Chip stocks have soared to record highs. Why share prices still have room to climb.

• Barely three months into 2024, semiconductor stocks have already risen by close to 30% (as of 18 Mar 2024). This follows an eye-popping rally of 66% in 2023. 

• As the recovery in the semiconductor cycle starts to pick up steam, we believe that the earnings outlook for chipmakers will turn increasingly positive, paving the way for more upside ahead. 

• Going forward, we expect the recovery in chip sales to see an earlier and stronger recovery, powered by the automotive and AI segments. 

• Using our revised fair PE multiple of 24X, we project an upside potential of 33% for the VanEck Semiconductor ETF, which translates to a target price of USD 290 (as of 18 Mar 2024).

2024 is shaping up to be one of the best years for chip stocks.

Semiconductor companies got off to a blistering start this year, with share prices rising close to 30% on aggregate (as of 18 Mar 2024). This follows an eye-popping rally of 66% in 2023 (Figure 1). With share prices at their all-time high, many investors are wondering if it is too late to buy into chip stocks now. We believe the answer is no, and we will share our reasons in this article. 

Figure 1: Semiconductor stocks have been on a tear over the past few months

Higher-than-expected earnings growth to support rally in chip stocks 

The recent rally in chip stocks may be attributed to a combination of factors, including the growing expectations of a soft landing and the potential for Fed rate cuts to begin this year. 

More importantly, we believe that the surge in share prices has been catapulted by markets pricing in higher future earnings growth potential for chip stocks, which have seen significant upward revisions over the past few weeks. This follows a string of much better-than-expected earnings results and strong guidance from several chipmakers in the most recent earnings season. 

One example would be NVIDIA, which recently announced that it beat both revenue and earnings estimates despite declining sales in China. In 4Q23, the poster child of AI investing saw its quarterly revenue rise by 265% year-on-year to a record high of USD 22.1 billion, even surpassing its previous guidance of USD 20 billion. Unsurprisingly, growth was driven mainly by its Data Center segment, which rose 409% year-on-year to USD 18.4 billion (Figure 2).

What was once a tiny segment of its entire business has now turned into its biggest revenue driver in a span of a decade. 

Figure 2: NVIDIA’s Data Center revenue has eclipsed all other segments 

Besides NVIDIA, TSMC – a key enabler for AI technologies and the maker of NVIDIA’s chips – has also said that the semiconductor cycle is likely to have bottomed, and it expects 2024 to be a year of recovery and growth, supported by robust AI-related demand. The company added that it has observed a much higher level of customer interest and engagement for its 2nm node (compared to 3nm at the same stage), adding to its conviction that AI-related applications will be a structural driver of chip demand in the years to come. 

ASML, the Dutch company that supplies most of the world’s lithography machines, wrapped up the year with net sales of EUR 27.6 billion, 30% higher than the year before. The company expects demand for its products to pick up markedly in 2025 once the cyclical upturn goes into full swing. 

As the recovery in the semiconductor cycle starts to pick up steam, we believe that the earnings outlook for chipmakers will turn increasingly positive, with the potential for growth rates to reach as high as 40% over the next few years (Figure 3). Consequently, valuations will also look more attractive, and that should pave the way for more upside ahead. 

Figure 3: Chipmakers to see robust earnings growth in the coming years

Semiconductor sales to see an earlier and stronger recovery

Naturally, our earnings growth projection is underpinned by our investment thesis that semiconductor sales are expected to increase exponentially as the world becomes increasingly digitalised, leading to (i) more semiconductor applications; and (ii) higher silicon content in them.

We believe that the industry is once again at a turning point thanks to the rapid adoption of AI, which often requires the most cutting-edge chips. The AI megatrend is expected to have a profound impact on chip sales, especially for the logic and memory segments. According to an analysis by Deloitte, AI chips can cost as much as USD 40,000 each, or roughly 70,000 times more than the price of a regular chip. Therefore, as AI applications become more ubiquitous, semiconductor sales will only go higher.

Besides the AI megatrend, the massive government support across the world and the reversal in the inventory cycle should also lead to greater supply, thereby driving sales, especially given that demand will remain robust. 

