What ranks fourth on the list of the world’s most-traded products, behind crude oil, refined oil and cars?
I’ll give you a hint - these products are the tiny “engines” that help run everything from home appliances and personal computers to 5G-enabled smartphones, cloud internet servers and autonomous vehicles.
If you guessed semiconductors, you’d be correct! They are now in fact the lifeblood of the modern, electronics-driven economy. And they’re in serious short supply at the moment. This rising global dependence on semiconductors has important implications both economically and politically.
Over a year ago, the pandemic and resulting economic downturn derailed global supply chains and caught the semiconductor industry off guard. It had been focusing on producing the more profitable, advanced chips that go in 5G technologies. As consumer demand suddenly rocketed for electronics that needed the older chips, the shortage began to take hold.
The trade dispute between China and the U.S. that flared up last year caused Chinese chip makers to hoard supplies, exacerbating the shortage. Then bad weather in the southern U.S. states and Taiwan, one of the world’s biggest chip producers, disrupted supplies further.
The chip supply crunch has hit big industries like the auto industry hard, particularly for the older, less sophisticated chips that are used in cars, computer monitors, speakers and appliances.
Interestingly, even hi-tech gadgets like 5G smartphones rely on these less advanced chips - especially power-management chips - to operate. Some customers are reporting they have to wait six months or longer to get their normal shipments. Here are a few examples…
- Microsoft Corporation reported in its recent earnings announcements that its hardware sales were impacted by the chip shortages
- General Motors has had to reduce production of almost all of its car and SUV models to prioritise chip supply for its more profitable full-size trucks, and has even built some pickup models without the chips, and is storing them until the supply returns and chips can be incorporated.
- Volkswagen has about 100,000 fewer vehicles on hand in 2021 because the shortage has hampered production and is expecting the trend to worsen in the second quarter.
- Tesla, Inc.’s CEO Elon Musk said during the company’s recent earnings call that the shortage is a “huge problem,” despite measures the company is taking to use new micro-controllers and firmware
The consulting firm AlixPartners has estimated the global auto industry will produce from 1.5 million to 5 million fewer automobiles this year than expected, as a direct result of the shortage of chips.
Now even the government is stepping in to help. President Biden recently met with industry executives about the issue and has called for $50 billion of his proposed $2.3 trillion infrastructure plan to support the chip industry in the U.S.
Meanwhile, some of the best chip makers in the industry are scheduling massive capital expenditures to help meet the growing demand in the coming years.
Chip Equipment Makers Have Dialled Up Their 2021 Earnings Expectations in a Big Way.
This exploding demand coupled with constrained supply is obviously very good news for the chip manufacturers. With Intel and TSMC having already set huge 2021 capex budgets, it was well-known going into earnings season that this would be a very good year for chip equipment makers. Nonetheless, some of the numbers shared by the leading players truly raised eyebrows. For example, Lam said it now expects industry wafer fab equipment (WFE) spending to top $75 billion this year, up from about $60 billion last year.
Taking another leading example, ASML now expects its 2021 revenue to be up about 30% in euros - far above a pre-earnings consensus of 17% euro-based growth. ASML also said it now expects its sales to foundry/logic and memory clients to respectively be up 30% and 50% this year, up from prior guidance for 10% and 20% growth. As strong as ASML’s full-year guidance is, the company indicated it would’ve been stronger if not for supply constraints for both its cutting-edge EUV lithography systems and its traditional DUV lithography systems.
But the situation with semiconductors isn’t just an industrial problem; there are security issues at stake. John Neuffer, SIA president and chief executive, lays bare the strategic dilemma: “the share of global chip production done in the US has declined from 37 per cent in 1990 to 12 per cent today, and that disparity will only intensify without US government action”.
And it is also true that advanced manufacturing in the sub-sector has become over-concentrated in the hands of an ever-dwindling number of fabricators. As chips have become steadily more advanced for high-end applications in telecommunications and gaming, the costs of physical production have increased dramatically, essentially creating a prohibitive barrier to entry. The market isn’t exactly silted-up, but regulators may be hard-pressed to avoid the kind of antitrust issues synonymous with some other tech sectors.
At the end of February, US President Joe Biden launched a 100-day review of supply chains critical to national security and public health, including those for semiconductors. The rationale behind the Biden review is also playing out on this side of the Atlantic. The IC’s Nilushi Karunaratne recently outlined why the UK government has intervened in Nvidia’s proposed takeover of chip designer Arm Holdings.
While the semiconductor suppliers cheer the supply/demand imbalance, many of the world’s manufacturers are struggling, and nowhere is this better illustrated than in the automotive industry. Jaguar Land Rover has become the latest industrial casualty of supply-side delays, having been forced to temporarily shut down production at two of its main UK factories. Industry heavyweights Daimler, Honda and VW have also been forced to curb production. The value of microprocessors as a proportion of overall production costs in the automotive sector has increased significantly over the past decade, a trend which could become more pronounced due to the large-scale roll-out of electric vehicles.
The supply squeeze comes amid surging consumer demand for phones, computers and video games during the Covid-19 pandemic, and as automakers made overly conservative estimates of their chip needs.
Figures from the Semiconductor Industry Association (SIA) show that global sales increased by 6.8 per cent year-on-year in 2020, giving a total value of $440bn. Given the extent of dislocation in the wider economy, a percentage rise of that magnitude seems extraordinary, particularly within a mature industry.
Original equipment manufacturers (OEMs) typically order semiconductors six to nine months in advance. Having under ordered at the height of the pandemic when their plants were shuttered, they have now been caught out as demand has been a lot stronger in the fourth quarter than they anticipated. This situation is clearly beneficial for semiconductor manufacturers, because it means that their fabs are going to be fully utilised, and they’re going to be able to get better pricing as well.
But while Allianz Technology Trust’s Walter Price expects the supply squeeze to ease by the second half of this year, he thinks the shortage will continue for longer. “I think to get out of the shortage, it’s going to take probably two years,” he says. “So somewhere in 2022, even if you start adding capacity today.”
Overall, while these shortages mean strong growth for many semiconductor companies right now, and given there is a lot of unmet demand for various products, this boom may last longer this time. Having said that, this is a notoriously cyclical industry, so it isn’t out of the realm of possibility that the new capital investment currently being deployed will at some point in the medium term lead to overcapacity.
How can corporations hope to get around future supply-side disruption? Well, it helps to have deep pockets. Deep enough to allow you to develop your own vertically-integrated systems. Apple Inc has just showcased a suite of new products that incorporate its in-house developed M1 chip, as the tech titan seeks to reduce its exposure to the global semiconductor shortage. Not everyone has the financial clout to attempt to alleviate supply chain disruption by bringing design in-house, but it is not beyond the bounds of reason to suggest that large industrial conglomerates may even consider a foray into the market through M&A channels in a bid to guarantee supply. Semiconductors have become the lifeblood of modern industry, so it is not difficult to understand why supply chain management in this area has moved beyond shipping, warehousing and logistics into the strategic realm.
Next time I would like to tell you about my favourite picks and shovels play in this space, a company that is not only benefiting from this incredible supply/demand situation, but who also has an unrivalled market leading position serving nearly all the semiconductor industry leaders.
Which semiconductor stock do you feel is best placed to benefit, and why? Do you think the shortages will continue over the long term? Do you worry about the World’s reliance on China for such a vital resource? Can you guess which often overlooked leading player in this space I will tell you about next time?