Semiconductor industry deep dive - from history to margins
Semiconductor industry research
Find the corresponding spreadsheet for the post here (google drive link to xls. file): Semiconductor industry research
1. History of semiconductors
In the beginning semiconductor companies made everything, from radio to chips. In the 70’s the first split happened between semiconductors and electronics. Through innovation – Moore’s law – specific parts of the chip development became extremely complex and costly. Due to those developments in the industry another split happened. In the 90’s companies started to focus on different parts of the value chain which were chip design and manufacturing. This change in the market led to the foundation of the well-known companies most people either in investing or technology are familiar with like Nvidia, Qualcomm or Broadcom. The fragmentation did not stop their because due to the high demand in consumer electronics for more power, reliability and efficiency. Which led to the market in late 2000’s and early 2010’s in which the industry focused on the development of chips for mobile sector. In the market today another step towards more power and efficiency in electronics happens triggered through innovation in artificial intelligence like autonomous driving, Internet of things (IoT), and Blockchain. Companies like Tesla, Google (Video Coding Unit) or Apple (M1 & M2) started to design their own chips to improve their products even more.
2. Covid Crisis and its impact on semiconductor industry
The current semiconductor market is not only very highly fragmented horizontally, but also very concentrated in terms of location. 75% of chip production happens to be in Asia, which was the reason why many consumers had to wait for many products and still have to. Although the US contributes about 38% of the complete value chain in the semiconductor industry, they have no capacity for manufacturing. Most of the contribution consists of process and task related to R&D (EDA = electronic design automation and Core IP = Intellectual property – logic of the design of the chip). When the covid crisis happened and government order lockdowns on multiple countries people were stuck at home and spend time streaming, gaming, homeschooling and work from home which all involve consumer electronic products, until today the main demand driver of the semiconductor industry – 175 Billion dollars in value. The demand piled up but nobody was able to produce which has led to a supply chain issue. Due to this high fragmented and concentrated market governments took action and released major programs. Those programs involve but are not limited to:
The EU chips act released on February 2022 worth 43 billion euros
Japan sponsors domestic investment in semiconductors with 6.8 billion dollars to double chip revenue by 2030
Taiwan released a tax program to attract more talent
India released a 10 billion incentive package to drive growth in the domestic semiconductor market
The United States released a 39 billion manufacturing incentive program and additionally 25% tax credit plan.
This numbers might seem impressive but the semiconductor is a very capital-intensive industry. In fact, semiconductor companies invest about 18-20% of their total revenue in R&D. The only industry, that spends more in R&D is biotech according to BCG. To put those numbers in context, Intel alone did spend 15+ billion dollars in 2021 alone and the top foundry in the industry will spend more than 5+ billion dollars this year. All those programs have one goal to strengthen the supply chain but could also lead to price increases of 35-65%.
3. Brief explanation of semiconductors and their production
Semiconductors or chips are made of silicon which is found in the ground. The silicon become purified and melted down and sliced into circular wafers. Those wafers represent the surface on which chips are built in a grid formation. The wafers can consist of millions of different thin layers which allows engineers to incorporate billions of transistors. The transistors determine to what the chip is capable of. To design each layer a method called lithography is used. Lithography is the latest innovation in chip design and allows to develop much smaller and complex chips. A synonym of lithography is called EUV, which stands for extreme ultraviolet lithography. The only company capable of developing the equipment of this technology ASML – a company in the Netherlands. The machine is worth about 200 million dollar, showing again how capital intensive chip manufacturing can be if you work on the forefront of the industry. The main customers of ASML are Samsung, Intel, and TSMC. To build this machine ASML needs more than 700+Suppliers.
EUV are used to produce chips with high power demand such as iPhones, Ipad and Laptops. To produce chips for more simple products like toasters or filter coffee machines another technology is used called DUV. This shift in technology chip production is probably also the reason why Intel got stuck behind as they were not able to use EUV for their chips in last three to four years. In very simple terms EUV allows to print each transistor very precise allowing to work on smaller transistors (five nanometers, three nanometers) to fit more processing power in a given space with less power needed. The smallest transistors are 10,000 times thinner than human hair. In very simple terms, the bigger the chip the less complex the device it is used for.
4. Semiconductor industry map – Value chain
The value chain of the semiconductor industry is shown above. Design or IP means providing the intellectual property to design a chip. Such companies like arm provide the necessary architecture. Electronic design automation delivers (mostly) software, hardware, and other services to assist in defining, planning, design, implement and manufacture semiconductors. Equipment companies like ASML provide important tools to be actually able to manufacture semiconductors. Raw materials are suppliers of silicon, germanium, gallium arsenide and other raw materials for chips. Fabless design are companies the public is most familiar with. Nvidia, Qualcomm and AMD are companies that just design chips but outsource the manufacturing to TSMC or UMC which are called foundries. Foundries are nothing else than companies that focus only on the manufacturing part of chips. The final step is the assembly, testing and packaging of chips. Integrated device manufacturer (IDM) are companies which design, produce and sell chips on their own.
