The Philadelphia Stock Exchange Semiconductor Index has been on something of a rollercoaster ride for the past six months.
The benchmark for chipmakers SOX, +0.10% plunged 22% between Oct. 3 and Dec. 24 amid rising trade tensions between the U.S. and China, and on concern that slowing growth in the world’s second-biggest economy could crimp global demand for semiconductor components. Then, in the year through March 21, the index rebounded 25%, outpacing the 14% rise in the S&P 500 Index SPX, +0.00% over the same period, as investors wondered if their fears might be overdone.
For long-standing industry watchers, such gyrations are nothing new. The fortunes of chipmakers have long been characterized by sizeable peaks and troughs. Throughout the 1990s, industry performance was inextricably linked to the ebb and flow of personal computer sales following each Windows operating system upgrade. That cycle switched in the 2000s to mirror mobile-phone launches.
So should investors expect shares of companies in the chip-supply chain to move in lockstep with sentiment about China’s economic outlook and news flow on tariffs and trade? Short-term concerns about the global economy led FactSet to forecast a 24% drop in first-quarter earnings for the S&P semiconductor group. However, chipmakers including Microchip Technology Inc. MU, +0.45% have said they expect the current cycle to reach a bottom in the first quarter. Others, such as Texas Instruments Inc. TXN, +1.51% and Nvidia Corp. NVDA, +0.39% have suggested more of a second-half recovery. Such forecasts helped chip stocks to recover from their fourth-quarter slump.
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Brighter prospects
Whether the recovery comes in the second quarter or the second half of 2019, or even not until 2020, if investors look beyond the near term, the prospects for semiconductors have changed substantially in recent years, making it a sector that appears to be under-appreciated and undervalued. The semiconductor index is trading at a price to earnings ratio of 16.37, compared with 18.49 for the S&P 500.
Two key reasons for long-term optimism are industry rationalization and an expansion in the number of uses for semiconductors, driven by the Internet of Things.
Take memory as an example. Since its commercial introduction in 1971, about 80 global companies have operated in the DRAM market. Over the past 10 years, the number of producers has shrunk, through bankruptcy and consolidation, to three — Samsung Electronics Co. SSNLF, -3.07% SK Hynix Inc. and Micron. As such, structural profitability through the cycle has improved.
Other parts of the industry are also improving efficiency. Equipment makers such as ASML Holding NV ASML, +0.71% and Lam Research Corp. LRCX, -0.24% benefit as we press the boundaries of Moore’s Law and it becomes tougher to pack more circuits onto each chip.
Lam and ASML customers including Samsung and Taiwan Semiconductor Manufacturing Co. Ltd. TSM, -0.24% can also take advantage as more companies — from aircraft manufacturers to cloud computing giants Alphabet Inc. GOOG, +0.51% GOOGL, +0.55% and Amazon.com Inc. AMZN, -0.01% — contract fabricators to produce chips of their own design. This trend also potentially means more customers for companies such as Cadence Design Systems Inc. CDNS, -0.29% which makes the software needed to design chips.
Wider margins
Companies are also pivoting to serve higher-margin markets such as medical devices where demand for chips is rising. Texas Instruments announced in 2008, a year after Apple Inc. AAPL, +1.45% launched the first iPhone, that it would stop producing chips that connect mobile phones to wireless networks, even though the communications segment of the business accounted for 40% of its $12.4 billion revenue that year.
Texas Instruments wanted to build dominance in embedded processors and analog semiconductors, with long-duration product cycles and a deep catalog. The company invested in industrial and automotive markets, whose share of revenue rose to 56% in 2018 from 22% a decade earlier. In addition to altering the revenue mix, the shift created a fundamentally different customer relationship and product portfolio, as these industries have higher durability, reliability and longevity requirements than wireless handset producers, who are tied to an annual cycle of product launches.
That decision looks even more prescient when put in the context of the Internet of Things. While personal computing created a market in the millions of units, and mobile phones in the billions, the consumer and industrial IoT have the potential to spawn a market measured in the trillions of units as every device that is capable of being connected gets connected.
The wide availability of cheap, power-efficient sensors and microcontrollers that can capture data for analysis in the cloud means the IoT is reaching takeoff, with more and more people owning voice-activated digital assistants that control smart connected devices such as lights, sound systems, thermostats and door locks.
In the industrial arena, farms, factories and mines are increasingly automated, while drones make myriad tasks including inspection, repair and surveillance substantially cheaper and faster. In hospitals, computers can read diagnostic scans better than radiologists, while surgeons are robotically assisted.
All of which spells rising demand for semiconductors. So while trade disputes and concern about global growth may create short-term headwinds, the outlook for select companies in the chip industry looks positive, as better capital allocation stemming from consolidation meets a surge in the number of end uses. The result may be a decades-long tailwind for the sector, powered by the digital transformation of the global economy.
Denny Fish is co-manager of the Janus Henderson Investors Global Technology Fund.