If you are familiar with the term “semiconductor”, you can most likely be identified as one of these two: a tech enthusiast (or a “geek”, as some would call it) or an active investor. In this article, we will try to give you some ideas regarding the semiconductor industry and hopefully provide some guidance for analysing the industry as an investor.
Semiconductors, usually referred to as chips, are now playing a more essential role in modern society than ever before—I’m not talking about the chips in your fish and chips that are made of spuds, though they are also quite essential to many, including myself—I’m talking about the ones placed in your computer that are made of silicon, which is a type of semiconductor element. Leaving that to be explained by your chemistry teacher, who would most likely ask you to recite the periodic table first, why do we need to know about the semiconductor industry as investors? The answer is the return.
Since 2013, the Philadelphia Semiconductor Index (SOX), representing the equity of the semiconductor industry, has generated an astonishing 27% total annual return as of February 15. In contrast, the S&P 500 Index’s total annual return has only been 14% during the same period. The outperformance didn’t come out of nowhere—the revenue of the semiconductor industry had grown from US$312B in 2013 to US$519B in 2023.
Historically, the semiconductor industry has been a cyclical one—consumers and corporations upgrade their computers and other devices every few years instead of annually. The working-from-home movement during the COVID-19 pandemic, however, had pushed the upgrade time of many earlier, which led to the revenue boost of the entire industry from 2020 to 2022, as well as the sharp decline in 2023.
At the end of 2022, the introduction of ChatGPT pushed artificial intelligence (AI) under the spotlight once again, though this time it was different—after experiencing the amazing capability of ChatGPT, people and the financial market decided that AI can now actually change our lives in a meaningful way. Almost immediately, publicly traded companies tried to relate themselves to AI to receive higher valuations from investors by announcing that they were either developing their own AI or incorporating AI into their business operations. This AI race has been giving another strong boost to the semiconductor industry—in 2023, the SOX index recorded a 65% gain, and the average sales and earnings of SOX member companies are projected to grow at double digits annually until 2027.
However, not all chip companies are created equal. At a high level, we can divide chips into two categories: value-add chips and commodity chips. Value-add chips are differentiated products, which therefore have higher pricing powers; whereas commodity chips are more standardised, which can only be sold at a prevailing price. As a result, investors can expect better performance from the companies that design or manufacture value-added chips.
You see, the development of AI cannot be done without the computing power provided by AI chips, and AI chip is an example of the value-add chips. The AI chip makers then became the largest beneficiaries of the current AI race.
When an ordinary company decides to do something in the AI space, it has to purchase AI chips. This might remind you of the businessmen who sold shovels and picks during the Gold Rush—these makers of the AI chips are well positioned to be the most successful ones in the AI race, whether people end up finding the “gold” or not. The idea of having robots do all the work for us is compelling, but we don’t know how long it will take us to get there—that is saying whether the expenditures on AI from ordinary corporations can lead to earnings increase or not is well up in the air, while the sales and earnings recorded in the specific semiconductor companies are already booming.
The best example of this would be NVIDIA Corp. (NASDAQ: NVDA), a typical maker of value-added chips, including AI chips. For the fiscal quarter that ended in October 2023, NVIDIA reported a revenue of over $18.1B—a 206% increase from the previous year’s number of $5.9B. NVIDIA’s adjusted earnings per share also went from 0.32 to 3.77—a 1090% increase! More importantly, investors should notice that NVIDIA’s gross margin, a good representative of pricing power, was reported at 74%—much higher than its 10-year average of 59%.
In contrast, one example of a commodity chip is a memory chip, which we use for hard drives and other storage devices. The average P/S ratio of the semiconductor companies is sitting at 4.3, but that number is only 3.1 for memory chip producers. We can get a glimpse of commodity chip companies by examining Micron Technology Inc. (NASDAQ: MU), a typical memory chip company.
The standardised nature of memory chips means that they can only be sold at the market prevailing price, which means the profitability of companies like Micron is largely dependent on the market price of the commodity—not too different from the relationship between oil price and the profitability of an oil company, where the producers are price takers instead of price givers. By plotting the market price of the 512GB TLC flash, a popular type of memory chip, alongside the gross margin of Micron, we can easily spot a strong correlation between the two numbers—the gross margin fluctuates from year to year following the flash price closely.
In conclusion, we think the semiconductor industry will continue to be one of the best-performing industries in the equity market over the long term, mainly contributed to the increased demand and corporate spending on data centres. Currently, the strongest tailwind for the semiconductor industry is coming from the development and increasing demand for AI technology, though not every semiconductor company has benefitted equally from the AI race.
In addition, there is a significant difference between the makers of value-add chips and commodity chips. Investors should keep looking for companies with high pricing power and the ability to expand their margins.
Disclaimer: The statement provided are based solely on the opinion of the author and are being provided for general informational purpose only. Please be sure to consult with a professional financial advisor before making any investment decision.