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Slowdown in Semis? Why the Long-Term Growth Story Remains Compelling for the PHLX Semiconductor Index

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With 2022’s broadly disappointing performance in the rearview mirror, it is worth reassessing what drove investment returns over the past year and how investor consensus has evolved for different areas of the market. The global semiconductor industry is perhaps one of the most multifaceted and dynamically evolving industries of all time, straddling a number of key disruptive technologies that are still very much in the early stages, as well as massive, well-established consumer and enterprise end markets that are incredibly sensitive to macroeconomic developments. The Covid-19 pandemic turbocharged much of the industry thanks to widespread stay-at-home policies, prompting historic increases in demand for traditional semiconductor-laden products such as computers, smart phones, and gaming systems. At the same time, unprecedented supply chain interruptions led to painful shortages in many types of semiconductors that had varying degrees of impact on different end-users. With the last vestiges of pandemic mitigation policy recently abandoned in China, it now appears the global semiconductor supply chain has more or less returned to normal. In terms of demand, the “reverse-bullwhip” effect has firmly taken hold with undeniable declines in consumer purchases of electronics, and some deceleration in enterprise- driven demand as companies around the world have been gripped by fears of recession, especially within the broader Technology sector. The question now beckons: is the semiconductor industry entering a painful, multiyear leg in a cycle that sees widespread demand destruction and outright contraction in industry revenues?

The industry’s performance in 2022, as tracked by Nasdaq’s PHLX Semiconductor Index (SOXTM), certainly seems to indicate that likelihood: down 36% for the year, slightly underperforming the Nasdaq-100® and almost doubling the loss within the S&P 500. Yet the SOX Index established a rather clear low point in mid-October and staged a meaningful rally in Q4, finding strength yet again at the beginning of 2023 in the context of improving macroeconomic conditions. Most notably, the pronounced slowdown in US inflation over the past several months augurs well for a potential recovery in Technology, and Growth stocks more broadly. With inflation cooling, the Federal Reserve can potentially pause its rate hikes after February’s projected 25 bps increase, likely averting a true recession in the US as employment and other economic fundamentals remain fairly strong. In Europe, the lack of a catastrophic energy crisis in the current winter season has also prompted a reconsideration among economic forecasters of the depth of a potential recession. And in China, with the economy on its way to fully reopening, an additional global economic tailwind waits in the wings. With inflation, interest rates and growth all stabilizing, 2023 could very well be a year of recovery for the global economy, and for the semiconductor industry in particular.

Long-Term Semiconductor Growth Drivers Remain Compelling

Since the last true global recession, semiconductor revenues have increased at a compound annual growth rate (CAGR) of approximately 8%, more than doubling from $230 billion in 2009 to nearly $600 billion in 2021. Final expectations are for slower growth of approximately 4% in 2022, and a possible contraction of as much as 4% in 2023. Yet the long-term forecast for the remainder of the decade is very much on track as an extension of the previous decade, with industry bellwether ASML forecasting a CAGR of approximately 9% through 2030, and global revenue surpassing $1 trillion. Notably, this accounts for slow growth in the Personal Computing market, historically the largest destination for chips. Thus the current weakness in PCs (global shipments down 16% YoY) must be placed into the context of their declining importance for the semiconductor industry overall. Thanks to much faster growth in Automotive (14% CAGR), Servers/Datacenters/Storage (13%), Industrial Electronics (12%), Consumer Electronics (9%), Wired/Wireless Infrastructure (8%), and Smartphones (6%), PCs (3%) will be the 5th- biggest end market for semis by the end of the decade.

Let’s dig a little deeper into what’s driving the acceleration of growth in some of these other end-markets, starting with Automotive – historically, a light user of more advanced semiconductors that was disproportionately impacted by Covid-19-related supply chain disruptions. For much of the past two years, auto manufacturers were left waiting behind larger, more established customers like computer and smartphone manufacturers to get their orders filled. In 2022, light vehicle sales in the US dropped 8.1% YoY, “impacted significantly by supply chain disruptions, and sales were still down 19% from the 2019 level. This suggests vehicle sales might increase in 2023 even with higher rates and a soft economy.” In other words, there is now a likely backlog of buyers that will take some time to normalize, potentially offsetting some of the weakness in consumer electronics demand should it persist into this year.

More importantly and looking beyond the short term, however, is the transformation of high-end autos into “one of the most complex pieces of software you can have in the world at the moment,” per privately-owned semiconductor company Arm’s Vice-President of Automotive Go-to-Market Dennis Laudick, who also described it as: “basically a data centre on wheels.” Between advanced driver assistance systems, “infotainment” systems, and the rise of electric vehicles, “the average value of semiconductors per car is forecast to rise from $700 in 2020 to $1,138 by 2028” with “full electrification [adding] around $1,000 in the value of semiconductors to each vehicle and could require up to five times more chips.” 4 (Notably, this excludes charging infrastructure.) Given that the trend electric vehicles (EVs) is still in its infancy, an incredibly long runway exists for automotive-related semiconductor growth. The International Energy Agency (IEA) forecasts the share of global sales represented by EVs to grow from 4% (3.16 million units) in 2020 to 16% (25.76 million units) in 2030 understated government policies, with an increase to 34% (46.64 million units) under a more aggressive “sustainable development” scenario; the respective CAGRs this decade are 23.3% and 30.9%. With more ambitious goals set for 2035 by governments and individual automakers, double-digit annualized growth in automotive semiconductor demand can persist for many years to come.

