Finding Opportunities in the Semis
President Biden signed a new bill into law on Tuesday that provides ~$52B in investment and tax credits for domestic chip production and research.
The legislation garnered rare bipartisan support – boosting competitiveness with China seems an issue both Dems and Republicans can rally around. The long-anticipated funding did little to stem souring sentiment around chip stocks, with the VanEck Semiconductor ETF (SMH) shedding over 4% Tuesday, adding to Monday’s 1.7% decline. The group managed to bounce 4% with the broader market Wednesday, but is still off ~23% so far this year.
Semiconductor chips power a range of industries, from consumer tech, including gaming, PCs, and smartphones, to enterprise data centers for cloud computing, to software systems for automobiles.
Covid sparked a well-known surge in demand for at-home entertainment, while remote work accelerated the adoption of cloud services. At the same time, supply chain disruptions exposed the industry’s reliance on Asia for components.
Fabrication plants manufacture the small silicon wafers and integrated circuits that are critical inputs in the construction of finished chips. Roughly 80% of fabrication capacity is in Asia – a key catalyst for the Chips Act, as foreign dependence was portrayed as a national security risk.
Global fab capacity:
- South Korea: 28%
- Taiwan: 22%
- Japan: 16%
- China: 12%
Auto execs and frustrated car buyers have spent the last two years lamenting a backlog of near-finished vehicles that sat in lots for months, waiting for chips ahead of delivery.
This heavy demand, along with tight inventories, drove a surge in pricing that helped the SMH rally over 230% from its March 2020 lows to its Nov 2021 peak.
Semis are highly cyclical. When the economy is raging and people are spending, chip orders tend to follow. But a complex supply chain and low demand visibility leaves the industry prone to inventory deficits, or in current times, a major glut.
A recent parade of earnings misses and gloomy guidance have shed light on how dismal the group’s outlook has become.
PC, mobile, and gaming demand have evaporated
Intel sparked fallout across the sector when it reported abysmal second-quarter results two weeks ago. The company’s revenues fell 22% year over year, largely due to slumping PC demand. The release proved a harbinger of further pain for the space – mobile-phone chip supplier Qualcomm projected current year 5G smartphone shipments to fall 50 to 100 million units from previous estimates.
One area that’s held up relatively well has been data center demand. Earnings from Amazon and Microsoft showed enterprise cloud spend remains robust, as companies have opted for hiring slowdowns or layoffs to pare expenses.
Build it with Noonum: Semi trade idea (long data center and auto segments/short consumer tech chipmakers)
Using Noonum to analyze an ETF like SMH, we can quickly identify the individual themes that the fund has exposure to and which companies drive those themes.
For a more insulated demand segment like data centers, we can quickly identify Nvidia (NVDA) and Broadcom (AVGO) as the two most exposed names. Nvidia released Q2 earnings earlier this week, which showed data center revenue up 61% versus the same quarter last year.
Despite the weakness in memory and gaming segments, demand for chips from automakers remains resilient. Nvidia’s industrial and automotive segments saw 45% YoY revenue growth last quarter. NXP Semiconductors (NXP), the second largest supplier of chips to the car industry, recently raised its Q3 sales and margin guidance.
We can also look outside the chipmakers. If Nvidia and Broadcom are seeing relatively strong demand for their data center chips, end customers that use Nvidia’s graphic processing units (GPUs) to power their data centers should be faring well too. Noonum easily identifies digital infrastructure leader Equinix (EQIX) as a top exposed company to an enterprise cloud-driven semi strategy. Equinix operates data centers for the likes of Amazon, Apple, and Facebook, using Nvidia's chips for training AI models and storage. EQIX has outperformed the SMH by 7% YTD.
For broad industry exposure across the data center theme and its supply chain, Noonum surfaces the Global X Data Center REIT and Digital Infrastructure ETF (VPN) as a top fund to explore. Equinix is the ETF’s top holding with a 12.54% weighting.
Why Hasn’t the Chips Act Helped?
Cooling demand aside, another reason investors have discounted the impact of the Chips Act is because it won’t be enough to encourage a meaningful change in corporate strategy for semi manufacturers anytime soon.
The White House has been quick to highlight Micron’s $40B pledged investment in U.S.-based factories and Qualcomm’s $4.2B agreement to purchase chips from Global Foundries, but these are investments that will play out over the next decade.
For now, it’s all about right-sizing inventory and protecting margins.
If Amazon, Microsoft, and Google see cracks in their cloud businesses, the industry will be in for more pain. Then again, that would spell trouble for more than just the semis.
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Disclaimer: All opinions expressed are the author’s own, and nothing contained in this column is intended as financial advice.