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My view on what's going on in the financial markets and the global economy, and a few other things that might interest me from time to time.

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  • Writer's picturetim@emorningcoffee.com

Revisiting semi-conductors

Given the recent meteoric increase in many semi-conductor (“chip”) companies’ share prices – and ahead of earnings from the most iconic and well-known chip designer NVIDIA tomorrow after the close – now is a good time to revisit this high growth sector.  

 

“Chip War”: read for context

If you are unfamiliar with the semi-conductor sector, I would strongly encourage you to read the book “Chip War: The Fight for the World’s Most Critical Technology” by Chris Miller.  The book provides an excellent background of the evolution and growth of the semi-conductor business, as well as the role of many of the companies that are involved in various stages of the value-chain, including the design of chips, the manufacture of complex chip-making machinery, and the manufacture of the semi-conductors themselves.


How the semi-conductor value-chain works

Although loads of investors have piled into stocks of semi-conductor companies, I suspect that fewer really understand the business and its key drivers.  In fact, many investors seem to lump all chip companies together which – as you will find out shortly – is incorrect.  Many chip companies are involved in only one stage of semi-conductor production process.

 

  • Semi-conductor designers do not manufacture chips but rather are involved solely in the design and sale of chips.  The manufacturing process, or “fabrication”,  is outsourced.  Designing semi-conductors is a complex process and involves the design of state-of-the-art, value-added chips, including those used in gaming, mobile phones, and artificial intelligence.   Also known as “fabless manufacturers”, these companies include the likes of NVIDIA, Qualcomm, Broadcom, AMD and ARM

  • Semi-conductor manufacturers, also referred to as foundries, do not design chips, but rather own the manufacturing facilities and machinery necessary to make semi-conductors.  The capital investment necessary to build a foundry is huge, $3 billion or more according to one article I read, meaning that only a few elite such companies exist in the world.  A foundry must have the precision machinery and expertise to manufacture complex, state-of-the-art chips.  The most well-known foundry is TSMC (Taiwan-based), which is estimated to have a market share of 54% (source: visioncapitalist.com), but others include Samsung (S Korea, not a “pure play”), UMC (Taiwan), GlobalFoundries (US) and SMIC (China).  The estimated 87% of global semi-conductor manufacturing located in east Asia has increasingly put these companies in the spotlight politically, especially for countries that have limited or no manufacturing capabilities on-shore to make the latest-generation chips. 

  • Semi-conductor machinery companies make the amazingly complex machinery used by foundries to manufacture chips.  The process of making semi-conductors involves precision machinery including lasers.  Keep in mind that as chips get smaller and smaller, the components of such chips are getting smaller, too, and require unimaginable complexity and precision to produce.  Companies involved in this facet of the semi-conductor manufacturing business include ASML and Applied Materials.  ASML manufactures the precision laser machines, known as lithography equipment, needed to produce semi-conductors.  The company is essentially a global monopoly, and if you want to learn more, check out their website here.

  • Integrated device manufacturers (IDMs) are companies that both design and manufacture their own chips., including Intel, Texas Instruments, Micron Technology and Samsung, among many others.  This model seems less efficient these days, at least when measured by some of these companies’ recent share price performance.

 

Geopolitical concerns and the Chips Act

The combination of the pandemic and the “rise of China” has led to more and more countries wanting to develop on-shore semi-conductor manufacturing capabilities, recognising that supply-chain disruptions caused significant disruptions during the early stage of the pandemic since most chips are manufactured in east Asia, specifically in Taiwan and South Korea.  For the west, there is also the desire to stay one step ahead of China, recognising the growing importance of AI for all sorts of commercial applications, but also for defence.

 

In August 2022, President Biden signed into law the “CHIPS and Science Act of 2022”.  The extract from the Act below best summarises the focus of the $50 billion or so dedicated to essentially (re)on-shoring US semi-conductor manufacturing:

 

“The CHIPS and Science Act will boost American semiconductor research, development, and production, ensuring U.S. leadership in the technology that forms the foundation of everything from automobiles to household appliances to defense systems. America invented the semiconductor, but today produces about 10 percent of the world’s supply—and none of the most advanced chips. Instead, we rely on East Asia for 75 percent of global production. The CHIPS and Science Act will unlock hundreds of billions more in private sector semiconductor investment across the country, including production essential to national defense and critical sectors.”

 

In fact, the package of subsides and incentives seems to have been well-received, but as a recent article in The Economist pointed out (link here for subscribers to The Economist), for a variety of reasons fabrication plants are much more expensive to build and operate in the US (compared to east Asia), making the long-term viability of investing in these facilities on US soil not a straight-forward call. 

 

How has the semi-conductor sector overall performed?

The semi-conductor sub-sector is part of the GICS “information technology” sector.  There are several ETFs that track the performance of the information technology index broadly, as well as that of the semi-conductor sub-sector index.  With the aura around artificial intelligence, investors might forget at times about the inherent cyclicality of the sector, which is closely correlated with the economy overall.

 

Two ETFs I researched are the Vanguard Information Technology ETF (VGT) and the iShares Semiconductor ETF (SOXX).  Both are passively managed to track the performance of the index for the relevant sector: VGT tracks information technology (including semi-conductor companies), and SOXX tracks semi-conductor companies only.  You can find some of the metrics of both ETFs in the table below.


Both VGT and SOXX have significantly outperformed the S&P 500 over time as the table illustrates.

 

How have individual semi-conductor company stocks performed?

Below is a table of semi-conductor companies.  Size and valuation metrics are in the middle of the table, and the performance of the companies’ shares since the end of 2022 and the end of 2023 (i.e. YtD2024) are in the right-most columns. (For reference, I used prices at 10am today (Feb 20th) to calculate returns given market and sector weakness.)



 You can draw your own conclusions with respect to this table, although it seems relatively clear that IDMs like INTC and MU have recently experienced the most challenges.  This is certainly the catalyst behind periodic discussions about these companies becoming more pure-play chip design companies, forgoing their forging capabilities altogether.  Also, to put the valuation metrics in context requires a deeper dive into the actual businesses of these companies, with some designers on the cutting edge of technologies like AI and others in more mundane types of semi-conductors like those used for appliances and automobiles.  The growth trajectory of the top and bottom lines of these companies varies widely, and the growth has also varied significantly over time based on a combination of the evolution of disruptive technologies requiring advanced chip designs and overall economic conditions.

 

NVDA earnings

It would not be right to end this article without taking a look at NVIDA’s 4Q24 earnings, which will be released after the bell on Wednesday.  The table below provides some context as to what the analysts community is expecting, and I have also included the expectations from earningswhispers.com.



Needless to say, NVDA will need to deliver on the lofty expectations given the amazing performance of the stock over the last year and its current rich valuation.  The company has been in this position before, and with only a few exceptions (4Q2023 being one of them), has blown expectations away.  Investors will also be carefully listening to the outlook, especially since one of the key forward drivers of semi-conductors is the fast-evolving world of artificial intelligence. 

 

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