The U.S. semiconductor industry has been on a strong run since early 2016, with the PHLX Semiconductor Index returning nearly 76% from the market bottom on February 12 of last year through April 30 of this year. This compares to 28% for the broader S&P 500 Index. (See Exhibit 1.) Behind this performance are multiple drivers that we believe have reinvigorated the maturing industry.
Semiconductors are the foundation of electronics, controlling myriad consumer and industrial devices from personal computers and mobile phones to household appliances and cars to medical and energy infrastructure equipment. But after decades of rapid expansion, the industry struggled in recent years to recapture the high growth rates that defined its youth. Today, industry consolidation, new end markets, and China’s determination to be a leader in the space have reaccelerated semiconductor companies.
Shifting from Rapid Growth to Consolidation
The semiconductor industry has traditionally been highly cyclical, but some of the cyclicality has been attributable to a management style better suited to earlier-stage companies, even as the industry has matured. Recent turnover in the C-suite at many companies, however, has ushered in a wave of experienced managers focused on improving profitability and stewardship of capital, largely through shedding unprofitable businesses, price increases, mergers, buybacks, and expansions into new markets.
Slowing global growth and the low cost of capital have opened up the industry to mergers and acquisitions activity. The resulting widespread industry consolidation has reduced competition and enhanced financial performance. In 2016 alone, there were 14 mergers in the industry with an aggregate market value of more than $150 billion1. It has allowed the surviving companies to rationalize their cost structures, realize benefits to scale, and increase their operating margins by an average of 5% over the past five years. This consolidation has also led to higher multiples, because investors place more value on the consistency that these larger, higher-margin businesses can provide.
An Abundance of New Markets
Another trend adding to the attractiveness of semiconductor companies is the explosion of new products that require semiconductors. Traditionally, semiconductors have been associated with computers, and as the computer market grew from room-sized servers, to personal computers, to smartphones and tablets, the semiconductor market grew along with it. As the PC market matures and the smartphone market becomes increasingly saturated, semiconductor manufacturers are looking to new markets to power the next leg of growth.
The Internet of Things (IoT) is one such area. Common household items like thermostats, refrigerators, and even coffee makers now have the ability to connect to the Internet, and offer a wide range of new services to their owners. These new features are made possible by semiconductors. In addition, we’re in the early innings of the shift to cloud computing, which is enabled by huge data centers that contain large numbers of semiconductors. Spending on semiconductors for artificial intelligence platforms is expected to increase from $2 billion to $20 billion over the next four years2. Finally, the automotive market is another area of potential growth for the industry, as new cars contain more and more semiconductors, and the future of autonomous vehicles means this demand is likely to increase further (estimated growth from $32 billion currently to $42 billion by 20203).
The Rise of China
The entry of Chinese companies into the market has also benefitted semiconductor manufacturers and suppliers. China’s leadership has decided it is a national imperative for their country to be self-sufficient in the manufacturing of semiconductors. Currently, China claims about 16% of global production, while accounting for over 58% of global consumption4. They’ve set the ambitious goal of increasing semiconductor self-sufficiency to 70% by 20255.
To this end, Chinese state-owned enterprises have tried to purchase nearly every major semiconductor manufacturer in the world, which has helped to spur industry consolidation. However, in many instances, Chinese companies have been blocked on national security grounds from purchasing companies based in the U.S. and other developed nations.
Unable to purchase the expertise and manufacturing they need, China has decided to build it instead. The Chinese government is investing significant sums (estimated at around $120 billion by 20306) into the construction of large semiconductor fabrication plants, and many U.S. semiconductor equipment suppliers are seeing a surge in growth as they help to satisfy this demand. In the long run, the massive new semiconductor capacity being built in China could be a threat to established industry players. Currently, however, U.S. suppliers are benefitting substantially from the increased demand for their products.
