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Equity Perspectives

While some investors have benefited from record M&A activity in the semiconductor industry, high manufacturing costs and the laws of physics could slow the pace of disruptive technologies.

 

 

In Brief: 

  • The $330 billion global semiconductor industry is undergoing historic consolidation, but innovation in some quarters has stalled.
  • As manufacturing costs rose and the market matured, companies that skimped on innovation and milked existing product lines have found that mergers were the only way to diversify and grow.
  • China, the world’s largest consumer of semiconductors, is moving aggressively into manufacturing them, which threatens producers in Korea and Taiwan.
  • Industry leaders that have made strategic acquisitions should be well positioned to produce next-generation microelectronics that unleash a new wave of products and applications.

 

When Lord Abbett Technology Analyst Eric Ghernati started covering the technology sector 15 years ago, the semiconductor industry, one of the principal drivers of the digital revolution, was able to pack approximately 1,000 transistors (or solid-state electronic devices) on a single wafer-thin piece of silicon commonly known as a chip. The Google search engine, camera phone, USB flash drive, Bluetooth (a short-range wireless networking standard) and Sony PlayStation 2, were all in their infancy. All kinds of businesses and communities were staking out a place on the World Wide Web. While a number of Internet stocks would soon plummet, it wouldn’t be long before more powerful chip designs would lay the groundwork for more disruptive technology.

Underpinning much of that innovation was a dogma called Moore’s Law (named after Intel co-founder Gordon Moore), which extrapolated that computing would dramatically increase in power, and decrease in relative cost, at an exponential pace. Fast forward to the present, and you’ll find microelectronics with as many as 2 billion transistors crammed onto a single chip, with as many as 100 million transistor fitting as little of space as the tip of a needle. While all that computing power has helped facilitate the proliferation of smart phones, tablets, wearable computers and the like, for many manufacturers, the costs of developing faster and more powerful chips has become prohibitive, and the market for their products has matured.

All of which helps to explain not only the historic wave of mergers and acquisitions in the last several years (see Chart 1), but also the growing divide between “old tech” (Ghernati’s term for companies that catered to markets that were flat or declining) and “new tech” (from growth leaders with disruptive innovation).  

And then there’s the rise of deal making in China’s semiconductor industry, which is already affecting chip makers in Taiwan and South Korea, according to Lord Abbett Research Analyst Naimish Shah, who travels to Asia several times a year and regularly shares his insights with Ghernati. (More on that later.)

Commenting on the many deals this year, Ghernati said the market sometimes rewarded both acquiring companies and their targets by driving their stock price higher. In other deals, the stock of the acquirer dropped a lot. “The market was smart enough to figure out the value of the assets being acquired was priced higher than it should have been, either because the acquirer was desperate to buy whatever quasi-asset it needed or because the financial forecasts of the acquiree didn’t hold up,” Ghernati added.

Some of those disappointing forecasts can be traced to what renowned economist Joseph Schumpeter called creative destruction, the relentless ingenuity that fuels the capitalist engine. As Ghernati put it, “Smart phone growth came at the expense of other consumer devices because smart phones integrated eight to ten different devices on one platform, so it was deflationary to consumer electronics, including personal computers. There is also as of now a noticeable lack of a big ‘killer app’ that would spur future demand for semiconductors.”

Technology investors used to be more patient; now they aren’t. Companies that aren’t innovating, or showing any breakthroughs will be hard pressed to justify their existence as a public company, Ghernati added.

 

Chart 1. Chip Crunch
Total value of announced mergers and acquisitions involving semiconductor companies, in billions

Source: Dealogic
*As of October 18, 2015

 

Amending Moore’s Law
Ghernati began questioning the economic validity of Moore’s Law three or four years ago. History may have shown that transistors doubled in performance every 18-24 months (see Chart 2), but the industry had reached an inflection point because reducing silicon costs at its historical pace became impossible given much more stringent manufacturing requirements. From a physics standpoint, the industry was in uncharted territory when it came to developing new products. 

While the industry’s dominant players appeared able to stomach the costs of staying at forefront of semiconductor manufacturing, Ghernati believed others would fall behind, particularly companies that were not used to introducing new products each year, or companies that outsourced manufacturing to separate fabrication plants known as foundries in Asia. “Such companies used to get price cuts of 20-40% a year from foundries, but now they don’t because it costs a lot more for foundries to manufacture for them,” said Ghernati.

As a result, semiconductor companies that relied exclusively on foundries for better prices and performance, as opposed to relying on their own design and software, would find themselves at a distinct competitive disadvantage. Absent foundry support, some companies’ economics were no longer viable, which is why management eventually felt compelled to sell out—a theme Ghernati was recommending for some time.

“The reason we’ve seen so much consolidation this year is that companies are realizing they would have to do dramatic things to drive growth and double-digit earnings,” Ghernati said. “The best they could hope for was sluggish growth in line with the nation’s gross domestic product. But if they wanted to drive double-digit earnings and double-digit appreciation of their stock price, they would have to raise their scale and therefore reduce their costs.”

While financial engineering and diversification played a big role in the M&A wave over the last year, the only strategic deal Ghernati saw was a major global player’s acquisition of a company that makes chips used in a variety of markets, ranging from communications to consumer electronics. Assuming a successful integration, Ghernati believes that deal will improve the combined company’s chances of introducing the next killer app in the Big Data and machine learning markets.

