Between recession and structural growth drivers Summary
With a recession looming, a short-term downturn in the semiconductor industry is probable, but this is unlikely to have much impact on structural trends as these trends are long-term drivers. Various forces are currently affecting the semiconductor industry, whose products are indispensable in many parts of the global economy. This situation is complicated: An improvement in supply chain problems meets recession concerns, and global tensions, particularly between the U.S. and China, are creating uncertainty. What investors should know now.
Downturn approaching - already increased DRAM inventories
While last year there was still a chip shortage in many industries and sectors, a downturn in the semiconductor sector now seems inevitable in view of the impending global recession. The key question will be how severe a recession will be and how long it will last. Currently, the order books of almost all semiconductor companies are well filled, which could cushion the downturn somewhat next year. This is already visible in memory chips, in particular so-called DRAMs (Dynamic Random Access Memory, "volatile memory"). Important end markets in particular, such as those for PCs and smartphones, are losing force, and DRAM spot prices have fallen accordingly by 33 percent year-on-year.
Price development for DRAM
In order not to exacerbate the price pressure, DRAM producers are taking their chips onto their own balance sheets for the time being. As a result, producers' inventory rose from three to 13 weeks. Three producers dominate this market: Samsung is the market leader with 44 percent in 2021, followed by SK Hynix with 28 percent and Micron with 23 percent. However, inventory levels are still elevated in the other sales channels as well (especially among PC manufacturers at around twelve weeks). With lower capacity expansions on the supply side for next year, attempts are now being made to reduce the increased inventories again in perspective. Inventories for the semiconductor sector as a whole are also slightly higher at 114 days at the end of the second quarter of 2022 compared with 101 days on a five-year average. However, it must be taken into account that all companies now generally hold higher inventories, especially for chips, in order to avoid supply chain problems. Currently, brokers and market research institutes are forecasting a decline in sales of five to ten percent in the semiconductor sector and a decline of ten to 20 percent in the equipment market for 2023.
State intervention on the rise
For some time now, it has been observed that state intervention is on the rise. The focus here is primarily on China. If possible, the USA wants to prevent China from succeeding in building up its own semiconductor industry. For example, US equipment suppliers are not allowed to supply the latest manufacturing technology to Chinese customers. Only machines for semiconductor production from 14 nanometers (nm) onwards are allowed. Adding to this, even high-performance processors can no longer be supplied without approval. Since China is denied access to the latest technology, the long-planned development of a local semiconductor industry is not progressing. The Chinese semiconductor industry is limited to passive devices, smaller DRAM and logic producers, and Chinese chipmaker SMIC without access to the latest manufacturing technology such as five nanometers. In the short term, the increasing restrictions partly lead to sales losses for NVIDIA, for example (no more high-performance processors for China). In the long term, however, this is likely to strengthen the technological dominance of US companies. With the exception of EUV (from the Dutch company ASML), almost all important technologies are in the hands of a few US companies.
Risk factor geopolitics: Taiwan in focus
Geopolitical risks are also increasing. Should China invade Taiwan, this would have devastating consequences for the entire semiconductor industry. 75 percent of outsourced semiconductor production comes from China and Taiwan (TSMC from Taiwan is the world's largest chip manufacturer). The efforts of the U.S. and Europe to establish their own local semiconductor manufacturing should also be seen against this background. The U.S. is granting a 25 percent tax advantage for production in the U.S., after a 52 billion U.S. dollar program to build up domestic chip production was approved last year. Europe is providing 43 billion euros in public funds to boost semiconductor production in the EU.
A favourable entry point?
In the past, semiconductor stocks rose most strongly yet paradoxically during years of downturn. Currently, the environment on the capital markets remains tense and an entry is accordingly still somewhat premature. Rising inflation and interest rates are a burden. A stronger than expected decline in inflation in the USA would be a catalyst. In view of a price correction of 38 percent in the semiconductor index SOX, a partial entry is conceivable. Finding the right time to enter the market is difficult anyway, but the long-term prospects remain good.
Short-term downturn for DRAM manufacturers
By price-to-book ratio, DRAM manufacturers are now trading below historical averages. The sector entered the downturn first and could be the first to bottom out with more conservative capacity planning for 2023.
Above-average growth prospects in the medium term
According to World Semiconductor Trade Statistics, the semiconductor market grew at a CAGR (compound annual growth rate) of 13 percent from 1992 to 2000, 16 percent from 2002 to 2007, and eight percent from 2008 to the present. This growth is well above that of the global economy. Although these high growth rates, driven by the spread of PCs, the Internet and mobile communications, will probably not be achieved in the future, it should still be possible to achieve figures in the mid to high single digits. This is due to a number of growth drivers such as increasing demand from cloud applications and data centers, electric cars, autonomous driving, the Internet of Things, fast 5G mobile communications and artificial intelligence.
