Semiconductor Business Results, July 2017

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Can you wait a year to understand the strategic actions of Semiconductor companies or do you need quarterly updates?

If you are a Semiconductor Professional, a Strategic Purchaser or a Supplier to the Semiconductor Industry you need to understand what the latest results of semiconductor companies really mean.
We provide the most comprehensive analysis of the Q4-16 results of the top semiconductor companies to be used as the foundation for your strategic analysis and decision-making processes.

63 pages packed with Charts, Analysis, Strategic Models and Infographics.

43 charts comparing the Q4 results of top semiconductor companies with each other and average results.

8 Infographics Including The Semiconductor Value Chain, M&A Overview, Synergies and Meger balance sheet.

3 Strategic Business Model Analysis: The Competition Map, The Price Efficiency Gap & The Operating Model Grid.

Semiconductor Purchasers Index for Strategic Selection of Semiconductor suppliers.

You can buy the Semiconductor Business Results Quarterly here: SBRQ July 2017

Guidepoint Semiconductor Consulting

 

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Claus Aasholm consults for Top Semiconductor Producers, Strategic Purchasers, the Investment Community and Companies selling equipment to the Semiconductor Industry. If you want to understand the latest developments in this fast moving industry, you need to talk to Claus.

He tracks all metrics of the semiconductor industry. He monitors the business models of top 30 semiconductor companies by tracking key financial metrics on a quarterly basis. Semiconductor companies reveal changes in strategy through financial metrics.

Semiconductor market metrics are also tracked by Claus. He has developed a new market metric that apart from traditional market models also is able to track new developing market like IoT, the Datacenter, GPU & Mobile market together with more established markets

You can get advice from Claus Aasholm through Guidepoint

Semiconductor Investment or Extraction?

It is expensive to participate in the Semiconductor industry. Billion dollar fabs are needed, full of equipment their weight worth in gold. Chasing the leading edge technology while being chased by obsolescence. Moore’s law has not created a linear market but an industry full of exponential increases. The cost of developing new technologies and new products are dramatically increasing as are the costs of manufacturing facilities and equipment. The only element of the semiconductor business model that is slowing down is revenue growth.

This development is changing the business models of semiconductor companies. Not all companies are participating in the technology race anymore. Some have become predators and live of acquiring other companies. Others have outsourced most of their manufacturing and other elements of their business hoping that the loss of value chain does not impact overall value creation. There are also companies that are consolidating their operation trying to make careful strategic bets hoping to create golden eggs – products that can withstand the technology race and deliver revenue for many years.

What used to be one business model has morphed into many different business models. For most stakeholders in the industry, it is important to understand the business model as it can predict the behavior of semiconductor companies in certain situations. If you work for, sell to or buy from a semicoductor company, you want to know.

One of the key financial metrics you want to follow is the R&D spend. If a company is not investing in the future there is a high likelyhood they are focusing on extracting value from their current relationships. You don’t want to work with semiconductor companies that want more of the cake, you want to work with companies baking bigger cakes. The largest spenders are not necessarily the best companies to work with, but there is a correlation.

 

Semi R&D Compare to other industries report

 

 

The semiconductor industry outspends most other industries, even the pharma and biotek industry that do a good job of telling everybody how much they invest. The R&D spend is increasing although the Q4 spend was down compared to the same quarter last year. We believe this increase will continue givent the challenges the industry is facing from a product development perspective and technological perspective.

What looks like an impressive spend in another industry can be unambitious in semiconductors. You need to compare the spend to other semiconductor companies to get any insights. The large spread of R&D spending in the semiconductor industry combined with other information can uncover different business models. There are investor and extractor companies in the semiconductor industry.

We believe this matters to all stakeholders in the industry. We are currently working on a report that dissects the Q4 results and the business models of the top semiconductor companies. Sign up for a notification here.

 

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Micron and Hynix will not be catching Toshiba Semi

The air is thick with rumours about Toshiba’s semiconductor division. Toshiba has massive losses on their nuclear operation and desperately needs cash. The only division in Toshiba that makes a meaningful profit is the semiconductor division. After having announced the Semiconductor division is going to be divested into a separate company, Toshiba has opened for outside investors to buy a share in the new company. Their want to base the investment on a valuation of the company of 17B$.

