Chip sales to soar. Here’s how you can capitalise on this opportunity

The semiconductors sector will be 1 of the best-performing sectors over the next decade due to the structural megatrends such as AI and digitalisation (pic: Bloomberg)

Semiconductor is once again at a pivotal turning point thanks to the rapid adoption of AI

by IFAST RESEARCH TEAM

THE semiconductor industry has been mired in a downturn since the fourth quarter of 2022 (4Q22) as chip sales plunged by nearly -10% year-on-year (YoY), the first negative print since 2019.

Fast forward to today, the slump in sales has worsened, coming in at -20% as of 2Q23. This comes as many chip-makers, including the likes of Taiwan Semiconductor Manufacturing Co Ltd (TSMC) continue to warn of falling demand and rising inventories, a trend that is likely to persist for the remainder of the year.

Despite the grim near-term outlook, we have a bold prediction to make. And that is for semiconductor sales to hit 40% YoY growth by 2Q25.

Underpinning this prediction is our investment thesis that chipmakers will see a massive structural increase in demand as the world becomes increasingly digitalised, leading to more semiconductor applications and higher silicon content in them.

Over the past few months, our conviction has become even stronger as the generative artificial intelligence (AI) frenzy took the world by storm following the launch of ChatGPT in late 2022.

We believe the industry is once again at a pivotal turning point thanks to the rapid adoption of AI, which requires highly advanced processors capable of handling huge, complex workloads efficiently. Just like the PC and mobile revolutions, we believe the AI revolution will bring tremendous opportunities for chipmakers over the next decade.

We are already starting to see a few early beneficiaries of AI. Nvidia, the poster child of AI, saw its data centre revenue rise from a negligible amount in the financial year 2014 (FY14), to more than US$15 billion (RM70.20 billion) in FY23. Today, the segment continues to be its largest source of revenue by a long shot.

Inventory Cycle Adjustments

To better comprehend why we think 40% YoY sales growth is achievable, we’ll have to revisit the inventory cycle. Semiconductor cycles are essentially driven by fluctuating sales growth numbers, which are caused by distortions to supply and demand dynamics. There are a few factors, but for the most part, these distortions can be explained by over-and underestimations in production levels.

Given how dependent the world is on technology and the growing number of end-use products we have today, the overall demand for electronic products (and hence semiconductors) tends to see a steady increase each year under normal economic conditions.

On the contrary, the supply of semiconductors tends to vary a lot more. This is mainly due to adjustments in production levels by chipmakers. When times are good, chipmakers tend to overestimate demand, invest heavily in capacity and produce more than what the market can absorb.

Over time, the high level of production eventually becomes unsustainable as inventory starts to build, leading to an oversupply. When this happens, chipmakers slash prices and cut down on production as they work through excess inventory, causing sales growth to fall even as demand remains relatively stable.

But just like how chipmakers tend to over-produce when times are good, they also have the tendency to under-produce when times are bad. Put simply, it is the excessive adjustments in production levels that lead to fluctuating sales growth numbers, a characteristic that defines the cyclical nature of the semiconductor industry.

The current downcycle began with a shortage back in 2020. Back then, chipmakers were under enormous pressure from stakeholders and clients to meet the growing demand for semiconductors, which many responded to by ramping up their capacity. As a matter of fact, industry capital expenditure (capex) rose by a staggering 39% and 20% in 2021 and 2022, respectively.

Unsurprisingly, this sudden and sharp increase in capex resulted in a supply glut. Today, several chipmakers have made significant downward revisions to their capex budgets, citing bloated inventory channels as one of the key reasons. On an industry level, capex is projected to shrink by nearly -20% this year as chipmakers continue to hold back on spending.

While the near-term outlook certainly warrants a more cautious approach, we think that chipmakers are underestimating the impact AI will have on the chip demand in the long run, the supply of which is currently inadequate at present. Once this downcycle blows over and clearer signs of a recovery emerge, chipmakers will likely feel more confident to bring more supply online, which should translate to higher sales growth in the future.

Govt Incentives and Base Effects

Across the world, governments are doling out massive incentives to build fabs, adding to the total supply of semiconductors in the years to come. In the US, we have the US$280 billion CHIPS and Science Act, designed to boost US semiconductor research and development, and manufacturing.

Since the Act was passed in August 2022, several domestic companies such as Micron Technology Inc, Qualcomm Inc and GlobalFoundries Inc announced plans to increase their manufacturing capacity on US soil. Even foreign chipmakers, notably TSMC have also taken advantage of the Act by building two leading-edge fabs in the state of Arizona, which it targets to be operational by 2025.

In Asia, China has made the development of its domestic semiconductor capabilities one of its biggest national priorities. Support from the central government comes mainly from the China Integrated Circuit Industry Investment Fund (ICF), which has raised a combined total of over US$40 billion in its first two phases. In September, it was reported that fundraising for Phase 3 had begun, with a target of US$40 billion.

Japan, whose chipmakers once dominated the industry in the 1970s to 1980s is also looking to regain its lost status as a semiconductor powerhouse. The Japanese government has launched several initiatives geared towards attracting semiconductor investments on Japanese soil and fostering collaboration between foreign and domestic chipmakers.

With the industry in a steep downturn today, base effects as well as the massive incentives handed out by governments across the globe should help to drive higher sales figures once the recovery gets underway.

Look Beyond the Current Down Cycle, Invest for Long-Term

Taking into consideration all the factors mentioned above, particularly the structural megatrends such as AI and digitalisation, we are confident that semiconductors will be one of the best-performing sectors over the next decade. And with a recovery of the chip cycle in sight, we see a positive earnings outlook for semiconductor companies in the near to mid-term. The recent selloff has also made valuations slightly more attractive, providing investors with a better entry point.