Semiconductors: Chip drought? It’s time to start worrying about a chip glut

• The share prices of chipmakers have risen to a record high on the back of strong semiconductor sales over the past few quarters. 

• The chip shortage has prompted many chipmakers to increase their capex spending, which we fear may lead to a supply glut in the near future.  

• While the future of the semiconductor industry remains bright, it is still affected by factors such as supply-demand imbalances in the short-term.

• With the industry on the cusp of a new down-cycle and valuations remaining stretched, we maintain a 2.5 Stars “Neutral” rating for the semiconductor industry.

Chipmakers are among the biggest winners in 2021

Since March 2020, semiconductor stocks have been on a tear as the cyclical upswing continued. The VanEck Vectors Semiconductor ETF (NASDAQ:SMH), our recommended ETF for the semiconductor industry, rose to a record high of USD 318 at one point as investors kept pouring money into the sector, betting that chipmakers will continue to perform well (Figure 1).

Figure 1: Semiconductor stocks have done well as investors continued to pour money into the sector

The impressive share price performance comes as global semiconductor sales reached a new record high of USD 48.8 billion in the month of October. In terms of quarterly numbers, semiconductor sales grew by 29.5% year-on-year, and up 25.6% from 2Q21 (Figure 2). Heavy demand, coupled with supply chain disruptions and price increases, contributed to greater chip sales this quarter. 

Figure 2: Semiconductor sales grew 29.5% year-on-year in 3Q21

With such strong sales momentum over the past few quarters, chipmakers have been overwhelmed by the sudden surge in demand for chips, resulting in the shortage that we are experiencing today. The auto industry is without a doubt one of the biggest victims of the chip shortage, as many automakers were forced to curtail production throughout the year due to the lack of components. 

But as we head into 2022, there are signs that the shortage is starting to peak. Lead times, the duration between placing an order and taking delivery, is currently hovering around 25 weeks. While lead times are still rising, the pace has started to slow, indicating that supply is starting to catch up with demand. The latest measurement in December showed that lead times increased by only 3.2% over the previous month, a slower pace compared to an average increase of 4.9% across the year (Figure 3). 

Figure 3: Increases in semiconductor lead times have started to slow

Sharp increase in capex may lead to a supply glut in the future

Even so, the industry is still facing tremendous pressure by stakeholders and clients to meet the growing demand for semiconductors. In an effort to alleviate the shortage of chips, semiconductor companies have been furiously investing to build capacity or have announced plans to do so. 

Earlier this year, TSMC (NYSE:TSM) announced that it intends to spend USD 100 billion over the next three years to increase capacity to support the manufacturing and R&D of advanced semiconductor technologies. 

Meanwhile, Intel (NASDAQ:INTC) is budgeting for a capex of between USD 25 billion to USD 28 billion in 2022, substantially above the USD 20 billion which it is projected to spend in 2021. Other chipmakers that have guided for significant increases in capex include Micron (NASDAQ:MU) and UMC. 

In total, worldwide semiconductor capex is expected to surge by close to 40% in 2021 to reach a new high of USD 152 billion (Figure 4). 

Figure 4: Worldwide semiconductor capex is expected to surge 40% in 2021

Beyond individual companies, several countries are also looking to shore up their domestic production of semiconductors after the events that have transpired over the past two years. The US government is leading the charge, as it looks to introduce the Creating Helpful Incentives to Produce Semiconductors Act, otherwise referred to as the CHIPS Act.

The CHIPS Act will see the US set aside USD 52 billion to invest in semiconductor manufacturing incentives and research initiatives over the next few years. It aims to sustain America’s leadership in chip technology, and also to attract more companies to locate their manufacturing facilities in the US, which accounts for just a meagre 12% of the global semiconductor manufacturing capacity today. 

China, the biggest geopolitical rival of the US, is also accelerating its efforts to build up its own semiconductor industry by implementing numerous initiatives such as the creation of a national fund, favourable tax policies, and more. 

Related Article: China’s semiconductor industry: Strong performance year-to-date, but share prices could still rise

With such a sudden and sharp increase in capex, we fear that chipmakers and governments alike are becoming overly optimistic, setting the stage for a severe down-cycle once demand tapers off and supply chain issues are resolved. 

The semiconductor industry is notoriously cyclical, which we can tell by the fluctuating sales growth numbers (Figure 2). When times are good (such as now), manufacturers tend to overestimate demand, which leads to higher-than-normal production levels and capacity expansion activity which could result in supply-demand imbalances.

Demand expected to soften in 2022 

Even though demand has been pretty robust throughout 2021, we think that it should begin to normalise in 2022 as new capacity gradually comes online. 

While the sudden and sharp rise in demand that we have seen over the past two years can be explained by supply chain disruptions and the growing adoption of digital technology in the wake of the pandemic, such high levels of growth are generally unsustainable over a prolonged period of time. 

Furthermore, the demand that we are seeing today may be artificially inflated due to double ordering, adding to the risk that it may not be sustainable. 

When demand eventually normalises, the large increase in capex will start to take a toll on the industry as it grapples with an inventory build-up and an overcapacity. When this occurs, chipmakers will inevitably have to lower prices and cut down on production as they work through excess inventory, causing sales growth to fall, marking the start of a down cycle in the industry. 

Right now, there is a potential glut brewing in the USD 120 billion memory market, which accounts for roughly 26% of total chip sales in 2020. DRAM prices have tumbled by more than 40% since January, and will likely fall further in 2022 as supply growth is expected to outpace demand (Figure 5). 

Figure 5: A downtrend in DRAM prices are expected to persist into 2022

Several chipmakers are already sounding the warning bells, projecting that DRAM sales growth in 2022 will likely be weaker compared to 2021 owing to higher inventory levels and a slowdown in procurement activity across most major segments such as PCs, mobile and servers. 

Maintain rating of 2.5 Stars “Neutral” as valuations remain lofty 

With share prices still hovering near record high levels, the valuations of semiconductor companies remain stretched. As of 5 Jan 2022, the VanEck Vectors Semiconductor ETF (NASDAQ:SMH) is trading at 21.1X 2023 estimated earnings, suggesting that it is slightly overvalued. And with earnings growth expected to be tepid, we have decided to maintain our 2.5 Stars “Neutral” rating for the semiconductor industry. 

Table 1: Valuations remain stretched 

While we have no doubt that the future of the semiconductor industry remains bright, driven by secular trends such as 5G and the Internet-of-Things, the industry is still affected by short-term factors such as supply-demand imbalances which gives rise to its cyclical nature. 

From what we observe, we feel that the industry may be on a cusp of a new down-cycle, led by the massive increase in capex spending and a level of demand that does not look sustainable in the long run. 

Considering that most of the good news is already priced in, we think that at this juncture, the semiconductor industry carries more downside risk than upside potential. As such, we recommend investors to consider taking some profits off the table. 

Declaration:

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