3 Reasons Why You Should Invest In The Semiconductor Industry

Overall outlook remains positive. Industry revenue is forecasted to grow at a CAGR of 6.17% and hit USD 503 billion in 2020.

The semiconductor industry is fairly consolidated, with the top 9 companies making up approximately 59% of worldwide semiconductor sales revenue. US listed companies account for roughly 48% of global market share.

Wireless communication is the largest end-use segment for semiconductor products. Growth in this segment is expected to continue on the back of increasing smartphone penetration rates and infrastructure spending in preparation for 5G networks.

Steady increases in IOT hardware spending will be a major source of revenue for the semiconductor industry in the future.

VanEck Vectors Semiconductor ETF (NYSE.SMH) provides diversified exposure to the entire US semiconductor industry, and may be incorporated into an investor’s tactical portfolio.

Semiconductor devices are made from semiconductor materials such as silicon, and are essential components of electronic circuits. They can be found in almost every electrical device such as your smartphone, computer and even your coffee machine. Companies that operate in the semiconductor industry generally belong to one of three groups:

1. Pure Play Foundries: These are companies that do not have any design capabilities as they focus only on the fabrication and testing of semiconductor products.
2. Integrated Device Manufacturers (IDMs): IDMs are companies that design, fabricate and sell semiconductor products.
3. Fabless: Fabless companies are involved only in the design and sale of semiconductor products, while outsourcing the fabrication to foundries.

Together, these companies design, manufacture and sell products such as memory chips, microprocessors, integrated circuits and complex systems-on-a-chip (SOC).

Consistent Revenue Growth in a Consolidating Market

According to Gartner, global semiconductor industry revenue totalled USD 419.7 billion in 2017, a 22% increase from 2016. For the period between 2012 and 2017, the industry has achieved a compounded annual growth rate (CAGR) of 7.6%. The six main end-use segments of semiconductor products are PCs, wireless communication, wired communication, automotive, consumer and industrial/government (Chart 1).

Chart 1: PCs & Wireless Communications Are The Largest End-Use Segments

Only a handful of countries are considered major players in the semiconductor industry. Unsurprisingly, US based companies make up nearly half of the global industry revenue. Most US based companies are either fabless (Qualcomm, Broadcom, NVIDIA) or IDMs (Intel, Micron, Texas Instruments). Fabless companies typically outsource the fabrication of devices to semiconductor foundries located in Asian markets such as Taiwan, South Korea and China because of the lower labour cost.

Taiwan Semiconductor Manufacturing Company (NYSE.TSM), the largest foundry in the world, has clients such as Qualcomm, Broadcom and NVIDIA. Table 1 below shows the top 10 companies and their revenues for 2017. Collectively, nine of these companies (TSMC is excluded because it does not derive revenue from sales to end-use product manufacturers) constitutes approximately 59% of the entire global semiconductor industry sales revenue. The industry has been consolidating, with plenty of M&A activity going around, for instance QUALCOMM (NASDAQ.QCOM) recent bid to take over Dutch chipmaker NXP( NASDAQ.NXPI)

Table 1: Top 10 Companies By Revenue

Chart 2: US Accounts For Nearly Half Of The Global Semiconductor Industry Market Share

Why Invest In This Space?

1. Positive Expectations & Industry Outlook

Estimates published by Gartner and Statista predicts semiconductor sales revenue to grow at a CAGR of 6.17% and hit USD 503 billion in 2020, driven by increasing demand for Internet Of Things (IOT) applications.

Chart 3: Strong Revenue Growth Expected, Driven By IOT Applications

A recent report published by KPMG surveyed executive level insiders about their perspectives and expectations for the semiconductor industry in 2018. Here are some of the observations:

- 64% of respondents expect revenue to grow
- 57% expect an increase in operating profit
- 62% feel that the industry is still in the expansion stage

Overall, the results of the survey suggests that most respondents are optimistic and that they predict significant, steady growth ahead. Most feel that the industry is still in the expansion stage, and the possibility of a contraction is unlikely in the near term. Expectations of increasing profitability is also a good sign for the industry, signalling continuing earnings growth into the future.

Chart 4: Going Forward, Investments in R&D Are Expected To Increase

In particular, the industry’s R&D spending is set to rise further, with 50% of the respondents indicating that they will increase their R&D budgets this year. R&D spending is a key metric for semiconductor companies as improvements in manufacturing processes can help to drive down production costs, which leads to higher margins for semiconductor companies (Chart 5). With R&D spending expected to increase, we expect profit margins to expand over the next few years.