Overall, there are three major steps to do to create a semiconductor. The design of a chip which is also called fabless manufacturing. Front-end processes involve the actual manufacturing of semiconductor in ultra clean facility which are also called fabs. This step is also the most capital intensive one. The facilities and the necessary equipment can make up to 7+ billion dollars up-front investment. Back-end processes usually involve assembly test and packing.
5. Business models, competition and market barriers in semiconductor industry
As mentioned above the semiconductor industry is capital intensive. Building a foundry from ground up involves billions of dollars up front. That is why business like Nvidia, Qualcomm or Broadcom were successful, because they did not an upfront investment (capex). However, R&D cost are still high in all areas as talent is one of the most crucial factors. The business models themselves vary a lot from a licensing agreement with arm to selling chips from intel. The fabless design business model not only is successful because of light capital needs the design of the chip was also the most “value-add” task. 50% of the value created by the chip is produced in the design step. While the actual fabrication of the waver just adds 24 % but takes up over 50% of capital expenditure.
Design = largely skill and design, about 20% of revenue in R&D, 50% value add, concentrated in US
Front end = 13% R&D, 64% capex, 24% value add, concentrated in East Asia
Back end = 3% R&D, 13% capex, 6% value add, concentrated in China and Taiwan
Equipment = 9% R&D, 3% capex, 11 % value add, 50 different high sophisticated specialized equipment, market leader ASML (EUV).
*Rest: others
The process of making wafers, which contains multiple chips of the same design includes 400 – 1400 process steps and can take up to 12 – 20 weeks. Three (to four) business models stand out: a pure design focus which are called fabless design, pure focus on manufacturing which are called foundries and a mix of it IDM which are a mix of them – Intel for example. A fourth business model represent the highly specialized equipment sector like ASML which provide the highly complex machines which allow the production of leading semiconductors in the first place.
6. Market size and growth rates of semiconductor industry
According to fortune business the semiconductor industry had a size of 527 billion dollars in 2021 and 573 billion in 2022 with a CAGR of 12% (2029). To obtain more insight I collected data of crucial companies to size the market on my own. In 2022 the total semiconductor market generated a revenue of 583 billion dollars. The companies I included in the analysis are named at the end of the article, with Samsung missing as the biggest name assuming the market reached 600 billion already in 2022. I calculated a 2y, 3y, 5y and 10y CAGR and saw growth rates of 21.4%, 16.9%, 13.2% and 10.8% respectively. This is in line with the anticipated CAGR of fortune business of 12%. If the semiconductor industry continues to grow with this pace it will reach about 1.5 billion dollars in 2030. I will crack down more specific numbers in future posts. I do want to say that all companies, utilizing a fabless design business model and are part of my industry analysis (Nvidia, AMD, Broadcom, Qualcomm & Marvell technology) had above average CAGRs in all four periods (2y, 3y, 5y, 10y).
7. Headwinds and tailwinds
7.1. Headwinds
Due to the very concentrated market in certain regions, geopolitical conflicts effect the success of the semiconductor industry. Especially the situation between Taiwan and China could result in major issue as 64% of all semiconductors are fabricated in Taiwan. 53% of them are just manufactured by one company TSMC (Ticker: TSM).
The announced a released programs by governments bringing more diversity in the supply chain of semiconductors could result in price increases.
There is debate whether Moore’s law, the doubling of transistor every year, is still applicable. In September 2022 Nvidia CEO Jensen Huang said the following: “A 12-inch wafer is a lot more expensive today than it was yesterday, and it’s not a little bit more expensive, it is a ton more expensive (…) Moore’s law is dead (…) And the ability for Moore’s Law delivers twice the performance at the same cost, or at the same performance, half the cost, every year and a half, is over. It’s completely over, and so the idea that chip is going to go down in cost over time, unfortunately, is a story of the past”.
Inflation and FX currency…
7.2. Tailwinds
Semiconductor companies have now the opportunity to expand due to various mentioned government programs and diversification of the supply chain could lead to more flexibility for customers and consumers.
IoT, Artificial Intelligence, green energy or blockchain are favorable secular tailwinds. Those technologies provide new business opportunities and maybe new business models due to general development of the industry to more specialized semiconductors in general.
8. Margins analysis & Investments
Below you find the pictures of all margins described now. I will dig deeper into specific parts of the industry at a later point.
8.1. EBIDTA margin
EBDITA margin is calculated as EBIT (income statement) + depreciation & amortization (cashflow statement) divided by Revenue
Based on the company I have chosen to incorporated in my analysis the highest EBIDTA margin in 2022/TTM is 57.9%. A significant drop from 67.6% in 2021. On the low end in 2022 EBIDTA margin was 20% while in 2021 it was even lower with 12.9%. Median EBIDTA margin is 34.6% Companies who deliver a more than 50% EBIDTA margin are Broadcom, Micron Technology, TSMC, Texas Instruments and United microelectronics.
8.2. Free cashflow margin
Free cashflow margin is calculated as (OCF – Capex) / Revenue
TSMC delivers a 57.3% free cashflow margin representing the highest of all companies. Free cashflow margin ranges from 57.3 % (max) to -19.1% (min – Intel). Median free cashflow margin is 19%. The only other company that is close to TSMC in terms of FCF margin is Broadcom with 49.1%.