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

In our previous update, we wrote that semiconductor sales were due to turn positive in 1Q24, before subsequently hitting a peak of over 40% year-on-year in 2Q25. However, due to the quicker-than-anticipated recovery, semiconductor sales growth came in at 5.4% year-on-year in 4Q23, marking the start of a new upcycle. Following this, we have updated our sales growth estimates for the industry as shown in Figure 4 below. 

Figure 4: Chip sales to hit 35% year-on-year as early as 2Q24

Based on our new estimates, we see the potential for sales growth to reach 35% as early as 2Q24. While we have lowered our forecast for peak growth rates, investors should note that our forecast for total semiconductor sales in 2024 and 2025 has been revised to USD 675 billion and USD 842 billion respectively. Although our forecasts are noticeably higher than the consensus, we believe that they are achievable, and markets have grossly underestimated the impact AI will have on chip demand in the long run. 

Twin engines of growth: Automotive & artificial intelligence

According to a survey conducted by KPMG among senior executives across several global semiconductor companies, the majority said that automotive and AI chips will likely be two of the most important revenue drivers in the coming year. In addition, these two segments also possess the greatest growth opportunities, with AI leaping to second place after placing fourth in the previous two surveys (Figure 5). 

Figure 5: AI and automotive chips are widely anticipated to be the two fastest-growing segments of the chip industry

Source: KPMG

As of late, automotive chipmakers, such as the likes of Infineon and NXP Semiconductors, are turning more positive on this segment as the auto industry becomes increasingly digitalised – leading to greater demand for chips used in autonomous driving and power management applications. Furthermore, with global electric vehicle (EV) sales set to skyrocket in the coming years as more countries pursue their environmental goals, opportunities in the space are aplenty. 

With regards to AI, chip demand in this segment will be powered mainly by hyperscalers ramping up their capex. In recent years, the big three cloud service providers (Amazon’s AWS, Microsoft Azure, and Google Cloud) have all raised their capital spending substantially, a trend that will likely carry into the years ahead as these companies move to integrate AI solutions into their products. 

In their latest earnings call, Microsoft said that they expect capital spending to increase materially driven by investments in cloud and AI infrastructure. The same sentiment was echoed by Amazon, which anticipates higher spending on infrastructure to support the AWS business, including additional investments in generative AI and large language models. AI infrastructure, which can often be significantly more expensive compared to traditional general-purpose data centre infrastructure, will be a major cash cow for chipmakers going forward.

Figure 6: Hyperscaler capex to surge as they invest heavily in AI infrastructure

Share prices of chipmakers have more room to climb 

Keeping in mind the structural factors supporting the growth of the semiconductor industry, we believe that chipmakers deserve to be awarded with a higher valuation multiple. After careful consideration, we have decided to raise the fair PE ratio of this sector from 20X to 24X. While this may seem like a significant increase, we believe that 24X is a reasonable number that accurately reflects the long-term growth trajectory of this sector. It is also similar to the level chipmakers (as gauged by the MVIS US Listed Semiconductor 25 Index) have been trading at over the past five years (Figure 7).

Figure 7: Chipmakers deserve to be trading at a higher multiple 

Using our revised fair PE multiple of 24X, we derived a target price of USD 290 for the VanEck Semiconductor ETF (NASDAQ:SMH). This translates to an upside potential of 33% (as of 18 Mar 2024). While we remain optimistic on the long-term fundamentals of this sector, we have opted to keep the Star Rating of this sector at 3.0 Stars “Attractive” given its volatile nature, especially after the surge in share prices. 

Table 1: Chipmakers possess strong earnings growth potential 

Figure 8: Share prices are driven by earnings in the long run

While the performance of chip stocks has surpassed our expectations, we continue to believe that semiconductors will be one of the best-performing sectors over the next decade. Investors who view this sector with a long-term lens should see that it not only deserves to be trading at a much higher multiple than what the market has ascribed to it today, but also merits inclusion as a core holding in any equity portfolio.

*The VanEck Semiconductor ETF underwent quarterly rebalancing on 15 Mar 2024. NVIDIA’s weight has been reduced to 20% 

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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.