 

Negotiation tactics.

Toshiba knows very well that nobody wants to buy a share, only a complete acquisition will make sense. A valuation of 17B$ would require the company to have a consistent revenue growth rate of 5%+ (last decade has been negative) and a Gross Profit margin of 23%+ (last quarter the GPM was 12.4%). The current business model is not even cash flow positive as it is estimated that the unit has a capital expenditure of over 1.5B$ a year. The semiconductor division needs to be combined with another company to unlock the required value.

Toshiba can attract investment in their memory division but not in their supervision of its operation.

 

Scale of economies

Amongst the suitors are two of Toshiba’s largest competitors, Micron and SK Hynix. If any of the companies succeeded, they would both make it to number two spot in the NAND flash market behind Samsung. They would triple in revenue in the process which is likely to create scale of economies that could unlock the value of Toshiba’s Semiconductor division, so an acquisition could make sense from a financial perspective. But would it be approved by the authorities?

 

Establishing market concentration

The Herfindahl-Hirschman Index or HHI sounds like a terribly complex financial parameter but really is a simple way of understanding the concentration of a market. In its simplest form, HHI is a percentage between 0% (Infinite number of small companies and 100% (A perfect monopoly of 1 company). A low HHI indicates a highly competitive market and a high HHI suggest that the market could be non-competitive. The US Department of Justice considers a market above 15% as moderately concentrated and a highly concentrated market has an HHI over 25%. Generally, the US DOJ will not accept mergers that create markets with and HHI above 25%. EU are interested in markets with HHI’s over 10% and will bar a merger that creates an HHI change over 2,5%. The US and EU can base their decision on other reasons than HHI alone but the current environment is not very merger-friendly. The semiconductor industry has become strategic to governments and trade blocks around the world. China has made no secret of this with their ambition to become the leading manufacturer of semiconductors and is already well underway. A violation of HHI rules is all the excuse a government need to block a merger.

For the semiconductor market as a whole, the HHI is 6% and should cause no anti-competition problem but for the NAND market it looks very different:

HHI Toshiba-01

 

The current HHI of 22.7% is above the EU radar horizon but below the US assigned threshold of 25%. As can be seen on the chart, both a Micron-Toshiba and an SK Hynix-Toshiba merger would trigger the HHI thresholds of both EU and the US. With a change in HHI of 3.9 to 4.1%, well above the EU trigger point, these mergers would create a new market with an HHI of 26.6 to 26.8% well above the US trigger point.

We do not believe Micron or SK Hynix will be allowed to acquire the semiconductor division of Toshiba, no matter how much they would like to.

 

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Memory on a silver platter?

Toshiba has once more demonstrated that Conglomerates with semiconductor divisions behave very differently from pure-play semiconductor companies. Business issues elsewhere in the corporation are forcing Toshiba to sell the only part of their business that makes money. Although the bait was for 20% of the division, everybody knows that Toshiba will have to sell it all. The value of the standalone semiconductor unit is less than the value of the division combined with a business in another company.

Toshiba For Sale-01

 

 

 

The hierarchy of memory

Toshiba is a big player in non-volatile Flash memory. Although not sufficiently fast to replace the DRAM that processors need close by, Flash is a lot faster than hard disks and placed between the two. A lot of flash memory between DRAM and Hard Disk Drives (HDD) in the memory hierarchy, drives the total performance of the memory system closer to DRAM and the price per bit closer to HDD memory. Market leader Intel has made no secret of their big bet in Flash Memory. They know processors, and fast memory is in love and wants to be close.

 

Screen Shot 2017-03-02 at 15.22.55

 

Intel investing in Flash means they do not consider it a commodity and believe they will have commercial advantages by being able to sell both the processor and the flash at the same time. In short, memory is worth more in a CPU company than it is stand-alone.