Equipment suppliers in particular are structurally interesting
In view of the persistently difficult stock market environment, investors should currently focus on companies with good market positioning and moderate valuations and tend to avoid stocks with high growth potential but low profitability. TSMC is a good choice for a broad representation of the sector. The Taiwanese are the world's largest semiconductor manufacturer with a market share of 53 percent and the technological leader in five-nanometer production, with a 21 percent share of sales in the second quarter. Meanwhile, the majority of semiconductor companies have outsourced their production. TSMC produces chips for customers such as Apple, AMD, Broadcom and NVIDIA. The strongly growing high-performance processors (43 percent share of sales, main customers NVIDIA and AMD) have meanwhile replaced the rather saturated smartphone market (38 percent share of sales, main customer Apple) as the largest area.
Good prospects also for high-performance processors
There is also strong structural demand for high-performance processors (GPUs), which are increasingly being used in data centers, cloud applications and artificial intelligence. The leaders in discrete GPUs are NVIDIA with a market share of 78 percent and AMD with 17 percent. Intel has meanwhile been able to catch up somewhat here and has a market share of four percent. The automotive sector is also growing structurally because the share of semiconductors in cars has risen for years. This trend is accelerating again with electric cars, as the semiconductor share is almost doubling here. Driver assistance systems and, in the future, autonomous driving also require a significantly higher share of semiconductors - especially high-performance processors, lidar and radar sensors are needed. Among others, Infineon, NXP and ST Micro have a high exposure to the automotive sector.
Furthermore, customer-specific semiconductors, so-called ASICs, are becoming increasingly widespread thanks to ever higher computing power and energy efficiency. Broadcom, for example, is developing the high-performance processor TPU (= Tensor Processing Unit; latest machine learning supercomputer developed for Google). Broadcom is positioned primarily in the networking sector. Various areas such as broadband expansion, 200/400G switching technology, campus upgrade cycle and WiFi6/6E could prove to be less cyclical demand drivers even in the event of a recession. In addition, Broadcom now generates almost a quarter of its revenue from relatively stable software business through its acquisitions of CA, Symantec and, most recently, VMWare (antitrust approval is still pending here). Thus, profits should remain at a high level next year.
Often overlooked: Chip designers
Often underestimated, but an increasingly important part of the value chain, are companies that focus specifically on chip design. This involves, for example, questions of optimal architecture, advance simulations and development of the most suitable circuit. As this expenditure is usually subject to the research and development budget, it is not cut as much in times of crisis as, for example, investments in semiconductor production. Although the market volume is still relatively small at an estimated $7.5 billion, growth rates of ten to 15 percent are expected over the next few years.
Under pressure: Shares of equipment suppliers
Shares of semiconductor manufacturing machinery companies have also come under particularly heavy pressure. These tend to be particularly cyclical, and earnings should accordingly come under significant pressure. In the long term, however, equipment suppliers are particularly promising. The manufacturing process is becoming increasingly demanding. In order to improve the performance of semiconductors and make them more energy-efficient, the structures are becoming smaller and smaller. TSMC, for example, is already manufacturing to five nanometers. To get a better idea of how small a nanometer is, it helps to compare sizes: A nanometer relates to a meter like the diameter of a one-cent coin to that of the globe. There are physical limits here, especially with exposure to light. To be able to image such tiny structures, a photolithography process with extremely strong ultraviolet radiation (EUV) is required. ASML now holds a monopoly position in this field. In the context of EUV, however, other important processes such as circuit etching or chemical vapor deposition (CVD) are becoming increasingly complex. The market is shared here by Applied Materials, LAM Research and Tokyo Electron.
Equipment business: Capital-intensive with stable long-term growth
Overall, the manufacturing process is becoming increasingly capital-intensive in almost all areas. Investment in semiconductor manufacturing rose from nine percent at the low point in 2014 to 15 percent in 2021, and the equipment market is expected to peak at $95 billion this year (up ten percent year-on-year from already up 40 percent in 2021). Next year, market participants expect the market to decline by ten to 20 percent. Major customers such as TSMC or memory chip producers have already announced investment cuts or postponements. However, the market may underestimate the stability of the business. On the one and, all equipment suppliers now have a significant stable service business (mostly 25 to 35 percent share of sales). On the other hand, all companies still have a well-filled order book and cannot even process all orders by the end of the year, which provides a certain safety buffer for the coming year 2023. In the long term, growth in the equipment market is likely to be significantly higher than in the semiconductor industry, as manufacturing processes are becoming increasingly complex. There is also a trend towards local manufacturing, rather than a few large factories in Asia. The U.S. and Europe in particular are providing subsidies to support the development of local manufacturing in order to become less dependent on Asia and China.
Conclusion: Short-term downturn, but structural trends ensure good long-term prospects
After the sharp decline in semiconductor shares, there are successive opportunities to enter the market. While a downturn with declining sales and earnings seems inevitable next year, the sector should grow significantly faster than the global economy in the long term, thanks to structural trends such as increased use of cloud applications and data centers, electric cars, Internet of Things, 5G, and artificial intelligence. However, as is often the case, precise timing is difficult: It may still be a bit too early to enter the market, given the persistently difficult stock market environment.
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