Emerging Markets Equity
Semiconductors in Asia: Where Established Leaders and China’s Ambitions IntersectDominic Jacobson, AnalystSeptember 22, 2021
In the world of semiconductors, a number of the largest and most innovative chip manufacturers call North East Asia home. In fact, Taiwan Semiconductor Manufacturing Co., Ltd. (TSMC) (3.99% of Emerging Markets Equity Strategy assets*) and Korea’s Samsung Electronics Co Ltd. (SEC) (3.26% of Strategy assets*) have become the most valuable semiconductor companies in the world. Meanwhile, China is also becoming more prominent as a fertile breeding ground in the space.
Emergence of TSMC as the Undisputed Champion of Foundry
TSMC, backed by visionary founder Morris Chang, not only anticipated the explosive proliferation of semiconductors, but crucially identified a key gap in the market—a niche that they filled, which came to be known as foundry. Essentially, TSMC accurately projected that exponentially more companies would be in need of customized chips, but would not have the balance sheets or the motivation to build their own foundries, or fabrication plants, given the tremendous upfront capital requirements, technological know-how and time. In other words, they foresaw the fragmentation of the semiconductor supply chain, where manufacturing and designing chips would eventually become two completely separate disciplines.
With this insight, TSMC developed a business model that allowed their customers and chip designers to focus on design and adopt an asset light approach that enhanced margins1 and return profiles by outsourcing chip manufacturing to TSMC. In return, TSMC would manufacture higher quality chips at a fraction of the price versus what these (often) smaller companies could ever hope, in our view, to achieve alone.
Over the years, our Emerging Markets Equity Investment Team has developed an intimate understanding of TSMC as an incredibly well-oiled machine. Take the “Nightingale Program” as an example. In response to competitors narrowing the technology gap with TSMC, management initiated a three shift, 24 hour non-stop Research and Development (R&D) operation.2 At the same time, the margin for error during this perpetual manufacturing process is almost non-existent. Every step has to be carried out flawlessly or else chip yields will be undesirably low. If an error is found, it is often after large amounts of capital have been deployed.
TSMC and Samsung Dominate the Small Semiconductor Market
Company Percentage of Overall Revenue by Node Size
Source: Macquarie Research, Company Reports, VanEck. Data as of August 31, 2021.
TSMC has invested billions of dollars in R&D and manufacturing processes with a compounding effect that has seen TSMC’s dominance grow with every new node they reached, culminating in a staggering 90% market share3 of most leading edge nodes currently in production today – for all intents and purposes a global quasi-monopoly. This leadership gives them substantial pricing power, which was put on display at the end of August 2021, when TSMC announced that it was going to raise its prices by as much as 20% in response to the global chip shortage.4 First initiated in January 2011, TSMC is now a top 3 portfolio position in our Emerging Markets Equity strategy.* Needless to say, we remain confident in the sustainability of their dominant position and their ability to deliver visible and persistent earnings growth for the foreseeable future.
How Samsung Cornered the Memory Market
Samsung Electronics is planning to invest over US$200B and hire 40,000 employees over the next three years5 – a monumental feat considering the company’s humble beginnings as a shop selling dried fish and vegetables in 1938. A large portion of this investment will be funneled into their crown jewel: memory. The business unit is responsible for manufacturing dynamic random access memory (DRAM)6 and non-volatile flash memory (NAND). Both are critical components in computers, smartphone and data centers.
Samsung has been able to achieve its market leading position in memory through a combination of disciplined counter cyclical investing and process engineering. Memory was once a stereotypical boom and bust sector, as demonstrated by the dramatic DRAM down cycles of 2001, 2008 and 2012. During these volatile cycles, Samsung’s disciplined investing approach and engineering prowess created a positive feedback loop. Their technology leadership gave them a cost advantage, which meant that during an up cycle, they were able to generate more profits and cash than their peers, which was then invested in the subsequent down cycle. These investments went into R&D, creating a larger technology gap between themselves and the competition. During these cycles, many of their peers took on large amounts of debt in order to try and narrow the technology gap, more often than not resulting in them exiting the industry or going bankrupt.
Stacked DRAM Decision Led to Samsung Leadership
SEC Market Share of DRAM Sales
Source: Macquarie Research, DRAMeXchange. Data as of August 31, 2021.
If we had to pick a defining moment that led to Samsung’s technology leadership, it would be their decision to pursue a stacked capacitor architecture in DRAM. The capacitor is a crucial component in DRAM, responsible for storing charge as memory. Back in the early 2000s, there were two schools of thought regarding the architecture of capacitors that led to a divergence in the technology roadmap for DRAM – namely, stacked and trenched. Samsung’s competitors pursued trenched, because it was able to achieve higher frequencies with its vertical structure. However as chip sizes shrank over time, performance became an issue as chips became too thin and hence the vertical structure became a limiting factor. Although stacked capacitors had some initial performance issues, they proved to be more robust and crucially enabled companies like Samsung and Hynix to shrink their DRAM chips at a faster pace. Consequently companies such as Qimonda, Powerchip, Promos, Inotera and Elpida – that had cyclical investing strategies or pursued the trenched capacitors – were either acquired, exited the industry or went bankrupt.
Today, we are left with a memory industry that resembles an oligopoly, where the rational pursuit of profitability is prioritized over aggressive market share gains. Consequently, Samsung has become more aligned with our investment structural growth at reasonable price (SGARP) philosophy, as its profits have become far less cyclical and its moat7 has become sufficiently wide. We believe Samsung’s high levels of profitability are now sustainable, as proven by the most recent DRAM cycle, where margins remain relatively stable. Furthermore, excess investment appears to be a thing of the past as free cash flow margins are consistently positive and leverage has even fallen to levels where management has introduced regular dividends.