Opportunities in the Small and Mid-Cap Space
For our small- and mid-cap portfolios, we seek out high-quality, well-run companies in the semiconductor industry—both producers and their suppliers—that are positioned to outperform their peers. Examples include:
Monolithic Power Systems: A small-cap company that got its start on the consumer side, Monolithic Power Systems has developed into a diversified producer of analog and mixed-signal semiconductors. The company’s innovative process technology enables them to produce more-efficient, better-designed products for the same or lower cost than their competitors, and has helped them deliver attractive revenue growth versus their peers.
Silicon Labs: As discussed above, the Internet of Things has captured the attention of consumers and the media. While it offers the industry’s fastest growth rate, the size of the IoT market today is too small to move the dial for the industry on the whole, and it tends to make up a small percentage of a given company’s business. Silicon Labs, an analog semiconductor producer with attractive margins and top-line growth, offers one of the more direct ways to invest in IoT, as it represents a high percentage of the company’s sales today compared with other players in the IoT space.
Microchip Technology: This company is a leader in producing microcontrollers, which can control a wide variety of common electronic devices, and analog chips, which can recognize and process real world inputs such as temperature and pressure. Microchip Technology is a mid-cap company known as a skilled consolidator. The company has made four acquisitions in the last three years, focusing on buying and re-architecting inefficient businesses into accretive profit centers.
Lam Research: Lam builds semiconductor fabrication equipment, which it supplies to many key semiconductor manufacturers. They are a market leader in etch, a critical step in semiconductor manufacturing during which material is selectively removed. A shift in memory architecture, which is requiring more etch, has been a particular growth area for Lam. As the semiconductor manufacturing process becomes increasingly complex, we believe that advanced equipment providers like Lam could continue to see strong demand for their products.
As consolidation, innovation and a boost from China give semiconductors a new lease on life, investors are taking advantage of the opportunities for growth and industry consolidation. For U.S.-based companies, a decrease in the corporate tax rate may also help the bottom line. Against this backdrop, we believe that well-run companies that make smart investments and grow faster than their peers will continue to present enticing investment opportunities.
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1Source: Ed Sperling, “A New Wave of Consolidation,” Semiconductor Engineering, November 22, 2016, available at http://semiengineering.com/new-wave-of-consolidation/.
2Source: Pacific Crest Securities, “Semiconductor Tectonics: Seismic Shifts, Aftershocks and Tremors,” April 9, 2017.
3Source: Pacific Crest Securities, “Semiconductor Tectonics: Seismic Shifts, Aftershocks and Tremors,” April 9, 2017.
4Source: PwC, “China’s Impact on the Semiconductor Industry: 2016 Update,” January 2017, available at http://www.pwc.com/gx/en/industries/technology/chinas-impact-on-semiconductor-industry.html.
5Source: McKinsey, “A new world under construction: China and semiconductors,” November 2015, available at http://www.mckinsey.com/global-themes/asia-pacific/a-new-world-under-construction-china-and-semiconductors.
6Source: Pacific Crest Securities, “Semiconductor Tectonics: Seismic Shifts, Aftershocks and Tremors,” April 9, 2017.
As of 3/31/17, Oppenheimer Discovery Fund held 2.08% in Monolithic Power Systems and 1.07% in Silicon Labs. As of 3/31/17, Oppenheimer Discovery Mid-Cap Growth Fund held 2.10% in Microchip Technology and 0.86% in Lam Research. Holdings are subject to change, do not constitute a recommendation by OppenheimerFunds, Inc., and are dollar weighted based on total assets.
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The S&P 500 Index is a capitalization-weighted index of 500 stocks intended to be a representative sample of leading companies in leading industries within the U.S. economy.
The PHLX Semiconductor Index is a modified capitalization-weighted index comprised of companies that are involved in the design, distribution, manufacturing, and sale of semiconductors. Indices include reinvestment of dividends but do not include fees, expenses or taxes. Indices are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any particular any investment.
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