Recent Legislative & Regulatory Actions Impacting the Semiconductor Industry

Similar to how short-term uncertainties on the demand side need to be balanced against long-term convictions around growth prospects, recent legislative and regulatory actions impacting semiconductors have introduced volatility to the industry, but have been broadly targeted toward strengthening its resiliency with respect to both supply-chain interruptions and geopolitical risks. On October 7, 2022, the Biden administration (via the Commerce Department) announced a new set of restrictions on semiconductor exports to China – a set of policies that were not fully priced in by the market. The impact on returns to SOX was swift and severe, down 6.1% on the day of the announcement and 13.8% over the entire span of a weeklong drawdown. The index’s lowest closing level of the year was in fact on October 14, with names like NVIDIA losing 14.5% of their share price. Per Factset, 25.8% of NVIDIA’s trailing-12-month revenues came from Mainland China, near the 28% average across all SOX constituents.

Investors greeted the news with some shock given the severity of prohibitions, which are aimed at handicapping China’s tech sector from facilitating the country’s advancements in military and surveillance technology, AI, and other areas of such significance that “the country spends more per year importing chips than oil.” The restrictions cover not only the export of physical chips, but also “chip design software, chip manufacturing equipment, and US-built components of manufacturing equipment”; they “also apply to any company worldwide that uses US semiconductor technology” which ends up encompassing “all the world’s leading chipmakers” that are based in US-allied countries including Japan, South Korea, and the Netherlands. Severe restrictions on the ability of US residents to continue working at Chinese chip firms have led to an immediate exodus of highly-valued employees from the country’s semiconductor industry, leading some exports to label the Biden administration’s approach as “strangling with an intent to kill.” 

Current Fundamentals Remain Encouraging for Investors

Using the PHLX Semiconductor IndexTM (SOXTM) of US-listed semiconductor companies as a proxy for the global industry, one can clearly observe two trends that suggest fundamentals for the sector have changed for the better. Both operating and net margins are at or near record highs, and have been on a fairly steady uptrend since 2012 – much longer than previous cycles. 

Looking at valuations over the same time frame, one can see the sector currently trading notably below its index- weighted average trailing P/E of 22.2 since year-end 2010, with a year-end 2022 P/E of 18.2. EV/EBITDA multiples are also very reasonable, at 11.5 vs. a long-run average of 12.2 since 2010. Yet today, the fundamental long-term growth drivers are arguably much more obvious for the industry than they were 10 or 15 years ago. In terms of overall earnings power, the massive spikes of P/E in the early years of the 21st century seem to be a thing of the past, when large chunks of the industry were subject to brutal cycles of inventory buildup, demand destruction, and heavy losses. With valuations almost 50% lower than their recent peak levels around year-end 2020, investors may have an unusually attractive opportunity to consider as an entry point.

Summary

Certain segments of semiconductor demand have undeniably cooled off in the past year or so, just as supply chain disruptions are normalizing and boosting output. While the sector has gotten caught up in the broad-based correction impacting growth equities and especially Technology, numerous reasons exist for preserving long-term optimism. Several highly impactful secular trends, including the transformation of the automotive market with software and EV technology; the clean energy transition; the rise of artificial intelligence and its seemingly limitless applications; and the widespread adoption of cloud computing augur well for semiconductor companies of all stripes, from the major foundry players and cutting-edge design shops, to the various equipment providers and legacy analog chip suppliers. Other exciting trends outside of the scope of this paper, such as the cybersecurityindustry’s adoption of AI and the expansion of the gaming industry onto new platforms – including, eventually, the metaverse – are predicted to grow strongly in the current decade and beyond. With solid margins and pricing power, a normalization of supply chains, and historic support from multiple countries to subsidize future capex needs, the semiconductor industry is positioned for an extended period of exciting innovation and growth, easilyearning its moniker as the “new oil of the 21st century.”16

ETFs currently tracking SOX include the Invesco PHLX Semiconductor ETF (Nasdaq: SOXQ), the Mirae Asset TIGER US PHLX Semiconductor Sector Nasdaq ETF (South Korea: 381180), the Cathay PHLX Semiconductor ETF (Taiwan: 00830), and the Tachlit SAL (4D) PHLX Semiconductor Sector ETF (Israel: TCHF164).
The Mirae Asset TIGER Synth-US PHLX Semiconductor Sector Leverage ETF (South Korea: 423920) also tracks the index with 2x leverage.

Sources: FactSet, Bloomberg, Nasdaq Global Indexes.


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