Semiconductor bubble?

It has been a great year for semiconductor stock. This is important to the industry as stocks are often used to finance acquisitions and major investments. The industry is also known for its extensive use of options and warrants to keep executives and key people locked in. There is no problem in connecting results to rewards unless the increasing stock price is a result of speculation and not underlying results. A stock bubble might benefit a couple of lucky bankers but to most stakeholders it is damaging. The value created by the bubble will have to be paid back, and then some. People will get great bonuses and then get fired. Investments started and stopped.

 

Screenshot 2017-02-24 08.49.57

 

The obvious question

Nobody wants to spoil the fun and ask the obvious question: “Why are semiconductor stocks growing when the semiconductor revenue is not?”

Although revenue growth is one of the most important value drivers there could be other reasons for stocks to climb. One of the valuation methods used by financial analysts is the Shareholder Value Analysis (SVA). The analysis values a company based on its ability to deliver future cash flows. The model has 7 value drivers (as can be seen in the graphic) that create the valuation of a company. If the market change opinion about a company’s future revenue growth rate, the SVA shows a higher value for the company and the market respond immediately by adjusting the stock price accordingly. In theory at least. If the stock market and the underlying value drivers are out of sync, there is a high probability of a depression or a bubble.

The 7 drivers are:

  1. Revenue Growth.    Although there was an uptick in Q4-16 revenue the industry has been in low single digit growth for some time. This is not likely to change.
  2. Operating Margin.   Operating margins fell by 170 basis point from Q4-15 to Q4 -16
  3. Taxes.   The tax environment has two opposing forces: It is becoming more difficult to offshore profit for lower tax reasons and potentially lower corporate tax in the US.
  4. Working Capital Investments   The investments in working capital are likely to be flat following the revenue growth.
  5. Fixed Capital Investments     It is not becoming cheaper to participate in the industry. Both investment in replacement and new equipment only goes up.
  6. Cost of capital.    After many years with access to cheap captial, there are signs of increasing costs.
  7. Life of strategy.   There are many signs the current strategies are coming to an end. Exploding costs of chip design and the end of Moores law.

 

Value Drivers Bubble-01

 

From our perspective, there are no value drivers for the industry that warrants the current increase in stock prices. This does not mean that investing in individual companies still can be a good idea. All markets have winners and losers.

Article in Fox business here

 

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The GPU, CPU battle has reached the Economist

The Economist has decided to compare Intel against Nvidia and the result is as always interesting. With a level of simplification, they highlight the issues that Intel is facing. A competitor from a niche Intel should have been able to control is now starting to eat Intel’s future meal – the data centre.

Screenshot 2017-02-23 23.05.47

 

Read the article here

 

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China continues to gain share of Wafer Capacity

Research released by IC Insights confirmed that China keeps increasing its share of worldwide wafer capacity. Taiwan and China now collectively have 1/3rd of the global capacity. Trying to prevent China from buying western semiconductor companies will not be sufficient to stop them. There are many other ways of dominating. The research is based on physical location of the factory and not of the headquarter of the owner. Once again it demonstrates that semiconductors are a global business that cannot be isolated by isolationistic policies.

Screenshot 2017-02-23 17.24.11

 

Semiconductors have been declared strategic by both the US and by China. Europe has plenty to deal with and has decided not to have an opinion.

Read the research bulletin here

 

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The Semiconductor Operating Model Grid Q3-16

It is not unusual for people in the industry to talk about the semiconductor business model as it is something common and static for all companies in the market. While there are a lot of commonalities there is also a lot of interesting differences that can reveal a lot about what strategic choices a company is pursuing. Despite quarterly updates from the CEO, the format is dictated by Wall Street analysts trying to get numbers for their financial model so they can predict (guess) the numbers of the quarter. It is rare that something interesting is revealed. I cannot blame the leadership teams as they have lawyers and analyst hovering over them just waiting for a mistake.

What is much more useful is the financial reporting that public semiconductor companies have to deliver every quarter. As the format is reasonably stable it is possible to compare changes over time and also comparing companies to each other. This analysis is made for Semiconductor companies only – in our definition is public companies that have semiconductors as their only business and sell them to electronics customers. This excludes conglomerates as Samsung and foundries like TSMC and represents a choice taken for the availability of data and consistency.

While the manufacturing costs are hidden in the Cost of goods sold, the operating costs are more visible and interesting. Knowing where a company spends its operating dollars tells you a lot about that company.

Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are. James W. Frick

Other operating costs can exist, but the two most important ones are Research and Development (R&D) and Selling, General and Administrative (SG&A). The implications of a high R&D spend is understood by all people in this industry. It is a clear indication of the level of ambition of a company. SG&A costs are slightly more complicated as it is the sum of the selling costs and the general administration costs of the company, including management, staff functions, rent and utilities. A few companies report the two separately and offer a view into their relationship. The indications are that the G&A costs are dependent upon the size of the company and are somewhere from 2.5% to 7.5% of revenue, As such the G&A costs are relatively stable over time and changes in SG&A is a result of changes in sales and marketing activity.

The Operating Model Grid

A tool to investigate the two costs simultaneously is the operating model grid. The centre of the grid is representing the averages of the companies studied. By comparing companies this way, you can eliminate much of the economic noise that affects the entire market. By comparing similar quarters one year apart, any seasonality is excluded.  The periods compared in this grid is Q3-2016 and Q3-2015.

