Semiconductor supply limitations are unfolding mostly as S&P Global Ratings expected--supply is getting better, somewhat hampered by China's lockdowns and inflation. Information technology (IT) spending is slated to continue through 2022, as growth in the cloud accelerates, enterprise spending increases, and the 5G smartphone market keeps expanding along with its necessary infrastructure. Nevertheless, this positive landscape could be disrupted by various macroeconomic risks including inflation, fallout from the Russia-Ukraine conflict, COVID-related lockdowns in China, and rising interest rates, leading to some negative rating actions and outlook revisions in the U.S. tech industry. Tech issuers in the lower rating categories are most vulnerable to downgrades this year.

Semiconductor Supply Improving, Curbed By China's Lockdowns, Inflation

We believe the industry is past peak constraint, but supply remains tight, and balance won't return to the hardest hit markets until 2023 at the earliest. Smartphone chips are currently accessible because of good planning between phone makers and foundries, and personal computer (PC) and consumer electronic markets may already be in harmony because of waning demand. Supply for markets that require less advanced chips, like automotive and industrial, are still significantly taut because these chip suppliers are reluctant to significantly increase capacity for fear that new capacity might be idle after demand abates. Rising IT spending, which we expect to continue in 2022, is underpinned by accelerating growth in the cloud, improved enterprise spending, and the ongoing ramp-up of 5G smartphones and related infrastructure. However, macroeconomic risks--such as inflation, shocks to energy and other global markets from the Russia-Ukraine conflict, COVID-related lockdowns in China, and rising interest rates--could disrupt the positive environment we envisioned coming out of last quarter's earnings and worsen the creditworthiness of weaker borrowers. Together, these factors could lead to a negative bias for rating actions in 2022. We find the lower-rated tech issuers to be the most vulnerable to downgrade pressure because of their weaker business fundamentals, more leveraged balance sheets, and low free operating cash flow generation, which rising interest rates will erode.

China Breeds Uncertainty

We think the impact from China's COVID-related lockdowns is more a demand phenomenon than a supply one. Semiconductor makers cite China's mandated restrictions as incrementally negative to their operations and only temporary. Assembly operations are mostly back-up and running with lost production measured in weeks, rather than months. Almost all of Apple Inc.'s final assembly in Shanghai has restarted. However, we believe lockdowns will hurt consumer demand in China this year in categories like smartphones. For instance, Texas Instruments Inc. said that China's restrictions would weigh on second quarter revenues because customers' buying power there has been limited by the lockdowns and due to logistical challenges like shipping, rather than its own production.

Inflation Adds To Angst

Inflation is also starting to hurt tech companies' performance. We downgraded NCR Corp. following a large hit to EBITDA in the first quarter. The company reported a $75 million impact on EBITDA, with $38 million stemming from inflation, $23 million from COVID-related fallout, and the remainder due to the Russia-Ukraine conflict and interest rates. The company explained it paid $2,900 for some chips that were selling for $41 in the second half of last year, and $114 for power chips that were going for $0.42. We think other companies with large price-committed backlogs with low gross margins and high variable costs could face similar results due to less cost flexibility and lower capacity to absorb rising costs. We'll be monitoring upcoming earnings reports from Cisco Systems Inc., Dell Technologies Inc., Hewlett Packard Enterprise Co., and HP Inc. to determine if NCR is a one-off or the start of a broader trend.

End Markets Are Diverging

Consumer, Computer Markets Are Weakening

Consumer electronics is a weaker market today due to demand pull-forwards over the past couple years. In other words, consumers accelerated the purchase of new electronic devices and aren't likely to replace them any time soon. Consumers are now rotating more spending into services as in-person experiences have reopened, easing demand for goods. Computer demand is weaker, particularly for Chromebooks, because consumer spending for work- and learn-from-home has run its course, although enterprise PC demand is holding steady for now.

Data Center, Auto, Industrial Markets Are Strengthening

Robust hyperscale data center spending is supporting the data center market and we expect it to accelerate in the second half of this year. The public cloud businesses of Microsoft Corp., Google LLC, and Amazon.com Inc. continue growing in the 30%-50% range, which requires significant capital expenditures (capex) just to keep pace with demand. Meta Platforms Inc., better known as Facebook, is sticking with its capex guidance range, which calls for near-70% growth at the midpoint.

