Semiconductors: A Less Cyclical Future
A sea change is occurring in the semiconductor industry. Once notorious for boom and bust cycles that revolved around demand for a few consumer devices, the chip industry now powers most aspects of our economy. This proliferation, in our view, will smooth steep cycles and drive durable demand, even as the economy slows and recession risk increases. Yet chip stocks still trade at a discount based on the cyclicality of the 1990s and 2000s. We think this presents an attractive opportunity for investors ahead of what we believe will be a market revaluation to higher multiples as earnings prove more stable than in previous cycles.
Evolution from cyclical to secular
Historically, semiconductor manufacturing ran in boom and bust cycles correlated with global GDP growth: Insatiable demand for a consumer product – such as PCs in the 1980s, mobile phones in the 2000s, and smartphones in the 2010s – would lead manufacturers to aggressively expand capacity. Supply eventually exceeded demand, either through overproduction or an economic downturn – sending prices and revenues down. A new end product or economic recovery would reignite the cycle. Reflecting this cyclicality, equity investors have historically paid lower earnings multiples for semiconductor stocks.
But we believe these sharp peaks and valleys are a thing of the past.
Recently, semiconductors have become nearly ubiquitous, a key component in numerous industrial applications, leaving the industry far less vulnerable to single retail end markets. Many of these new end markets – including autos, industrial automation, 5G infrastructure, artificial intelligence, and cloud computing – require more chips per unit and have longer cycles than consumer electronics, lessening the industry’s reliance on consumer spending and potentially smoothing revenue (see Figure 1). One of the fastest growing markets is likely to be automotive. An electric vehicle currently uses more than twice the number of semiconductors when compared to its internal combustion engine ICE predecessor, and industry experts expect this gap to widen.
The industry’s supply structure too should, in our view, support more stable earnings cycles in the future. After a decade-long wave of consolidation, the semiconductor industry now exhibits an oligarchic structure with high barriers to entry and significant pricing power. Suppliers adhere to more stringent return requirements on capital expenditures, which are increasingly funded by upfront payments and government subsidies across Asia, Europe and the U.S.