Are Semiconductors Really That Cyclical?

Current Valuations

Semiconductors are one of the most beaten down spaces in public market equities in 2022. They shouldn’t be, but they are. They’re critical building blocks of the modern society, have compelling cash flow metrics, and generally have positive forward growth trajectories for their end markets. And yet they’ve gotten beaten up worse than a lot of other cyclical market sectors.

Lets walk through how we got here and why this could be a great time to pick up names for the long term.

How We Got Here

The semiconductor industry has long been thought of as high risk due to its cyclical nature and leverage to individual consumer spending. For years computing was dominated by the retail consumer. People everywhere were slowly buying connected devices; computers, laptops, and smartphones slowly permeated the global market. People were quickly picking up new technologies and the purchasing patterns were erratic; the chip companies struggled to match consumer demand. Consumer demand also varied a lot with product price and availability, and many products were just fads rather than essential devices. The whole space was extremely cyclical.

Fierce competition among chip manufacturing companies made matters worse – semiconductors generally cost less to produce as the volume produced increases, and with several companies marketing similar chips and scaling up production, they ended up in repeated races to the bottom in terms of final consumer prices. Companies would scale up production to compete, put pressure on each other, and flood the market.

Then hard times would hit, consumers wouldn’t shop, and companies already operating on thin margins couldn’t scale back production or raise prices without losing market share. Chips were commoditized and a lot of people lost money investing in the wrong part of a boom bust cycle.

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Semiconductor Demand

Today’s semiconductor landscape is very different in a few very important ways, both in terms of supply and in terms of demand.

First, a shift in the customer base for semiconductor chips. Retail PCs and hard drives are no longer the sole end market for semiconductors. Corporate chip spending has skyrocketed as data centers have expanded and technology has worked its way into every industry. Everyone from the auto industry to cloud leaders like Microsoft or Amazon need chips, both to grow and also to just replace existing infrastructure as it ages.

Second, retail customers have stabilized. Selling personal computers to American families isn’t a growth market anymore – it’s got a more constant demand as old tech wears out and gets refreshed. Phone cycles, computer cycles, it’s become more steady and profitability in these markets involves margin growth rather than just sales growth. Said another way, there’s not going to be another huge laptop boom, or another huge cell phone boom – we’re all replacing these devices as they age or break down. There’s still cyclicality in product refreshments or upgrades, but a lot of that demand is essential and planned for over the long term.

Third, technology is everywhere! Every appliance, every car, every speaker, they’re all connected. Just as technology has permeated our lives, so too have semiconductors become a core building block of modern society. This has led to a new phenomena – no longer is it just people who create data that needs processing. Today, machines are creating an incredible amount of data that also needs to be processed. Going forward, the rate of machine data creation is going to far outpace human direct data creation – this acts as a bit of a stabilizing mechanism in terms of long term data processing needs.

Semiconductor Supply

Even as demand dynamics across the globe have changed, so too have supply dynamics shifted to become much more stable. This evolution has come in two parts – the corporate landscape, and the technological complexity. Years of competition, specialization, and consolidation have changed the industry substantially. Today’s semiconductor companies have wide competitive moats, buoyed by a combination of increasing chip complexity and long term capital investments. They boast massive intellectual property portfolios, highly specialized work forces, and significant bases of deployed capital. Consequently, it’s unusual for a new competitor to emerge in a market.

Furthermore, while it’s become harder for new companies to enter the market and provide competition, the existing players have consolidated. Years of mergers and acquisitions have remade the chip space – any given product segment only has a few companies left standing. In some cases, there may in fact only be one company who makes a particular part or component. This shift, combined with shifts in demand, have allowed companies to refocus away from rapidly scaling production to focusing on margins, cash flows, and balance sheet health. Capital expenditures and research budgets remain robust, but are not pursued at the expense of profitability. Inventories are more well controlled, order books are deeper, and customer relationships are more robust. In short, the companies have become better stewards of capital and the business models are more insulated than they used to be.

Geopolitics

The semiconductor space is recognized as a foundational building block of the modern economy. Its strategic importance makes it a geopolitically sensitive sector that receives government attention across the globe. The recently passed Chips and Science Act in particular warrants mentioning. The push by the US govt to onshore some semiconductor manufacturing is great for the industry and the companies will welcome the subsidies and the security that comes with having more fabrication facilities based in the United States. The subsidies may accelerate some long term growth for US based companies and give them an advantage over some of their Asia oriented peers who receive help from their respective govts and ministries.

Geopolitical concerns are also tangible – Taiwan and China are essential parts of the Semiconductor supply chain, as are some industrial gases traditionally sourced from Ukraine. While geopolitical tensions have yet to significantly impact business for US listed companies, the push to restrict the supply of advanced semiconductor technologies to China could have impacts on revenues for some firms going forward. Furthermore, any conflict in East Asia between China and any of its neighbors, such as Taiwan, could upset the entire semiconductor ecosystem. While these tensions are ever present, we don’t believe they are acute enough to deter us from investing in the space.

How to Play the Space

As with any ecosystem, there are a lot of different ways you can try to approach the space. As we mentioned before, at any given level of the industry you have fewer participants than you used to. In some cases there may actually only be one option. For example, look at a company like ASML. They are the key supplier for the lithography machines used to etch the chips. Sure, there’s some cyclicality in their business – fabrication facilities go through investment cycles and aren’t always building new semiconductor manufacturing lines – but when new lines are built or refreshed, ASML’s lithography equipment is an essential component.

In a similar vein on the manufacturing side, companies like Lam Research LRCX operate in an oligopolistic market where three or four large companies dominate wafer fabrication equipment. Not only do they have fewer competitors in the space, but these companies also operate business models that are increasingly resistant to cyclicality. While their top line growth is driven largely by new sales and equipment installations, every piece of equipment they install becomes a future revenue stream for their servicing and maintenance division. This durable revenue stream expands as the install base expands and tends to boast healthy margins.

Another way to target the industry is through leaders in specific types of computing. For example, companies like Nvidia who is the undisputed leader in the graphics space. While graphics cards used to be highly cyclical, used primarily for applications like gaming or crypto mining, they are also increasingly being used for AI computing in data centers and in the automotive industry. These are not only massive growth opportunities, they’re also going to become more stable industries – data center growth and refreshment cycles are planned years in advance and the companies ordering the components are significantly less volatile in their purchasing patterns than retail consumers focused on gaming installations.

Finally, another wide moat business investors could consider would be an actual manufacturer such as Taiwan Semiconductor. While they’re not the sole manufacturing company for chips, they are arguably the most sophisticated and most friendly for large chip companies They boast an enormous capital base with cutting edge manufacturing that can handle the most detailed current chip designs. Furthermore, unlike rivals such as Samsung or Intel INTC , they don’t have their own line of chips that they manufacture and sell – they are a pure play outsourced manufacturing facility which makes them really attractive as a partner for cutting edge fabless companies like AMD, Qualcomm QCOM , or Nvidia.

We could go on and on describing different companies in the ecosystem but the overarching principals are the same. Increasing specialization, increasingly wide barriers to entry, less competition, a better focus on margins – the space is maturing as it increases its strategic importance.

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