What will chip makers say about the trade war?

Chip-company executives will to have to address an elephant in the room on conference calls this earnings season as the industry grapples with growing trade tensions with one of its largest customers, China.

Last week, the White House threatened to slap tariffs on another $200 billion in goods imported from China if the country retaliated for U.S. tariffs already levied. So far, China has held off on imposing retaliatory tariffs on U.S. tech products, but those products, which are so important to China’s own tech industry, will likely get included if the country seeks dollar-for-dollar retaliation.

China, however, has demonstrated other tactics against U.S. chip makers. Earlier in the month, Micron Technology Inc.’s MU, +1.44% stock weakened and then rebounded after a Chinese court blocked the sale of certain memory chips in a patent dispute that Cowen analyst Karl Ackerman said “appears inextricably linked to the U.S. and China trade war.”

Read: Trade war, tariffs and inflation will be the big worries this earnings season

While Micron said the injunction will have a fractional effect on sales, any escalation of the trade war carries consequences for the Boise, Idaho-based chip maker, which derives about half its sales from China. Overall, China accounts for about a quarter of global memory-chip sales, which leaves many questions for chip makers as we enter tech’s earnings season.

“If not for the current uncertainty related to an escalating China trade war, we would look to be aggressive buyers of semiconductor stocks on the recent pullback,” said Evercore ISI analyst C.J. Muse, who believes a lot of potential tariff anxiety is already baked into chip shares.

At the end of the June quarter, the PHLX Semiconductor Index SOX, +1.47% logged its first losing quarter in nearly three years. While still up 8% for the year, the chip index had been up more than 16% on the year back in March. In comparison, the S&P 500 index SPX, +0.40% is up 5.1% for the year, while the tech-heavy Nasdaq Composite Index COMP, +0.63% is up 13.8%.

Don’t miss: What will chip makers say about the trade war?

“So this earnings season will likely be volatile and calling the near-term is quite difficult,” Muse said.

Earnings season for chip makers ramps up July 25 after the closing bell, when Advanced Micro Devices Inc. AMD, +1.75% is scheduled to report, followed by Intel Corp. INTC, -0.50% the next afternoon. On average, tech companies on the S&P 500 were expected to post 20.9% quarterly earnings growth year-over-year heading into this quarter’s results, with chip maker earnings to grow 27.5%, according to FactSet.

Going into earnings season, Muse favors shares of Micron, Nvidia Corp. NVDA, +2.21% Marvell Technology Group Ltd. MRVL, +2.60% and Analog Devices Inc. ADI, +0.63% while downgrading shares of Intel to an in-line rating now that he believes investors are fairly appraising the chip maker’s data-center business and on uncertainty following the departure of Chief Executive Brian Krzanich along with growing competition from Nvidia and AMD.

In the meantime, China appears determined to wean its reliance upon foreign chip suppliers by building up its own fabs. While South Korea, home to Samsung Electronics Co. 005930, +2.84% and SK Hynix Inc. 000660, +2.48% remains the largest buyer of chip-making equipment, the chip trade association SEMI forecast that China will overtake Korea as the largest market in 2019, accounting for an estimated $17.32 billion in sales. Taiwan is forecast to be in third place with $12.3 billion in sales. Many analysts, however, see China’s self-sufficiency for chip needs as being years away.

“Semis remain at the heart of the U.S. and China trade war, as China’s aspirations to acquire global intellectual property and expand indigenous semiconductor production from 10% today to 70% by 2025 has been met with heavy resistance from [the Committee on Foreign Investment in the U.S.],” Cowen’s Ackerman wrote in a note.

“A $160B treasure trove of China state-backed investment funds is now squarely focused on building the country’s IP in the memory market given China must import all of its ~$40B in memory chip demand, and we track ~$90B of capex investment across 6 indigenous memory fabs,” according to Ackerman.

Should China start targeting U.S. chip makers with tariffs, it would be harming itself, according to Cowen analyst Matthew Ramsay. The analyst covers Nvidia, Intel, Qualcomm Inc. QCOM, +0.96% and Broadcom Inc. AVGO, +2.49% which have between 15% and 30% market exposure to China.

“Despite the high exposure for nearly all of our coverage universe into China, we believe in digital and analog semiconductors Chinese buyers have essentially zero sources of competitive domestic supply — at least in the medium term — and a full non-compromised trade war between the U.S. and China would irreparably damage global competitiveness for several important Chinese tech giants (smartphone, wireless infrastructure and cloud vendors in particular) that rely often on single or dual-sourced critical semiconductor components from U.S. suppliers,” Ramsay said.

While tech products have been left off China’s list of retaliatory tariffs so far, if a trade war with China escalates to the point where tech companies become pawns, those companies with high domestic assets are better positioned than those with low domestic assets, UBS strategist Keith Parker said in a recent note.

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Among the high domestic asset chip-related companies cited by UBS were Nvidia, Applied Materials Inc. AMAT, +2.14% Cirrus Logic Inc. CRUS, +1.08% KLA-Tencor Corp. KLAC, +1.66% Lam Research Corp. LRCX, +3.17% MKS Instruments Inc. MKSI, +2.85% Silicon Laboratories Inc. SLAB, +2.13% Teradyne Inc. TER, +1.23% and Xilinx Inc. XLNX, +0.78% Low domestic-asset chip companies include Micron, Broadcom, Monolithic Power Systems Inc. MPWR, +1.19% and Skyworks Solutions Inc. SWKS, +1.93% Parker said.

Also, if Trump imposes further tariffs, China may start responding by devaluing its currency, and if that happens, U.S. chip and tech hardware companies lead the list of those who will feel the pain.

“If the Trump administration imposes another ~$200-400bn in tariffs on Chinese goods, then China may need to shift from retaliating with tariffs to pressuring U.S. multinationals with China exposure,” Parker said. “Additionally, those stocks would be impacted by further FX moves, as the fall in CNY has been a headwind.”

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