A well-rounded look at the state of the semiconductor industry as a component of technology investing from Chris Moshy, Senior Vice President of Equity Research.
September 30, 2022
If the classic 1967 film “The Graduate” was re-made today, the sage advice Dustin Hoffman’s character Benjamin Braddock received from a family friend would be undoubtedly updated to: “I’ve got one word for you, Benjamin: semiconductors.”
While plastics(1) are no doubt ubiquitous in today’s economy, the world could not function without semiconductors: small silicon-etched(2) integrated circuits found in everything from laptops and kitchen appliances to smartphones and self-driving vehicles. Undeniably, and for better or worse, innovation, product cycles, and device proliferation of all kinds are inexorably driving semiconductors deeper into the infrastructure of our daily life.
Think about the feature set of today’s vehicles—lane departure warning, blind spot detection, GPS mapping, adaptive cruise control, and performance-tuned engines—all semiconductor enabled. Electric vehicles are really supercharged computers with microchip-laden battery systems and software on wheels. The smartphone you may be using to read this operates primarily on semiconductors with its bright OLED(3) foldable screen, powerful digital camera, a super speedy and cool-running CPU, plenty of fast-swapping memory to manage and store apps, and is web-connected via a cell signal using a 5G millimeter-wave chipset. Yikes! Where’s my rotary phone?
The comprehensive nature of the semiconductor industry underscores why we strongly believe the group is an integral component of a technology investment strategy. It is also an industry defined by rapid innovation, brutal competition, significant capital investments, and, as the current environment reminds us, one subject to substantial cyclicality.
By many measures the current business cycle for semiconductors has peaked and the retrenchment in stock prices has been painful. Over the past 12 months ending September 2022, the Philadelphia Semiconductor Index (SOX), a broad industry performance measure, is down 29.3% versus the S&P 500 Index, down 17.7%. On a ten-year basis, however, the SOX Index gained 528% vs the S&P500 at 153%; and a 20-year comparison shows the SOX Index up 682% vs S&P500 less than half that at 304%.(4)
The semiconductor industry is still expected to grow mid-single digits this year, and current estimates for 2023 reflect low-single digit declines in global semiconductor revenues. This is down from the 26% growth enjoyed in 2021.(5) After several years of above-trend demand, particularly in consumer durables during the pandemic, many end markets are now faced with excess customer inventories and buyers retracing their steps. PCs and smartphones sales have contracted meaningfully in 2022, as have other consumer products such as appliances, leisure equipment, and entertainment hardware. Even in areas showing good demand, think of the auto sector, component order rates are slowing as inventories fill up and the outlook for the global economy darkens.
Whether this downturn in the semiconductor sector will be short and shallow or more protracted is actively analyzed in the markets. Our current view is it will be early- to mid-2023 before visibility improves and industry recovery begins, but stock prices often anticipate a business upturn by a quarter or more. The depth and breadth of an economic recession of course will impact that forecast.
There are other issues at work that impact both the current business cycle and the long-term supply challenges. Some may be surprised to learn that many of the most recognizable consumer products in the world are dependent on very few regional suppliers. This includes the most advanced semiconductors and sophisticated electronic components that are at the core of flagship products. As Apple Inc. states in its annual 10k filing, “Substantially all the Company’s hardware products are manufactured by outsourcing partners that are located primarily in Asia… A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners often in single locations.” This concentrated supplier risk is not limited to Apple; many leading semiconductor and consumer device companies(6) rely on the same narrow supplier channels for product manufacturing and assembly.
Recent supply chain disruptions, capricious government closures of regional manufacturing hubs, and China’s increasingly menacing posture towards Taiwan has brought the issue front and center for business executives and members of Congress alike. Interestingly, Eastern Europe’s unrest and Western Europe’s unpredictable energy supply and expensive workforce makes the U.S. the location of choice for future semiconductor capacity additions. Of course, the effort will greatly benefit from the CHIPS Act, a bill signed into law this past summer that provides grants and tax breaks to companies building semiconductor manufacturing plants in the U.S. The CHIPS Act helps a select set of companies finance capacity expansions to build semiconductor facilities for their own operations or to provide outsourced fabrication services for others.
The CHIPS Act does limit companies from using funds to pay dividends or for share repurchases. Yet, it also improves the flexibility for companies to make capacity investments while maintaining capital return programs for shareholders—even during an industry downturn. In today’s environment, semiconductor companies are aware of the industry’s cyclicality and have learned to budget capacity growth based on demand forecasts and cost targets rather than the availability of capital. Understandably, with so much new investment capital and incentives entering the industry in coming years, it will be important to monitor the impact on industry supply discipline including the growth of outsourced capacity in the U.S.
Lastly, the rise of export restrictions on key technologies to China is a growing concern for companies and investors. Chinese firms are among the largest buyers of U.S. technology, including semiconductors, components, and fabrication equipment. Currently, most U.S. technology sales to China are considered “lagging” or “legacy” products and equipment, but still amount to 20%+ of sales for many companies, while sales of leading-edge products that tend to be restricted are in the low single digits. Without better policies around technology transfer, continued export restrictions will limit the long-run potential of the region’s growth for U.S. companies.
This year has not been easy for technology investors and, once again, the semiconductor industry has proven its cyclicality. While we expect some pressure on business fundamentals through year-end, we are on the offensive for investments, including in the semiconductor ecosystem. It’s an industry in which the most innovative and competitive companies are generally rewarded by successively higher revenues, profits, and stock prices with each business cycle. The industry is well-capitalized, and the CHIPS Act ensures continued growth investments in its manufacturing base. Market leaders in the technology industry can shift surprisingly quickly from cycle to cycle so investing in the sector requires attention (and patience), but the fascinating and rewarding opportunities justify the effort.
1 The original piece of advice to Benjamin Braddock!
2 Germanium substrate is also common, and the latest generation chip designs incorporate gallium arsenide substrates
3 Organic light emitting diode
4 Philadelphia Semiconductor Index; SPDR 500 ETF; Bloomberg LP
5 Gartner Forecasts Worldwide Semiconductor Revenue Growth
6 Qualcomm, Inc., AMD Corp., Nvidia Corp., Microsoft, Inc. and many other operate under similar “fab-less” manufacturing models