Samsung Exhibits Superior Operating Performance
SEC Profitability Relative to Major Peers
Source: Macquarie Research, DRAMeXchange. Data as of August 31, 2021.
Potential Pockets of Opportunity in China
Collectively, as an Investment Team, we have spent a significant amount of time researching China’s semiconductor landscape, given that the Middle Kingdom now accounts for ~20% of the world’s semiconductor capacity,8 combined with a policy backdrop that is highly favorable for Chinese companies looking to manufacture or design chips. In 2014, China’s state council set the goal of having the number one semiconductor design and manufacturing industry in the world by 2030.9 One of the biggest questions facing the industry and investors is – can they achieve this ambitious goal? The implications of China succeeding are clearly negative for incumbents, as China’s techno-nationalist agenda seeks to create a wholly owned semiconductor supply chain with zero reliance on outside entities. It is as much a national security issue as it is an economic issue, stretching beyond semiconductors. The ideal outcome for China is having a fully owned integrated vertical stack. The current equivalent is Apple’s iOS running on TSMC chips and/or Samsung’s DRAM.
Our research efforts suggest that complete self-sufficiency is unlikely – not only because competing at the leading edge with TSMC and Samsung is extremely difficult, but also due to the heavy reliance on other countries for high end equipment and software. However, there are pockets where we believe China could experience outsized success. For instance, 5G should drive the proliferation of chips into almost anything that’s electronic with the aim of achieving greater interconnectedness. Most of the chips required for 5G are rudimentary, resulting in lower barriers to entry, and the need for high volumes and fast production cycles play to Chinese strengths.
Chinese Semiconductors Relative Valuations Reinforce Need for Selectivity and Discipline
P/E multiple Index ticker Description FY19 FY20 Current (TTM) FY21E FY22E Global MSCI World Semiconductor Index 23.5 32.6 31.7 23.2 21.5 Philadelphia Stock Exchange Semiconductor Index 27.2 33.9 30.2 20.8 19.0 Bloomberg World Semiconductor Index 23.4 30.0 28.0 21.5 19.1 S&P 500 Semiconductor Index 21.5 29.3 28.3 20.8 19.6 Average 23.9 31.5 29.6 21.6 19.8 China FactSet China Semiconductor Index 63.1 51.0 38.8 32.8 Wind Semiconductor Index 93.2 85.2 77.8 59.9 43.9 Citic Semiconductor Index 126.0 98.2 77.0 65.3 52.1 Average 109.6 82.2 68.6 54.6 42.9
Source: Macquarie Research, DRAMeXchange. Data as of August 31, 2021.
If it wasn’t clear already, the last six months of regulatory turmoil in China have made it abundantly clear that investors must allocate capital to sectors and businesses that are aligned with the ambitions of the Chinese Communist Party (CCP). The trend of semiconductor localization is among one of the highest priorities for the government. However, the companies we have identified, beyond TSMC and Samsung, as having strong business models that fit this criteria are richly valued. Hence, we continue to be disciplined and wait for appropriate entry points – staying true to our SGARP philosophy, process and approach to investing.
1 The operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales.
2 Source: Yuanchuan Research Group.
3 Source: Macquarie Research, Company Reports, VanEck. Data as of August 31, 2021.
4 Source: Nikkei Asia.
5 Source: Reuters. Data as of August 24, 2021.
6 Dynamic random-access memory (DRAM) is a type of random-access memory that stores each bit of data in a separate capacitor within an integrated circuit. The capacitor can be either charged or discharged; these two states are taken to represent the two values of a bit, conventionally called 0 and 1.
7 A moat is a sustainable competitive advantage that is expected to allow a company to fend off competition and sustain profitability into the future.
8 Source: Credit Suisse, Gartner.
9 Source: CSIS. Data as of February 27, 2019.
Please note that VanEck offers investments products that invest in the asset class(es) or industries included in this commentary.
*All company weightings are as of August 31, 2021. Any mention of an individual security is not a recommendation to buy or to sell the security. Strategy securities and holdings may vary.
The MSCI World Semiconductors and Semiconductor Equipment Index is composed of large and mid-cap stocks across 23 Developed Markets (DM) countries. The PHLX Semiconductor Sector is a Philadelphia Stock Exchange capitalization-weighted index composed of the 30 largest companies primarily involved in the design, distribution, manufacture, and sale of semiconductors. The Bloomberg World Semiconductors Index is a capitalization-weighted index of the leading semiconductor stocks in the World. The Standard and Poor's 500 Semiconductors & Semiconductor Equipment Index Industry Group Index is a capitalization-weighted index. The FactSet China Semiconductor Index is an equity benchmark designed to track the performance of the growing domestic semiconductor industry in China. The index captures Chinese companies that are focusing on semiconductor manufacturing and relevant components. The Wind Semiconductor Index consists of 102 stocks in total and is based on weighted market cap. The Citic Semiconductor Index consists of 72 stocks in total and is based on weighted market cap.
The operating margin measures how much profit a company makes on a dollar of sales after paying for variable costs of production, such as wages and raw materials, but before paying interest or tax. It is calculated by dividing a company’s operating income by its net sales.
The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results, are valid as of the date of this communication and subject to change without notice. Information provided by third party sources is believed to be reliable and has not been independently verified for accuracy or completeness and cannot be guaranteed. VanEck does not guarantee the accuracy of third party data. The information herein represents the opinion of the author(s), but not necessarily those of VanEck.
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