8.3. Operating income margin
The operating income margin of the complete semiconductor industry has a CAGR of 2y = 31.9%; 3y = 23.0%; 5y = 18% and 10y = 15.4% respectively. In 2022/TTM Texas Instruments generates an operating profit margin of 50.6%. Prior to that year they reached a margin of 48.8% which is both years the margin in the industry. The median operating profit margin in 2022 and 2021 was 28.8% and 23.8%. Probably due to high volume (Wright’s law) foundry TSM has also high margins ranging between 30% and 40% in the last couple years. ASML has specialized equipment company and generates operating profits margin between 20% and 30%. The biggest drop happened at Intel which had an operating profit margin in 2020 of 30.4% but is now at 11.5% on the smallest in the industry.
8.4. Gross profit margin
As SaaS business Synopsis and Cadence have the best gross profit in the industry. Also business based on fabless design have high gross profit margin like Nvidia, Broadcom and Qualcomm. The median gross profit of the industry is about 50% and the top 75th quartile is 62.3%. Companies who deliver top gross profit margins, besides the previous mentioned, are Lattice (LSCC), Microchip Technology (MCHP) and Texas Instrument (TXN).
8.5. Net income margin
Median net income margin is about 23% in the industry leading by Infineon, Teradyne and TSMC with 43.1%, 44.9% and 43.7%.
8.6. Investments
Capital expenditure: The median and average of capex as % to revenue is very different. While the median shows a margin of 6.3%, the average margin of capital investments is at 10.8%. This also shown in the different outcome of the max and min values. The smallest investment back in the business is 0.5% by Qorvo, which however is inline with their historical numbers. On the other side Micron Technology invests 39% back in their business, which is also in line with their historical numbers. TSMC invested 13.8% in their business which is very low compared to their prior results which ranged from 20% to 30% in the last 10 years. The depreciation to capex ratio median of the industry is 0.7x suggesting that at least half of the companies invest like a growth company (maintain assets = depreciation to capex ratio of 1; maintain AND add assets = deprecation to capex ratio below 1). However, historical periods show a different picture. The median for that ratio always ranged between 1.0x and 1.3x. Adding up capital expenditure and business acquisitions the median ratio changes below 1.0x in the last 6 years. To name a few companies AMSL have investment behavior like a growth company has a ratio below 1.0x in all periods measured. In comparison to BCG research the average R&D cost for the semiconductor industry is between 13.5% and 17.0%. The median is even a bit lower. The 75th quartile is about the range of the BCG source ranging from 18% to 22% in all periods measured.
9. Experts in the semiconductor industry
Bernstein Research: Senior Analyst Stacy Rasgon
WSJ: Journalist Asa Fitch
D2D Advisory: CEO Jay Goldberg
Goldman Sachs: Co Head of TMT Tammy Kiely
Fletcher School at Tufts Unversity: Prof. Chris Miller (Author Chip war)
Greater Phoenix Economic Council: CEO Chris Camacho
SEMI: CEO Ajit Manocha
NZS Capital: Investor Jon Bathgate
NZS Capital: Investor Brinton Johns
Susquehanna: Senior Semiconductor Analyst Christopher Rolland
10. Sources (not all included)
https://www.fortunebusinessinsights.com/semiconductor-market-102365
https://irds.ieee.org/topics/future-of-semiconductor-performance
https://irds.ieee.org/topics/new-challenges-facing-semiconductors
https://www.goldmansachs.com/insights/pages/the-scale-and-state-of-the-semiconductor-industry.html
https://spectrum.ieee.org/semiconductor-ceos-on-life-after-moores-law-climate-change
https://www.semi.org/en/semiconductor-industry-2015-2025
WSJ youtube - Semiconductor companies now face an oversupply. What happened?
https://www.marketwatch.com/story/moores-laws-dead-nvidia-ceo-jensen-says-in-justifying-gaming-card-price-hike-11663798618
https://irds.ieee.org/topics/semiconductor-leaders
https://www.accenture.com/content/dam/accenture/final/industry/communications-and-media/document/Accenture-Pulse-Semi-Research-Survey.pdf
https://www.semiconductors.org/wp-content/uploads/2021/05/BCG-x-SIA-Strengthening-the-Global-Semiconductor-Value-Chain-April-2021_1.pdf
https://www.semiconductors.org/state-of-the-u-s-semiconductor-industry/
Youtube video: Everything you need to know about Semiconductor industry
Business Breakdown by Colossus (Episode AMD)
10. Companies used to evaluate margin and size of semiconductor industry
Nvidia, AMD, Broadcom, Qualcomm, Analog Service devices, Applied Materials, Amkor Technologies, ASML Holding, ASE, Entegris, GlobalFoundries, Intel, KLA Corporation, LAM Research, Lattice, Microchip Technology, Marvell Technology, Micron Technology, Micron Technology, NSP Semiconductors, Skyworks Solutions, Teradyne, Taiwan Semiconductor Manufacturing, Texas Instrument, United Microelectronics, Synopsis, Cadence, Infineon