 

The suitors and their reasons

SK Hynix, Micron – Both playing in the Flash market Hynix and Micron is interested in Toshiba for “scale of economies” reasons. An acquisition would make them stronger in the flash market and would allow them to command larger R&D budgets and CAPEX expenditure. Memory fabs and technology is expensive. Intel’s big bet on memory is founded on the argument that memory is worth more when sold together with processors. If this is right, Toshiba will be worth less in Micron and Hynix than it will be in some of the other constellations. What something is worth and what somebody wants to pay for it is two different things, and Toshiba could end up here.

Westen Digital – Being a key player in Hard Disk Drives, Western Digital is well positioned at the low end of the memory hierarchy and want more. They have already demonstrated their appetite for flash by acquiring SanDisk recently.

Foxconn, Softbank – Both companies are significant stakeholders in Apple. Foxconn handles most of Apple’s manufacturing, and Softbank owns ARM – the processor IP of Apple’s CPU’s. They are interested in Toshiba as Apple are one of the largest consumers of Flash for all their products. This Apple Mafia has announced a joint venture investment company this week, undoubtedly to bid for Toshiba and command even more of Apple’s need. It would be a miracle if Apple were not part of these conversations.

Bain Capital – As an investment company, Bain has already made some investments in cloud-based companies, cloud computing and SAS companies. For them, it is a datacenter play in line with their existing technology investments.

SilverLake – Investigating SilverLake’s investments reveals a couple of interesting positions. Broadcom, also a player in the processor and datacenter space and Alibaba – the Amazon of China. (Also Softbank has a stake in Alibaba). Alibaba wants to be the future trade platform for companies selling to consumers and know this will rely heavily on cloud computing. Currently, only 8% of Alibaba’s revenue is associated with the cloud.

Tsinghua Unigroup – The preferred semiconductor investment vehicle of the Chinese authorities are undoubtedly interested in Toshiba, but is not likely to receive approval from the Japanese authorities.

Any of these suitors are possible winners of the bid for Toshiba, but we believe the Apple Mafia is likely to be able to unlock most value from the deal.

 

Full article in the Korean Herald here

 

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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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You need a big stack of chips to play the Semiconductor Roulette

Most of the technological development over the last couple of decades has been driven by an industry driven by a very simple equation. Moores law states that the density of transistors in semiconductor chips doubles every two years. This means semiconductor companies deliver cheaper, faster and lower power consumption chips every year enabling other industries to grow.

The semiconductor industry itself is not growing significantly anymore even though the number of transistors it manufactures doubles every two years. It has reached a commodity equilibrium hard to break.

Just to stand still semiconductor companies need to invest massively in new technology and in acquiring competitors to get to a higher scale of economy that allows massive investments.

This is not an even race as can be seen in the chart. Three companies dominate the roulette table:

Top R&D Spenders 16Q3-01

 

A few companies dominate the race followed by a long string of companies that are struggling to handle the investments needed to participate in Moore's race. Although the technology is available through subcontractors, using it comes with a loss in the value chain that has an impact on costs and gross margins.

Moore's law is available only to a few companies

If you want to be in the semiconductor game you need to go big or go home. The R&D cost relative to sales is an average of 17.2% for the major semiconductor companies. This is significantly over what other industries normally invest in R&D and way above technologically (still) respected Apple Inc, that only invest 5.5% of sales into R&D.

Top R&D Spenders 16Q3 Share of Revenue

Investing too much into R&D makes you a target for acquisition. To buy a company you have to pay more than it is worth (many different measurements available). For an acquisition to make sense it has to either deliver revenue synergy, cost synergy or both. In the semiconductor industry, cost synergies dominate. This means a high R&D ratio gives an acquirer the opportunity to cut R&D spend with little immediate impact. Longer term there might be ramifications.

The industry is entering a new phase of uncertainty where M&A might not be the path to survival it has been for the last few years. What the Obama administration started the new Trump administration will continue, blocking foreign acquisitions of semiconductor companies. In return China and Europe are likely to block any intra-US mergers. Soon the industry will have to learn how to grow organically again.

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