Chart 5: Increasing R&D Expenditure And Its Positive Impact On Gross Margins

2. Wireless Communication Products A Major Driver For Semiconductor Demand

Currently, wireless communication is one of the largest end-use segment for semiconductor products (Chart 3). Growth in this area is heavily driven by trends such as:

- Increasing smartphone penetration rates
- Demand for faster connection speeds (5G wireless networks)

Three of the most populous countries, China, India and Indonesia have a combined population of approximately 3 billion. However in 2017, their weighted average smartphone penetration stands at only 35.8%, compared to 69.6% for developed countries. As countries become more developed, their penetration rates should converge to that of developed economies.

Table 2: Immense Growth Potential For Developing Nations

The popularity of ecommerce and mobile payment services in is one of the key reasons why there is immense potential for smartphone penetration rates to grow in the near future. The demand for smartphones looks extremely promising and this in turn bodes well for the semiconductor industry.

5G wireless, the latest iteration of cellular technology, promises to provide data transmission speeds over wireless broadband networks of up to 20Gbps, 20 times faster than 4G networks. Unfortunately this does not come free. It is estimated that by 2025, 5G infrastructure spending will hit USD 326 billion. Nearly 80% of this figure will be spent on network infrastructure, which is essential for 5G networks to operate smoothly. 5G compliant modems, wireless devices, small cells and data centres are a few examples of the hardware required by 5G networks. This investment should have a positive impact the entire semiconductor industry. 5G networks are expected to be available commercially as early as 2019.

3. Rise In Hardware Spending For IOT Applications

Semiconductors is the bedrock of technology. These days, it is nearly impossible to find a device that doesn’t rely on semiconductors. Autonomous vehicles, one or the up and coming IOT application, saw a 58% jump in semiconductor revenues from 2016 to 2017. As the IOT continues to materialise, other applications such as cloud based computing and artificial intelligence (AI) will also see an increase in hardware spending, thus leading to additional demand for semiconductors. Gartner estimates that there will be 20.4 billion smart devices in 2020. Hardware equipment such as smart devices, is estimated to account for 35% of the total IOT market in 2020.

Chart 6: Robust Growth Expected For The IOT Market

The past has shown us that tech innovations tends to opens up new markets, like how the rise of social media gave birth to digital advertising. IOT will be no different. The point is, whatever new market IOT brings us, semiconductors will definitely play a part in it.

How To Play This Trend?

A suitable way to gain exposure to the trend of rising demand for semiconductors is through an exchange traded fund (ETF) such as the VanEck Vectors Semiconductor ETF (NYSE.SMH). While you can invest in individual stocks, ETFs eliminate company specific risk, providing diversified exposure across the entire industry.

The VanEck Vectors Semiconductor ETF (NYSE.SMH) is an equity based physical ETF which seeks to track the MVIS US Listed Semiconductor 25 Index (MVSMHTR). The index consists of US exchange listed companies that operate in different segments of the semiconductor industry from design to manufacturing. Table 3 below shows the top 10 holdings and their respective weights in the MVSMHTR index.

Table 3: MVSMHTR Provides A Balanced Representation Of The Semiconductor Market

As mentioned earlier in Table 1, majority of the largest players in the semiconductor industry are from the US. Thus, we feel that given its larger allocation to US companies, the MVSMHTR index is an appropriate representation of the semiconductor industry. In fact, the ETF holds 7 of the top 10 largest companies by revenue, excluding South Korea’s Samsung and SK Hynix, and Japan’s Toshiba.

Strong Growth Potential Balances Slightly Higher Valuations

Table 4: Low Valuations Supported By Earnings Growth

The MVIS US Listed Semiconductor 25 (MVSMHTR) is currently trading at 14.74x forward earnings estimates for 2018, while the S&P 500 (SPX) and S&P 500 Information Technology (S5INFT) indices are trading at 17.11x and 18.8x respectively. Based on its expected earnings growth, we expect MVSMHTR index to trade at a higher premium. Thus we believe that the lower P/E ratio is not a concern that there is a lack of growth opportunities, but rather an indication that the MVSMHTR is undervalued.

Table 5: VanEck Vectors Semiconductor ETF is the most attractive amongst its peers

The VanEck Vectors Semiconductor ETF (NYSE.SMH) boasts an expense ratio of only 0.36%, one of the lowest amongst its peers. In addition, its large AUM size of USD 1.47 billion helps to strengthen its liquidity, which sees an average of 6.8 million shares changing hands each day. Lastly, it has a 3 year tracking difference of only -0.18% which is very reasonable considering the ETF has an expense ratio of 0.36%.

If you have been looking for a tactical play, consider the VanEck Vectors Semiconductor ETF (NYSE.SMH). Positive analyst estimates, consistent revenue growth coupled with strong demand for end-use products by future tech innovations makes this industry an attractive investment.

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.