Chip sales to top 40% year-on-year by 2Q25. Here’s how you can capitalise on this opportunity

• The semiconductor industry is once again at a pivotal turning point thanks to the rapid adoption of AI. Despite the current down cycle, we think that quarterly sales growth has the potential to reach as high as 40% by 2Q25.

• We believe that excessive adjustments to production levels is one factor that will contribute to higher sales numbers in the future as chipmakers underestimate the impact AI will have on chip demand in the long run.

• Besides the inventory cycle, base effects as well as the massive incentives handed out by governments across the globe will increase supply, thus driving higher sales growth as demand continues to rise. 

• We upgrade the semiconductor industry from a rating of 2.5 Stars “Neutral” to 3.0 Stars “Attractive”. Our target price for the VanEck Vectors Semiconductor ETF is USD 182, which represents an upside potential of close to 30% as of 23 October 2023.

• With a cyclical (but constantly growing) industry such as semiconductors, investors should adopt a longer investment horizon and make use of down cycles to build a position. 

A new revolution in the chip industry is upon us  

The semiconductor industry has been mired in a downturn since 4Q22 as chip sales plunged by nearly -10% year-on-year, the first negative print since 2019. Fast forward to today, the slump in sales has worsened, coming in at -20% as of 2Q23. This comes as many chipmakers, including the likes of TSMC continue to warn of falling demand and rising inventories, a trend that is likely to persist for the remainder of the year. 

Despite the grim near-term outlook, we have a bold prediction to make. And that is for quarterly semiconductor sales to hit 40% year-on-year-growth by 2Q25 (Figure 1). 

Figure 1: Chip sales to hit 40% year-on-year growth by 2Q25 

Underpinning this prediction is our investment thesis that chipmakers will see a massive structural increase in demand as the world becomes increasingly digitalised, leading to (i) more semiconductor applications and (ii) higher silicon content in them. Over the past few months, our conviction has become even stronger as the generative AI frenzy took the world by storm following the launch of ChatGPT in late 2022.

We believe the industry is once again at a pivotal turning point thanks to the rapid adoption of AI, which requires highly advanced processors that are capable of handling huge, complex workloads efficiently. Just like the PC and mobile revolutions, we believe that the AI revolution will bring tremendous opportunities for chipmakers over the next decade. 

We are already starting to see a few early beneficiaries of AI. NVIDIA, the poster child of AI, saw its data center revenue rise from a negligible amount in FY 2014, to more than USD 15 billion in FY 2023 (Figure 2). Today, the segment continues to be its largest source of revenue by a long shot. 

Figure 2: In a span of nine years, NVIDIA’s data center revenue went from near zero to become its biggest segment

Inventory cycle adjustments to result in higher sales growth in the future

To better comprehend why we think 40% year-on-year sales growth is achievable, we’ll have to revisit the inventory cycle. Semiconductor cycles are essentially driven by fluctuating sales growth numbers, which are caused by distortions to supply and demand dynamics. There are a few factors, but for the most part, these distortions can be explained by over- and under-estimations in production levels.

Given how dependent the world is on technology and the growing number of end use products we have today, the overall demand for electronic products (and hence semiconductors) tends to see a steady increase each year under normal economic conditions. This is represented by the grey line in Figure 3, which depicts a simplified version of the inventory cycle.

Figure 3: Semiconductor cycles are driven by fluctuating sales growth numbers

Source: iFAST Compilations 

On the contrary, the supply of semiconductors tends to vary a lot more. This is mainly due to adjustments in production levels by chipmakers. When times are good, chipmakers tend to overestimate demand, invest heavily in capacity, and produce more than what the market can absorb. 

Over time, the high level of production eventually becomes unsustainable as inventory starts to build, leading to an oversupply. When this happens, chipmakers slash prices and cut down on production as they work through excess inventory, causing sales growth to fall – even as demand remains relatively stable.

