threatening to push below support around $45 from a low point last seen in January of this year. A break below that point would likely see the stock push even lower, past its 52-week low at around $42.
While most of the stock’s basic fundamental measurements, like earnings growth, Return on Equity (ROE), and Debt/Equity, are very attractive, diving into the stock’s price ratios to evaluate its value status raises additional red flags. The stock is currently trading almost 42% above its historical Price/Book ratio, and its actual Book Value has declined in each of the last three quarters. A continued drop to par with its historical average Price/Book ratio would put the stock just a little above $28 per share – far below the technical risks I pointed out in the last paragraph.
Lam Research Corporation (LAM)
Current Price: $174.54
LAM could be at even more risk to exposure from China tariffs that AMAT. Their latest earnings report indicates that just 13% of all revenues in the quarter came from the United States and Europe, while Asia accounted for the rest. China itself isn’t even LAM’s largest market – that would be Korea – but even so revenues from China accounted for 17% of their total revenue, easily above the total for the U.S. and Europe combined. And we shouldn’t ignore the reality that increasing tariff costs on Chinese imports could have a residual, “rising tide lifts all boats” effect on other countries in the region that could dampen LAM’s business in a significant way. This is on top of what LAM themselves referred to as “increasing competitive risks” from China in late 2017 that they admitted they might not be able to overcome.
Like AMAT, LAM’s shares hit an all-time high at nearly $230 in early March before trade war rumors began to weigh on its price. The stock is down more than 24% from that point, and has lost about half of that amount since the beginning of June. It also still has about $10 to go before it is likely to find its next critical support level around $161 per share.
Also likes its counterpart, AMAT, LAM’s fundamentals are generally very strong. Cash flow has been strong, with the company holding more than 4x more cash and liquid assets than long-term debt. ROE is excellent and debt is low. Those are excellent measurements that imply the company can weather a downturn in its business that might result from increased tariffs quite well. The risk for an investor, however is how the market might treat that downturn. The stock is currently trading more than 33% above its historical Price/Book ratio. The stock would be worth only about $116 per share if it were to drop to par with that historical average, implying a very high level of downside risk compared to upside potential.