Semiconductors: A Less Cyclical Future
A sea change is occurring in the semiconductor industry. Once notorious for boom and bust cycles that revolved around demand for a few consumer devices, the chip industry now powers most aspects of our economy. This proliferation, in our view, will smooth steep cycles and drive durable demand, even as the economy slows and recession risk increases. Yet chip stocks still trade at a discount based on the cyclicality of the 1990s and 2000s. We think this presents an attractive opportunity for investors ahead of what we believe will be a market revaluation to higher multiples as earnings prove more stable than in previous cycles.
Evolution from cyclical to secular
Historically, semiconductor manufacturing ran in boom and bust cycles correlated with global GDP growth: Insatiable demand for a consumer product – such as PCs in the 1980s, mobile phones in the 2000s, and smartphones in the 2010s – would lead manufacturers to aggressively expand capacity. Supply eventually exceeded demand, either through overproduction or an economic downturn – sending prices and revenues down. A new end product or economic recovery would reignite the cycle. Reflecting this cyclicality, equity investors have historically paid lower earnings multiples for semiconductor stocks.
But we believe these sharp peaks and valleys are a thing of the past.
Recently, semiconductors have become nearly ubiquitous, a key component in numerous industrial applications, leaving the industry far less vulnerable to single retail end markets. Many of these new end markets – including autos, industrial automation, 5G infrastructure, artificial intelligence, and cloud computing – require more chips per unit and have longer cycles than consumer electronics, lessening the industry’s reliance on consumer spending and potentially smoothing revenue (see Figure 1). One of the fastest growing markets is likely to be automotive. An electric vehicle currently uses more than twice the number of semiconductors when compared to its internal combustion engine ICE predecessor, and industry experts expect this gap to widen.
The industry’s supply structure too should, in our view, support more stable earnings cycles in the future. After a decade-long wave of consolidation, the semiconductor industry now exhibits an oligarchic structure with high barriers to entry and significant pricing power. Suppliers adhere to more stringent return requirements on capital expenditures, which are increasingly funded by upfront payments and government subsidies across Asia, Europe and the U.S.
Strong balance sheets
Amid strong demand and pricing power, the larger semiconductor companies have built solid balance sheets, with strong cash positions and little or no debt, providing resilience in an economic slowdown and higher borrowing costs. Over the last decade, many companies have used excess cash to increase dividends and buy back stock, a trend we expect to continue.
Growth at a reasonable price
The semiconductor sector offers an appealing combination of quality, attractive valuations and a strong earnings outlook.
Growth: We believe the sector will grow earnings in the 15% –20% range over the next two years – well above the market – on continued double-digit revenue growth and margin expansion (see Figure 2). We expect secular tailwinds and shortages of production capacity to fuel strong pricing power, while dampening economic sensitivity.
Less cyclically sensitive applications seem likely to further drive industry growth, even as the economy weakens. Smart energy infrastructure, labour force automation, and electric vehicle adoption are only partly through a multiyear period of growth.
Visibility to future revenues has improved. The industry has moved towards long-term, non-refundable contracts, with capacity booked out to 2023 and in some cases 2024. Tight capacity promises to bolster revenues at equipment manufacturers well beyond 2022.
Valuation: As of June 6, the PHLX Semiconductor Sector Index (SOX) traded at 17 times forward earnings, a discount to the NASDAQ Index, which trades at a forward multiple of 23. Underneath the surface we see even larger discounts with some companies trading at single-digit multiples. We see room for future multiple expansion supported by the industry’s more stable secular earnings outlook.
We favour owning a well-diversified basket of semiconductor equities across the supply chain from end chipmakers to equipment manufactures and materials providers. This approach reduces concentration risk. We believe the sector will continue to post consistently strong earnings against a backdrop of a slowing global economy, inducing the market to recalibrate expectations in line with fundamentals – and afford the sector higher multiples over the coming years.
Geraldine Sundstrom is a portfolio manager focusing on asset allocation, Tania Bachmann is an equity research analyst, and John Mullins is a product strategist in EMEA.
For more insights on our asset allocation views, read our Asset Allocation Outlook
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