But just like how chipmakers tend to over-produce when times are good, they also have the tendency to under-produce when times are bad. Put simply, it is the excessive adjustments in production levels that lead to fluctuating sales growth numbers, a characteristic that defines the cyclical nature of the semiconductor industry. 

The current downcycle began with a shortage back in 2020. Back then, chipmakers were under enormous pressure by stakeholders and clients to meet the growing demand for semiconductors, which many responded to by ramping up their capacity. As a matter of fact, industry capex rose by a staggering 39% and 20% in 2021 and 2022 respectively. 

Unsurprisingly, this sudden and sharp increase in capex resulted in a supply glut. Today, several chipmakers have made significant downward revisions to their capex budgets, citing bloated inventory channels as one of the key reasons. On an industry level, capex is projected to shrink by nearly -20% this year as chipmakers continue to hold back on spending (Figure 4).

Figure 4: Semiconductor industry CAPEX projected to fall significantly in 2023 

While the near-term outlook certainly warrants a more cautious approach, we think that chipmakers are underestimating the impact AI will have on chip demand in the long run, the supply of which is currently inadequate at present. Once this downcycle blows over and clearer signs of a recovery emerge, chipmakers will likely feel more confident to bring more supply online, which should translate to higher sales growth in the future. 

Related Article: Stop trying to catch the bottom. The time to start buying semiconductor stocks is now

Government incentives & base effects to contribute to sales growth  

Across the world, governments are doling out massive incentives to build fabs, adding to the total supply of semiconductors in the years to come. In the US, we have the USD 280 billion CHIPS and Science Act, designed to boost American semiconductor R&D and manufacturing. 

Since the Act was passed in August 2022, several domestic companies such as Micron, Qualcomm and GlobalFoundries announced plans to increase their manufacturing capacity on US soil. Even foreign chipmakers, notably TSMC has also taken advantage of the CHIPS and Science Act by building two leading edge fabs in the state of Arizona, which it targets to be operational by 2025. 

In Asia, China has made the development of its domestic semiconductor capabilities one of its biggest national priorities. Support from the central government comes mainly from the China Integrated Circuit Industry Investment Fund (ICF), which has raised a combined total of over USD 40 billion in its first two phases. In September, it was reported that fundraising for phase three had begun, with a target of USD 40 billion. 

Japan, whose chipmakers once dominated the industry in the 1970s to 1980s is also looking to regain its lost status as a semiconductor powerhouse. The Japanese government has launched several initiatives geared towards attracting semiconductor investments on Japanese soil, and to foster collaboration between foreign and domestic chipmakers.  

Related Article: The resurgence of Japan: A new era of multi-year tailwinds with upside potential of 30% by 2025

With the industry in a steep downturn today, base effects as well as the massive incentives handed out by governments across the globe should help to drive higher sales figures once the recovery gets underway. 

Look beyond the current down cycle and invest for the long-term 

Taking into consideration all the factors mentioned above, particularly the structural megatrends such as AI and digitalisation, we are confident that semiconductors will be one of the best performing sectors over the next decade. And with a recovery of the chip cycle in sight, we see a positive earnings outlook for semiconductor companies in the near to mid-term. The recent selloff has also made valuations slightly more attractive, providing investors with a better entry point. 

Using a fair PE multiple of 20X, we project an upside potential of approximately 30% for semiconductor companies by 2025, and a target price of USD 182 for the VanEck Semiconductor ETF (NASDAQ:SMH). As such, we are upgrading the semiconductor industry to 3.0 Stars “Attractive”, from its previous rating of 2.5 Stars “Neutral”.

Table 1: Significant earnings rebound expected as the cycle turns 

Figure 5: Stronger earnings growth to drive share prices of chipmakers in the long run 

Known as the building blocks of technology, semiconductors will forever have a place in our global economy. The current downturn merely represents a temporary setback for chipmakers and does little to derail the industry’s long-term growth story. More importantly, it presents investors with an opportunity to build a position before prices rise. Those with conviction should look beyond the current down cycle and invest for the long term before the rest of the market starts to price in the recovery. 

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 Semiconductor ETF.