Even after a remarkable year, semiconductor companies still have more room to run

• After a disappointing first half, global semiconductor sales bounced back strongly, gaining 7.7% year-over-year in 4Q20.

• The industry is expected to do well over the next few years, with the push towards digitalisation and the adoption of new technologies supporting chip demand. 

• The growing chip shortage the world is currently experiencing right now is evidence that demand for semiconductors remains robust. 

• We maintain a 3.0 Stars “Attractive” rating for the semiconductor industry. Based on our estimations, the industry has an upside potential of 7.2% and 22.6% for 2022 and 2023 respectively.

The past two years have been a roller coaster ride for the semiconductor industry as worsening US-China tensions and the emergence of COVID-19 battered the industry, delaying its recovery. Despite these disruptions, semiconductor companies staged an impressive recovery with the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) rallying over 50% across 2020 (Figure 1). 

Figure 1: Fuelled by strong earnings, share prices of semiconductor companies climbed more than 50% in 2020

The surge in share price is largely due to the stronger-than-expected earnings growth delivered by several prominent chipmakers, such as TSMC and NVIDIA just to name a few (Table 1).

Table 1: Several prominent chipmakers delivered positive earnings surprises

Fast forward to today, both the earnings and share prices of semiconductor companies have already recovered to beyond their pre-pandemic level. Looking ahead, we think that this industry still has more room to run as earnings continue to rise. 

Semiconductor industry to benefit from COVID-19 in the long-run

Even though the industry was negatively impacted by COVID-19 during the earlier part of 2020, the pandemic did not derail its recovery, it merely delayed it. After a slight dip in the first half of last year, global semiconductor sales bounced back strongly, notching a gain of 7.7% year-over-year in 4Q20 (Figure 2). 

Figure 2: Global semiconductor sales grew by 7.7% year-over-year in 4Q20.

As economies begin to recover, we expect sales growth to continue expanding at a healthy pace and eventually hit double digits by the first half of 2021. We believe that COVID-19 is going to have a positive impact on the semiconductor industry in the long run, with the push towards digitalisation and the adoption of new technologies supporting chip demand. 

Chip demand supported by digitalisation push and the adoption of new technologies 

As the backbone of all electronic products, semiconductors will be one of the most important sectors of our future economy, in which technology is expected to play a much greater role than before. Right now, the industry is experiencing an unprecedented boom that could possibly be bigger and longer than the preceding one in the years following the dot-com bubble.

Across 2020, businesses have stepped up their digital transformation efforts, accelerating the adoption of digital solutions, such as cloud computing, e-commerce, and digital marketing, not only as a response to the pandemic, but also as a way to remain competitive in an increasingly digitalised world. 

As demand for digital services skyrockets, cloud service providers, such as Amazon (NASDAQ:AMZN), have spent billions of dollars each year building new data centres, with the bulk of the money used to purchase server chips. Since 2015, the number of data centres worldwide has increased significantly, with nearly 40 new hyperscale data centres being built in the first half of 2020 alone (Figure 3).

Figure 3: As demand for digital services rise, so does the number of data centres

Looking ahead, cloud service providers already have plans to build close to 200 new data centres over the next couple of years, spelling good news for data centre chipmakers, such as Intel (NASDAQ:INTC) and NVIDIA (NASDAQ:NVDA). 

Aside from cloud computing, the launch of 5G is another factor that will contribute positively to the demand for semiconductors. With 5G, users can expect to see significant improvements in network speeds and latency, making the overall user experience more enjoyable. 

However, before we can enjoy these benefits, hardware, such as smartphones and other telecommunication equipment, will have to be upgraded to be 5G-ready. The mass adoption of 5G will mark the beginning of a new hardware upgrade cycle, one that is expected to last for several years. 

On average, the silicon content of a 5G smartphone is roughly 30% to 40% higher compared to 4G. This, combined with the fact that 5G chips tend to command higher prices, should benefit chipmakers in the years to come as smartphone manufacturers expand their 5G product portfolio.

Growing chip shortage is evidence that demand remains robust

Right now, the world is experiencing a shortage of semiconductors, and this could last throughout the entire year. The global chip shortage is predominantly caused by the unusually large demand in 2020, as the stay-at-home economy spurred a sharp increase in the sale of consumer electronics, from laptops to game consoles and to everything else. 

Adding to the shortfall is the renewed interest in cryptocurrency mining, which has further strained the supply of computer chips. However, we think that demand coming from the cryptocurrency space is very unpredictable and can easily disappear with little warning, just like it did back in 2018.  

The supply crunch has led to price hikes throughout the entire industry, where several foundries have already begun raising contract prices for chip production. This will ultimately lead to a higher average selling price, a cost that will likely be borne by the end client (Figure 4). With the supply expected to remain tight over the next few quarters, chipmakers should benefit as they still have room to raise prices.

Figure 4: Memory prices have climbed significantly since the beginning of the pandemic

Among the various sectors, automakers seem to be the most heavily affected at the moment as the severe shortage of automotive related chips has forced car companies like General Motors and Ford to halt production at a number of plants.

At the beginning of the pandemic, automakers reduced orders for semiconductor components drastically in order to avoid a surplus. Now, with the economy recovering and the demand for new vehicles picking up, automakers are finding it hard to get their semiconductor orders filled as most foundries are already operating at near maximum capacity.

To alleviate the shortfall, several foundries already have plans in place to expand capacity. Taiwan Semiconductor Manufacturing Company (NYSE:TSM), for instance, announced that it will boost its 2021 capital expenditure to between USD 25 billion and USD 28 billion, a staggering increase of 54% at the midpoint from the USD 17.2 billion it spent in the previous year (Figure 5).

Figure 5: TSMC is planning to boost its capex significantly for 2021

Historically, TSMC plans its capex based on a number of factors, including its own assessment of the semiconductor industry, customer demand, and inventory levels. Thus, the fact that it is planning such a huge increase in capex is evidence that the world’s largest foundry expects semiconductor demand to remain robust.

Maintain a 3.0 Stars “Attractive” rating for the semiconductor industry

Even though share prices of semiconductor companies have risen by a fair bit since our last update, we believe that valuations are still attractive, with an estimated upside potential of 7.2% and 22.6% for 2022 and 2023 respectively. In line with our star rating methodology, we have decided to maintain the semiconductor industry at a rating of 3.0 Stars “Attractive”.

Table 2: Earnings table for the semiconductor industry

In the current global environment, where the demand for chips exceeds the available supply, we feel that there is a strong possibility for semiconductor companies to deliver positive earnings surprises, which would support higher valuations.

As the backbone of all electronic products, the importance of semiconductors and the companies that produce them cannot be understated especially as technology is going to play a much bigger role in our lives than ever before. 

Looking ahead, we are optimistic that the semiconductor industry will be one of the top performing industries over the next decade. Investors who wish to participate in the growth of this sector may consider our recommended ETF: VanEck Vectors Semiconductor ETF (NASDAQ:SMH).