Chip Shortage: Paradigm Shift or Post-Pandemic Demand Blip?

While news of chip shortages is now regular news fare, many believe it is temporary, the result of a post-pandemic demand surge for automobiles and other consumer products. But we view the shortage quite differently. Going forward, we believe chip availability could be the choke point for most tech-related buildouts over the next decade.

For stocks of semiconductor manufacturers and the equipment companies that supply them, this may have big implications. The industry’s inherent cyclicality has limited the price to earnings multiple on these stocks. We believe a paradigm shift in demand, coupled with a favorable competitive structure for the industry, could cause multiples to re-rate as the market comes to appreciate how strong demand could actually be.

Several technologies are creating more need for semiconductors, making current demand more secular than cyclical. Those include:

5G Deployment: It is important to note that the three major  telecommunications carriers have already invested almost $80 billion in spectrum alone, and thus, are highly incentivized to turn that into revenue.

So far, 5G has been a premium feature on $1000+ smartphones but it is quickly becoming mainstream. Consumers are adopting 5G at three times the speed of the 4G introduction a decade ago. Prices are falling rapidly and smartphone manufacturers have introduced sub-$500 5G phones. New component designs are driving down costs even as the price of chips, like modems, are double the levels of 4G generation models. Savings are being made by offering fewer bands for connections and excluding millimeter band technology, which offers speeds most users do not need or use.

Electric Vehicle (“EV”) Adoption: Electrical vehicle adoption is another secular force creating more chip demand. Current projections call for growth from 11% of auto sales in 2020 to an estimated 60% by 2030 (source: Wall Street Journal). That would imply more than 60 million EV units would be sold. We think it is likely that government policies, emission control demands and technology improvements, which reduce costs and improve performance, will move these estimates even further upwards. As EVs become more commonplace, the demand for chips is significant: semiconductor usage is twice as prevalent in an EV than in an internal combustion engine-powered vehicle.

Other secular demand drivers: We have talked in prior blogs and materials about EV adoption and 5G driving a new – and different – demand cycle for chips, but they aren’t the only forces at play. Chips are the virtual building blocks of the digital economy. Virtually every emerging investment cycle in the tech sector that we can think of – from the cloud to the Internet of Things – depends on chips.

Favorable Industry Dynamics Also Support Chip Manufacturers and Equipment Companies

The industry offers high growth and rising barriers to entry due to both technology hurdles and high capital intensity. For these reasons, the industry has sharply consolidated in recent years; for example, the top three chip manufacturers hold 87% of the dynamic random-access memory (“DRAM”) market and 78% of the NAND market (source: Credit Suisse).

Manufacturing technologies are proprietary and highly sophisticated and the supply of a well-trained labor force necessary to make it all work is limited. For these reasons, it is very difficult for new chip companies and even equipment suppliers to enter the market and compete to meet rising demand.

Given secular demand drivers and favorable competitive dynamics, we believe semiconductor manufacturers and their equipment suppliers represent some of the best investment opportunities within the broader technology sector. As such, they currently remain one of our major thematic areas of investment focus.

 

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