The 5G rollout and new flagship smartphone models boosted the smartphone market, although demand weakness in China is partly offsetting gains. Supply in the automotive and industrial markets remains highly constrained so semiconductor suppliers have solid pricing power and there's no end in sight as large backlogs continue to build. Enterprise demand in the second half of the year is questionable--if companies tighten information technology (IT) spending in response to a weakening economy, the solid demand tech companies have enjoyed for the past two years could begin to wane.

Rising Interest Rates Create A New Risk For LBOs

In a recent report, we concluded that despite higher financing costs, holding all else equal, many low-rated issuers shouldn't have trouble meeting their debt service obligations or are unlikely to breach their downgrade triggers over the next two years (see "Macroeconomic Uncertainties Matter More Than Rising Interest Rates To Low-Rated U.S. Tech," March 29, 2022). We identified the five most vulnerable companies in danger of their cash flows approaching breakeven. We based this on an expected 150 basis point (bps) increase in 2022 and a 125 bps increase in 2023. Since then, the Fed has mounted a more aggressive tightening campaign that we expected. We now expect two 50 bps increases at the May and June meetings, and possibly another in July. So much of the increase we anticipated across two years will happen in 2022. And should the Fed exceed our expectations again in 2023 and move rates to the 4%-5% range that former U.S. Treasury Secretary Larry Summers suggested might be necessary to contain inflation, we would anticipate low-rated issuers to focus even more on buttressing their liquidity positions. We would also expect their financial-sponsor owners to provide additional support to mitigate rising default risk due to increased debt costs on otherwise healthy businesses.

The Russia-Ukraine Conflict Isn't Hurting U.S. Tech Sales, Supply Much

Conflict in Eastern Europe isn't having much topline impact for most companies. The headwind of no longer selling to Russia will be about 1.5% for Apple, less than 1% for Microsoft, and 0.5% for IBM. According to International Data Corp., IT spending totaled about $52 billion in Russia and $5 billion in Ukraine, accounting for 1% of the worldwide total. The impact on supply is also muted. The most significant issue is availability of neon gas, which is used in the lithography processes in semiconductor manufacturing. Fifty percent of global semiconductor-grade neon comes from Ukraine and has been shut down. The 2014 Russian invasion of Crimea caused neon prices to temporarily increase 600%, after which the semiconductor industry diversified its neon sources, carried more inventory, and found ways to recycle neon gas in the chip-making process. The surge in price is less concerning because neon gas is a very small expense that the industry can easily absorb.

We believe semi makers have neon gas inventories for several months and they're working to secure new sources. Given that neon is a byproduct of steel production, we expect additional capacity to come from China and other countries, which would help avoid stoppages in the semi production process. TSMC Global Ltd. and Micron Technology Inc. said they don't expect disruption to their production because of neon scarcity. (For more details on our view of the impact of the Russia-Ukraine conflict, see "Macroeconomic Uncertainties Matter More Than Rising Interest Rates To Low-Rated U.S. Tech," published March 17, 2022.)

Macro Downturn, Rising Rates Could Turn Rating Bias Negative

Rising IT spending, which we expect to continue in 2022, is underpinned by accelerating growth in the cloud, improved enterprise spending, and the ongoing ramp-up of 5G smartphones and related infrastructure. However, macroeconomic risks--such as inflation, shocks to energy and other global markets from the Russia-Ukraine conflict, COVID-related lockdowns in China, and rising interest rates--could disrupt the positive environment we envisioned coming out of last quarter's earnings and worsen the creditworthiness of weaker borrowers. Together, these factors could lead to a negative bias for rating actions in 2022. We find the lower-rated tech issuers to be the most vulnerable to downgrade pressure because of their weaker business fundamentals, more leveraged balance sheets, and low free operating cash flow generation, which rising interest rates will erode.

Related Resources

• Macroeconomic Uncertainties Matter More Than Rising Interest Rates To Low-Rated U.S. Tech, March 29, 2022
• Impact On Tech From Russia-Ukraine Conflict Muted For Now, With Risk Of A Further Macroeconomic Slowdown, March 17, 22

This report does not constitute a rating action.