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Written by: Lisa Chai
A semiconductor isn’t exactly a household name, but the technology is a core engine behind our smartphones, video games, electric vehicles, streaming media, and so many other consumer products that we’ve grown to rely on. Over the past decade, AI has ushered in a new era of semiconductor architectures and computing platforms to handle the processing requirements of our digital world. To tackle the challenge, semiconductor companies are creating new, more complex AI chip engines.
Without today’s major leaps and bounds in the performances of these chips, the future of 5G connectivity, cryptocurrencies, vehicles, and advancements in gene therapies would be many years away; now, they lie within our grasp.
The semiconductor industry is currently experiencing an unprecedented obstacle: a tight supply environment for all semis—especially CPUs, GPUs, memory chips, and advanced packaging chips. This supply shortage may last through the middle of 2022, depending on the components. Let’s explore what the chip shortage might mean for investors and where to go from here.
What’s Happening With The Chip Shortage?
The shortage started during the U.S.-China trade war in 2019 and was then compounded by the COVID pandemic, which suppressed supply, as factories around the world were shut down for months on end.
The PHLX Semiconductor Sector (SOX) index is off 13% since its April high, despite strong earnings results, reflecting investors’ concerns about semi cycle peaking and future fundamentals deteriorating. Valuations are compelling as the SOX index is currently trading at 20x NTM P/E, despite improved profitability, high FCF margins of 30% range, and strong sales growth vs. other sectors such as industrials.
The supply chain of electronic devices and equipment will be disrupted, with passive component producers seeing the largest negative impact. However, we are seeing key technology providers and semi companies doubling down on investments in R&D and capex. We believe the innovative companies that aggressively navigated these challenges early on are going to be ahead later.
Semiconductor Industry And Sector Trends
Semicap Equipment providers who are enablers of leading-edge production are set to see growth. Three foundry makers are increasing their capex spending to $66 billion in capital equipment to migrate to newer technologies. This is creating a tremendous tailwind for the industry. AI, smart home, smart factory, and autonomous systems are not possible without some of these advanced node capabilities. These companies are currently in the best position with very strong visibility into the next 24 months in some cases.
Companies that have solutions in the semiconductor testing market, such as Teradyne, are also seeing robust growth. As complexity continues to increase and chip units grow in the double-digits, Teradyne is well-positioned to navigate in this capacity constraint environment.
Some of the key cloud providers and data center networking companies are getting priority in chip production and the supply situation is not as dire as it is in other segments. Meanwhile, companies like Sony and Microsoft are struggling with chip shortages in their consumer division, including gaming consoles (Playstation5 and Xbox). Lower-end consumer devices and appliances will also recover slower, as the shortage looks set to persist for some time.
According to a report by AlixPartners, the shortage will cost the global auto industry $110 billion in lost revenues this year. The entire global auto industry purchases about $37 billion worth of chips. Electric vehicles and autonomous cars will have about 4-5x more chips embedded than do traditional cars. Pricing across the value chain is up, leading to higher consumer ticket prices until the supply chain issues are resolved.
Capturing Exposure To Key Enablers Of Semiconductors
It’s important to note the progress of tightness over the coming quarters, as well as the longer-term investment perspective. These trends are positive for investors in the THNQ index and ROBO index because stocks will rebound as valuations remain reasonable and the end market demand continues to be robust. Companies focused on secular and structural drivers of AI, mobility, 5G connectivity, and hyper-scale computing should outperform.
The companies in our disruptive innovation indices may be the beneficiaries of the multi-year, global cap expenditures cycle and chip shortages. From a company perspective, we may see a capped revenue growth for some semiconductor providers but, near term, we expect to see continued positive earnings revisions through 2021 as global demand continues to expand.
The semiconductor subsector is one of the largest in THNQ, comprising 14% of the portfolio, and it has been one of the top contributing subsectors for the past few quarters. In ROBO, semiconductor stocks fall into the Computing & AI subsector of ROBO, consisting of less than 14% of the portfolio. Nonetheless, we believe that this exposure keeps investors well-positioned to the technology growth ahead, despite temporary market turbulence.
Unlike other semi cycles, we believe that this current landscape is less cyclical, less seasonal, and more secular-driven. A convergence of megatrends is occurring: massive cloud deployment, the building of AI systems, 5G upgrade cycles, autos going through electrification, and industrial machinery going through next-gen cycles. Our long-term outlook remains optimistic for the semiconductor industry as the technological growth across healthcare, financial services, autos, and industrials is only just beginning. \
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