Semiconductors: Downgrade to 2.5 Stars “Neutral” on lofty valuations and greater near-term risks

• Semiconductor companies enjoyed their recovery this year as strong sales momentum drove share prices to a new high.

• Although chipmakers are benefitting from higher prices due to the shortage of chips, we do not expect the current situation to last forever as demand gradually normalises. 

• Massive investment plans by chipmakers and governments across the world could lead to excess capacity in the future. 

• With valuations starting to look a little lofty in the near-term, we have decided to downgrade the semiconductor industry from 3.0 Stars “Attractive” to 2.5 Stars “Neutral”.

After years of delays caused by the worsening US-China tensions and COVID-19, the semiconductor industry was finally able to enjoy its recovery this year. As of early August, the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) set a new record high of USD 271, a stunning 170% rebound from the bottom of the pandemic (Figure 1).

Figure 1: Fuelled by strong earnings, semiconductor rallied by more than 170% from the bottom of the pandemic 

The sharp rally in share prices comes as global semiconductor sales hit a record-high, leading to much better-than-expected earnings growth for many chipmakers. In 2Q21, semiconductor sales grew by 25.6% over the previous year, a level not seen since 2010 when the industry experienced a strong recovery from the global financial crisis (Figure 2). 

Figure 2: Semiconductor sales growth rebound to 25.6% in 2Q21 as demand soars

Shortage still present, but unlikely to last forever

The strong sales momentum over the past few quarters have resulted in a shortage of chips, benefitting semiconductor companies but at the same time affecting several areas of the economy. 

The current shortage is mainly 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.

On the corporate side, many businesses have also stepped up their digital transformation efforts in the wake of the pandemic, increasing the adoption of newer technologies, such as cloud-based services and artificial intelligence, driving up the demand for semiconductors. 

Even though chipmakers have benefitted from rising prices in the near-term, the shortage is unlikely to last forever. As a matter of fact, many companies have indicated that supply issues are likely to normalise next year. TSMC, the world’s largest foundry, said in its 2Q21 earnings call that it expects the shortage in automotive chips to start easing in the next few months. 

The shortage of automotive chips has become a key area of concern over the past few quarters as it has adversely affected the ability of car manufacturers to meet the rising demand for vehicles as economies start to reopen. This has prompted many chipmakers, such as NXP Semiconductors (NASDAQ:NXPI), to ramp up production, pushing their profits to record-high levels. 

While the near-term boost in profits is certainly welcomed, investors should note that the auto industry only accounts for a small fraction of global semiconductor sales (Figure 3). Thus, we think that investors may have overestimated the positive impact of the heightened demand for automotive chips on share prices. 

Figure 3: The auto industry only accounts for a small fraction of global semiconductor sales

During this period of high demand, semiconductor companies also face the risk of double ordering. Double ordering is the practice of placing multiple orders for the same part from one or more vendors. This practice tends to pick up during times when demand is high and supply is low, as anxious customers panic buy for fear that they may not be able to get the components they need in the future. 

Double ordering can artificially inflate demand, causing chipmakers to overproduce. When demand eventually normalises, customers may be stuck with an excess amount of chips, leading to much smaller, or worse, cancelled orders in the future. It is this excessive adjustments in production levels that lead to fluctuating sales growth numbers, a characteristic that defines the cyclical nature of the semiconductor industry.

Figure 4: Lead times for semiconductors have reached their highest level in three years

Although rising lead times may in part be due to supply chain issues, we believe that given the current situation, there is a good chance that customers may be stockpiling chips over fears that they may not be able to get what they need in the future. 

This means that the demand that we are seeing today may not be sustainable in the long-run. If lead times continue to worsen, there is a growing possibility that an inventory correction might take place in the near-term, triggering a down-cycle in the industry.

Over-investment could lead to excess capacity in the future

To address the ongoing shortage and keep up with the structural increase in long-term demand for semiconductors, chipmakers and governments across the world have announced massive investment plans. 

TSMC said that it plans to invest USD 100 billion over the next three years to expand its fabrication capacity, a staggering increase from the USD 25 billion the company planned to spend this year. Under a national blueprint devised by the government, South Korean chipmakers Samsung and SK Hynix will lead a USD 450 billion initiative to bolster the country’s semiconductor capabilities. 

In the wake of the pandemic-driven shortage and geopolitical tensions, the US, China, and even Europe have started making plans to bolster their semiconductor industries, making them more resilient to unforeseen events and geopolitical shocks. 

While these massive investment plans are a sign that industry players are confident that demand will remain strong over the next few years, the risk of over-investment in the near-term certainly exists. This could lead to excess capacity when demand normalises, causing a greater down-cycle than before. 

Downgrade to 2.5 Stars “Neutral” after a 170% rally in share prices

Due to the outstanding share price performance of semiconductor companies this year, valuations are starting to look a little lofty in the near-term. As of mid-August, the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) is trading at 19X 2023 estimated earnings, suggesting that it is close to fairly valued at this point in time. 

Table 1: Valuations of chipmakers have become stretched in the near-term 

In line with our star rating methodology, we have decided to downgrade the semiconductor industry from 3.0 Stars “Attractive” to 2.5 Stars “Neutral”. While we recognise that the need for semiconductors will continue to grow as the world we live in becomes increasingly digitalised, the supply/demand imbalances that exist in the industry today are likely to be temporary. 

With demand expected to normalise over the next few quarters, semiconductor companies are unlikely to deliver the same level of earnings growth as they had over the past two years, and this could limit future share price appreciation. 

Furthermore, the massive investment plans announced by several industry players could result in overcapacity in the near-term, raising the possibility that a larger-than-normal down cycle may occur. Based on our observations, we think that the industry could be approaching a turning point. 

While the long-term growth story of the semiconductor industry is certainly intact, valuations are starting to become stretched. As the current share price of the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) is nearing our target price of USD 270, investors may want to consider taking some profits off the table. 

Those who have heeded our call since 2019 are likely to have made some decent profits already. Given the current environment where the risks are tilted to the downside, we think that investors can afford to be a little more cautious at this juncture.