RD vs SGA 4 Development

 

 

Although it is not suggested that one business model is superior to another, there are four zones in the grid representing four different operating zones when compared to average. Companies in the ambition zone outspend the average company in both R&D and Selling. Smaller companies are typically in the ambition zone as they need high R&D and SG&A just to survive, where larger companies have more options when choosing their operating model.

Companies in the consolidation zone spend less than the average company in both categories. This could be as a result of having a commodity offering where price is more important than selling and R&D is technology focused rather than product focus. It could also be a preparation for an acquisition. Companies in the selling zone prioritise selling spend over R&D. This could be a result of having products that need high support or it could be an indication that the company want to get bought. In the development zone are companies that typically have high volume leading edge products that are sold to few customers. What is more interesting than the zones is the change in operating mode over the year represented by the arrows.

The grid is not an absolute – it is a model to identify interesting questions to be researched. Both Nvidia and AMD have experienced healthy growth, and they have decided not increase the operating costs simultaneously. This could be a lack of confidence that the growth is sustainable or it could be that they are not able to find the right people and projects sufficiently fast.

Hynix and Micron have decided to handle the growth in memory differently. Where Micron keeps their R&D steady and increases their sales investment in line with growth, Hynix puts the pedal to the metal. This is a very strong indication that Hynix has a strong belief in their current strategy.

A merger will typically create a movement towards consolidation. (We compare the sum of the two entities to the newly merged company). The overhead you pay for the acquired company needs to be repaid. Operating costs are fast carbohydrates for merger integration teams.

What is interesting is the three European semiconductor companies all are quite close together and also close to TI. Intel is not surprisingly in the ambition zone but heading towards consolidation.  This could be a result of the change from PC focus to data centres, IoT and AI that cannot absorb the drop in spend on PC.

The Semiconductor Operating Model Grid for Q4 will be released in a couple of weeks together with an in-depth analysis of the fourth quarter for Semiconductor companies.

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Semiconductor Gross Margin update Q4-2016

The strong end of 2016 for the semiconductor market almost certainly had a significant impact on the gross margin of most companies. Overall the average gross margin grew 0.8% from 51.4% in Q4-15 to 52.2% in Q4-16. The high end of the spectrum is dominated by FPGA and analogue semiconductor companies. This would have included Altera prior to being acquired by Intel, with a pre-merge gross margin of 66.7%.

 

The next group of companies is focused on computation and communication, including Intel that heavily dominates the average gross margin for the industry. At the other end of the spectrum is Micron that plays the memory market with a low margin model. Also On Semiconductor has a low gross margin although is looks more like a conscious decision given their very low R&D and selling costs. 

Some companies have experienced a significant change in Gross margin Q4-15 to Q4-16. In the case of Marvell, it relates to significant extraordinary costs they had in Q4-15 that does not impact the last quarter. The Gross margin improvement of NXP is related to the acquisition of Freescale and divestiture of other assets and is likely to settle unless the Qualcomm merger gets a final approval. Similarly for Cypress that is trying to digest Spansion. 

The increase in gross margin of Hynix is related to the increase in memory pricing although this did not seem to impact the gross margin of Micron that stayed relatively flat.

A key competitive driver of semiconductor companies is their gross margin. Gross margin gives insight into the manufacturing efficiency of a company as it represents the revenue less the cost of goods sold. Cost of goods sold represents all of the costs associated with the manufacturing process but does not include any of the R&D, Sales or administration costs.

There is no right gross margin, it is an operating decision or a business result based on how you run your business. For semiconductor companies, their manufacturing decisions can have a significant impact on their gross margin. That said, you want to keep your gross margin as high as possible as it is the fuel for R&D and Sales activity, it pays for your administration and it creates the return to your shareholders.

If you are a customer of semiconductor companies you want to select a supplier with the right kind of gross margin. If the gross margin is too high, it could mean you are paying too much for the product and should find a better supplier.  Low gross margin companies are targets that can be improved by competitors in a takeover. Acquisitions are not your friends if you are buying.

Acquisitions in not a friend of the employee either. The chance of an employee surviving without loss of job, title or pay is low when you are in the target company. It is important to work in a company that has a high gross margin as such a company has difficulties in finding an acquisition target that meaningfully can add to the business as high margin businesses have high price targets.

 

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A shift in China’s Semiconductor Industry?

The announcement of Tsinghua Unigroup's acquisition of a majority stake in XMC under the supervision of the National Semiconductor fund could represent a change in China's quest for semiconductor domination. The two companies could be merged into the newly created holding company Yangtze River Storage Technology with a capital of 2.8B$. Read the story here.

As the antiglobalisation wave spreads, it is starting to have an impact on the semiconductor world. Many semiconductor companies have turned to M&A activity in a search for meaningful value creation for their shareholders. China's semiconductor ambitions are crystal clear and several attempts have been made by Chinese companies to acquire western semiconductor companies. These acquisitions have been blocked by the US government even though they did not violate the rules of market competition. The semiconductor industry has now been declared strategic by both China and the US.

China Chips

This deal could represent a shift in China strategy away from foreign acquisition into a race of technology and capital investments. This will be difficult to follow for western semiconductor companies that rely heavily on being able to syphon their capital investments from their retained earnings. They do not like large bets that involve asking their investors for capital and work to make the quarter. The Chinese are playing to win the decade and they are gaining ground, even without buying western companies.

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