Semiconductors, photo of the sector and problems in the supply

The supply is not being sufficient to cover the world demand for semiconductor components

A semiconductor is a material capable of acting as an electrical conductor or as an electrical insulator depending on the physical conditions in which it is found. These conditions often involve variables such as temperature, pressure, or exposure to a magnetic field. They are especially useful in the electronics industry for the manufacture of integrated circuits, graphic cards, transitors, sensors, diodes, modulators …, and are used in practically all economic sectors: communications, computing, health, transport, military systems, energy …. 

At the moment, the supply is not being sufficient to cover the world demand for semiconductor components, and this has been pointed out by some of the main players in the sector.

Although in recent months the words of automobile companies such as Ford, General Motors or Volkswagen have been echoed regarding delays in their production due to the shortage of chips, it is a problem that is affecting all industries. The current shortage of semiconductors is the result of an increase in demand above expectations, mixed with a shortage of supply.

To find one of the main underlying reasons we have to go back to the end of 2018, with the arrest in Canada of the financial director and daughter of the founder of the Chinese company Huawei. This event, together with the open trade war between the United States and China, set off the alarms of the Asian company before a possible veto by the North American country. In response, Huawei began to stockpile critical processors for its operations, such as Intel and AMD chips for servers, or programmable semiconductors from the US manufacturer Xilinix. Although in May 2019 the veto was finally imposed by the Trump administration that prohibited national companies from exporting technology to Huawei, The concession of several forewords until August 2020 allowed the Asian company to accumulate inventory necessary for two years. The company increased its purchases of chips and other critical technological components by 73% during 2019.

Another reason we found is the surprising advance in demand in the midst of the pandemic, leading to poor planning by market players. According to the Semiconductor Industry Association (SIA), the semiconductor market was maintained during the period 2010-2015 with a turnover between 290,000 and 340,000 million dollars. Between 2016 and 2018, the world market grew to reach 468,000 million dollars, and then fell to 412,000 million dollars, mainly due to the fall in the price of graphics cards due to the accumulation of stock.

During the past year, after growing slightly in the first three months of the year, volume came to a sharp halt during the second quarter due to the closure of factories. However, in the second half of 2020, we saw spectacular dynamism in the sector. Estimates made in October by the World Semiconductor Trade Statistics (WSTS) projected growth of 5.1% year-on-year, yet real growth for the year was 6.5%.

Apart from the obvious stoppage in production caused by the pandemic, there are other events that explain this imbalance between supply and demand, which has been extolled from the last months of the year. By the end of spring, Apple had already configured its new mobile device, the iPhone12, which was a strong order for the Taiwanese semiconductor foundry company Taiwan Semiconductor Manufacturing (TSMC) – the largest company in the sector and with the most advanced technology. -. Added to this was the launch by Sony and Microsoft of their game consoles before Christmas, putting pressure on the same company and strangling the supply even more. Among all this, it must be taken into account that the pandemic triggered the demand for computers and other computer products, which need processors and graphics cards designed by companies like AMD or Nvidia, which also rely on TSMC chips. Finally, we must highlight the role played by the automotive sector.

Demand for cars started to recover earlier than expected after the summer, especially for electric and hybrid cars that consume more chips than combustion cars. Car manufacturers tend to work “just in time”, without stocks, so the start of the pandemic and the drop in sales also led to a drop in the order of semiconductors. As the sector recovered, manufacturers increased the order of these components, finding themselves with the “surprise” that other industries had already monopolized practically all the production.

The set of chips and integrated circuits that a car requires is usually made up of a set of very low-priced microcontrollers that do not require state-of-the-art technology, and a highly sophisticated but very low cost chip as well. The unsophisticated automotive microcontroller industry is concentrated in a small group of companies: Japan’s Renesas, NXP of the Netherlands, Infineon of Germany, Texas Instruments of the United States, Microchip of Taiwan, and STMicroelectronics of Switzerland.

As for the sophisticated chip, TSMC makes about 70% of these microcontrollers, at a cost of about a dollar. According to the accounts presented by the company, car chips account for only 3.3% of its turnover, so it seems logical that the Taiwanese company prioritizes orders that, in addition to giving it a greater profit, account for a higher percentage of its business.