 

Chart 2. Moore’s Law on Trial
Trends in transistor counts and maximum operating frequencies (Intel microprocessors, 1970-2015)—Dennard scaling (EXPLAIN) hit a wall around 2005

Source: Company data, Macquarie Research, August 2015

 

The Implications for Innovation
What does all this deal making portend for future innovation and the pace of next-generation semiconductors?

“Excellent question, and that’s the only one you should ask yourself,” said Ghernati. “I am not that optimistic because I see the innovation engine in Silicon Valley slowing down dramatically. Some companies are continuing to push the innovation envelope to break into new markets, but others are retrenching aggressively.”

Part of the problem is the lack of a killer app (like mobile computing and personal computers) that unleashes tremendous growth in the chip industry. Of course, there has been a lot of hype about the “Internet of Things,” which connects everyday objects so they can sense and communicate with other operating systems, allowing them to be monitored and controlled from anywhere. But the infrastructure needed to make the Internet of Things as ubiquitous as envisioned is a long way off.

“The next two years will be a difficult time for Silicon Valley to demonstrate anything innovative,” Ghernati said. “The tools are not there, manufacturing is expensive, and even when you go to new manufacturing you are not getting a big boost in performance or power, certainly not with decent economics, which explains why one maker of smart phones, for the first time in its history, will be using the same manufacturing technology in 2016 as it was in 2015, with all cost and power reductions coming mostly from changes in silicon packaging technology.”

Potential Bright Spots
On a more positive note, Ghernati believes the auto industry, specifically advanced driver assistance systems, could be a game changer for semiconductor companies with the right products.

“One could argue we are in the early days of computerizing our cars,” Ghernati said. “Current automobiles already have a number of driverless features, such as adaptive cruise control, lane departure warning, and collision avoidance braking. And the pace of scientific advances is likely to spur some interesting collaborations in Silicon Valley over the next decade as cars consume an even greater number of semiconductors and sensors.”

Another driver of semiconductor demand could stem from the transition of Web 3.0 to Web 4.0 as major chip innovators and cloud companies make strides with enabling technologies such as machine learning and predictive analytics. If you define Web 3.0 as public, private and hybrid cloud computing and new apps combining Big Data, social and mobile, Web 4.0 would be where technology and human become one, and you’re already seeing some of that in the growth of speech-driven mobile network traffic and the increase in smart phones with gesture recognition features.

Meantime, adoption of machine learning can be found in a wide range of industries, including health care (via analysis of genomic testing, disease progression and hospital readmission rates); manufacturing (predictive maintenance, supply chain optimization); energy and power (smart grid/smart meter management), and oil field services (preventive maintenance of oil field assets), among others.

For all that innovation, the costs of building out a Web 4.0 ecosystem will be very expensive, especially when it comes to the logistics of extending an intelligent assistant system like Apple’s Siri to more than a billion users around the world.

“Development of Web 4.0 on that broad a scale will take time because the enabling technologies around semiconductors are not there,” said Ghernati. “But it may take a breakthrough in cost-cutting manufacturing technologies like extreme ultraviolet lithography (EUV) to unleash the next wave of innovation. Trouble is, EUV has been delayed by five or ten years.”

The Chinese Are Coming
Although China consumes half of the world’s semiconductors (see Chart 3), it doesn’t have a single domestic manufacturer among the 10 biggest chipmakers, according to Bloomberg News. Taiwan and South Korea account for the lion’s share of production. But with China’s government pushing to grow its own semiconductor industry for national security and lessen its dependence on foreign technology, recent deal making suggests a new world order may be in the offing. According to McKinsey & Co. estimates, the government has budgeted $161 billion to build up its chip industry over the next five to ten years.1

Despite an unsuccessful attempt to take over U.S.-based Micron Technology, Tsinghua Unigroup, a state-owned enterprise, has managed to become the nation’s top chipmaker after a series of acquisitions. It also took a stake in Western Digital, a manufacturer of hard disk drives and solid state drives, which in turn bought Sandisk, to create a global leader in data storage solutions. More recently, it paid $600 million for a stake in a Taiwanese chip packaging and testing company.

Considering the global interconnection of the semiconductor industry, it’s no wonder Naimish Shah shares his insights on the Asian companies he covers with U.S. analysts like Ghernati. After all, some sectors of the business are already oligopolies, and the battle for industry dominance can only intensify. Case in point: Intel last year bought a substantial stake in Tsinghua in what was described as a long-term partnership that aims to provide greater access to China and to overseas markets when Chinese phone makers expand internationally.2  

“The Chinese are already gaining share of the world-wide fabless (third-party production) market in terms of revenues (see Chart 4), and are poised to overtake Taiwan soon (see Chart 5),” said Shah. “And as if to underscore that point, Tsinghua recently hired the CEO of a Taiwanese joint venture with Micron.3 So it goes in a country that spends more to import semiconductors than oil.”

 

Chart 3. China Already Accounts for More than Half of the World’s Chip Consumption
Worldwide semiconductor consumption market by region, 2003-2014

Source: Semiconductor Industry Association, McClean Report 2015, Gartner Dataquest, CCID Consulting

 

Chart 4. More Chip Companies Are Outsourcing Production to China 
China foundries’ revenue contribution to the worldwide “fabless” market

Source:  CCID, IEK, and Gartner

 

Chart 5. China Is Poised to Overtake China in Third-Party Chip Production
Chinese and Taiwan Foundry Market Size

Source:  CCID, IEK, and Gartner

 

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