A lot of people these days say that “Data is the new oil”. Whilst the sentiment they are trying to convey – that information rather than physical commodities now underpin growth & prosperity on our planet – is correct, the analogy is imperfect. If data & information are now the underpinnings of a modern economy then it is semiconductors which are the new oil. Proof of the centrality of semiconductor availability is the impact the announcement semiconductor shortage is having on the share prices of even old-school (i.e. internal combustion engine) auto firms.
In fact, the analogy between semiconductors and oil can be extended further. Like oil, the semiconductor industry is now dominated by three manufacturers: TSMC, Samsung and Intel. Like oil, semiconductor manufacturing is concentrated in a geo-strategic flashpoint, Taiwan, which is prompting the Western powers to create local sources of semiconductor supply. And, from an Indian standpoint, like oil, we are importers of semiconductors as well! This piece from two investment professionals from Capital highlights the coming boom in semiconductor demand and the strategic nature of the product.
First, let’s focus on the boom in demand: “An increasing amount of data is being created every day. It started with social media and people posting pictures and videos of their children, food they ate at restaurants and places they visited. Then, in 2018, machines surpassed humans as the largest data creators. We believe this transformative shift will be a significant catalyst for the semiconductor industry.
Going forward, the majority of data will likely be created by machines that require massive amounts of processing power…Enormous amounts of data won’t reside in our phones, but in data centres. Today, data centres account for roughly 3% of global electricity consumption. If we do nothing to make them more efficient, they might account for 25% of electricity consumption in 10 years. Given this dilemma, the rule of thumb in semiconductor design is to try to reduce power consumption in these components by 30% every two years.
In our view, this is likely to drive growth for more advanced and complex chips used in high-end smartphones and data centres, which will drive up their semiconductor dollar content over the next five years.”
Then the authors shift their attention to the coming surge in supply alongside the geo-political considerations which is resulting plants being built in America rather than in China’s strike zone: “The world’s largest semiconductor companies are planning to spend billions of dollars on new manufacturing facilities to meet new demand, as well as to navigate geopolitical tensions with semiconductors being seen as a national security priority. The US and Europe both seek to bring critical supply chains closer to home, given that Taiwan controls a majority of the high-end manufacturing production for semiconductors.
Industry bellwether Taiwan Semiconductor Manufacturing (TSMC) plans to spend $100 billion through 2023 for new chip fabrication facilities, including a large site planned for Arizona. TSMC holds close to 80% market share for leading-edge chip production, and its clients include Apple, Qualcomm and Broadcom.”
Interestingly, such is the capital intensive nature of this industry that inspite of the booming demand, the industry has consolidated not just at the level of the final chip manufacturer but also along the entire supply chain which feeds TSMC, Samsung and Intel: “Following several rounds of consolidation, each segment along the supply chain — the chip designers, chip equipment manufacturers, the foundries that make the chips and the companies that test the chips — is dominated by a few companies.
With highly specialised expertise in each of these areas, competitive moats have expanded. Many of these companies are well-managed, with a stronger grasp of customer demand patterns. Pricing power remains high and margins are attractive.”
This dynamic – a cyclical and capital intensive industry – is leading to the creation of niche monopolies which appear to be tasty investments. The authors cite makers of the machines which are used to make semiconductors: “This market has heavily consolidated, with the top five companies controlling close to 75% market share, up from roughly 40% 15 years ago. These companies, including ASML in the Netherlands and Applied Materials and Lam Research in the US, have developed wide competitive moats, with each company developing its own specific niche within the semiconductor manufacturing and testing process.
As a result, they’ve become difficult to supplant given the complexities of their machines. For example, an extreme ultraviolet lithography (EUV) machine, used to make advanced chips, is made of more than 100,000 parts, costs approximately $120 million and is shipped in 40 freight containers. ASML is essentially the only manufacturer of this equipment.
The equipment makers have further developed a servicing model with recurring revenue from machine maintenance. Operating margins have averaged 25% over the past five years and are on track to expand beyond 30% based on our estimates. In years past, they would dip into the single digits.”
So, the next time an Indian auto OEM talks about margin pressure, you and I will know where that is coming from.
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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.