The truth is that this situation is practically becoming a state problem for countries with great economic muscle such as Germany. Thousands of workers in the German automotive sector are expected to work short hours later this month as a result of the shortage of semiconductor components. Faced with this situation, German Economy Minister Peter Altmaier has directly asked his Taiwanese counterpart, Wang Mei-hua, to intercede with TSMC for the lack of supplies. Therefore, the dependence not only on this company but on a country of only 23.5 million inhabitants is remarkable. Hence, the European Union has set as a goal that the production of 20% of advanced semiconductors by 2030 is carried out in Europe, where funds from the Next Generation program they will play a fundamental role. 

Another problem that has led to this bottleneck and dependence on a few actors is explained by the concentration of the sector. Today, Korea and Taiwan account for 43% of the world’s production capacity, and if we add the 15% that is currently in Chinese hands, and 15% in Japanese, we find that more than 7 out of 10 chips are developed in this Asian region.

But this has not always been the case, since until 2000 Europe and the United States were among the main players in the sector. However, in the new millennium, Japan, but especially Taiwan and South Korea, began to take over the market. What is really revealing and that reflects in a way the growth potential of the sector, is the estimate of China’s production for 2030 made by SIA, which places the Asian power as the main producer for that year. Undoubtedly, the policies carried out by the countries have played and will play an important role for the coming years. If before we saw the production plan established by the European Union for 2030, in the United States the Biden administration has recently proposed to channel 50,000 million dollars to the sector, with what has been found with a strong opposition in the Congress. The one who has really moved on has been China, under its “Made in China 2025” plan, in which it establishes a roadmap so that 70% of the components used in the country by 2025 are of national production.

But the concentration is not only geographical, but it comes from the production process. We can group the companies in the sector based on the activity they carry out throughout the manufacturing process until the final product is reached. On the one hand we have the “Complete Process” or IDM for its acronym in English, which are companies that manufacture, design and sell chips managing the entire manufacturing process (Samsung, Lam Research, ASM or Micron); there are the Fabless or “Design Only”, which lack the casting process focusing on processor design and commercialization (Qualqomm, Nvidia or Xilinix); and finally the Foundries or “Manufacturing Only”, which are solely responsible for the melting of semiconductors and the manufacture of chips (TSMC, SMIC or GlobalFoundries).

We ran into a serious problem regarding this, the disappearance of Foundries in the last two decades. Before we could talk about large integrated circuit manufacturers that did the whole process. However, today we only find three main agents in terms of the manufacture -not design- of chips for mobile phones: TSMC, which, as we saw, only manufactures, and Samsung and Intel, which are dedicated to the entire process. On the other hand we have the Fabless,whose number is multiplying. The main reason is explained by the famous “Moore’s Law”, which states that every two years the number of transistors that fit on a chip doubles. This update requires state-of-the-art technology with an equally important outlay of money every so often. Therefore, designing the chips is cheaper and more profitable than manufacturing them, hence the proliferation of Fabless and the destruction of Foundries , to the point that companies dedicated to the entire process outsource part of their production to the latter.

All this has served as a breeding ground for China and the United States to star in their umpteenth geopolitical pulse. Earlier we mentioned the arrest of Huawei’s CFO and the company’s veto, the proposed injection of public money by Biden, or the strategic plan developed by China. But there have been other events in the last two years, such as the inclusion by the US Department of Commerce of the company SMIC – China’s main semiconductor manufacturer – in its blacklist of companies, the decision of TSMC to set up one of its plants in Arizona after receiving incentives from the United States, or the increasingly notorious Chinese meddling in Taiwan.

These facts along with others, see the decision by the Taiwan Water Resources Agency, to prioritize this industry over the agricultural sector after the drought that the island is experiencing, highlight the importance of the sector and its adoption of a strategic character. To take advantage of this investment theme, we can invest directly in the companies that we have been naming in the report, which are present or have been in our Family Office asset selection grid. In the case of preferring to invest in a pool of companies taking into account a low management cost, we can use an ETF such as the VanEck Vectors Semiconductor UCITS ETF. Finally, if we want to invest in a group of companies and take advantage of the tax advantages of an investment fund, we have technology funds such as JPMorgan Funds – US Technology Fund with a portfolio weight in semiconductors of 32%. Although this note should not be taken as an investment recommendation, it is a sector where we have channeled part of our clients’ investment in recent years, and which we believe is on a positive trend.

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