An Investor's Look at Semiconductors

In this podcast, Motley Fool senior analysts Jason Moser and John Rotonti dig into one of the most important industries in the world and discuss:

• The semiconductor value chain.
• Geopolitical risks (and opportunities) and the industry's cyclicality.
• Implications of the CHIPS Act.
• One critical chipmaker that's cheaper than the S&P 500.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on Oct. 8, 2022.

John Rotonti: Ten to 15 years ago, the industry was largely driven by PC cycles and iPhone cycles, to be honest with you. But now, like we said, they go into everything. I mean, is demand for the cloud going to go away? I don't think so.

Chris Hill: I'm Chris Hill and that's Motley Fool senior analyst John Rotonti. He joined fellow analyst Jason Moser for an introduction to semiconductors. Computers, cars, and whatever you're using right now to listen to this podcast need them to function. They're an important building block for our economy. Today, John and Jason discuss companies in the semiconductor value chain, the industry's risks, and one important chipmaker that's cheaper than the S&P 500. 

Jason Moser: Let's go and start from the very beginning. What are semiconductors and why are they so important to the economy now?

John Rotonti: Thanks, Jason, one of my favorite things to talk about. Semiconductors are the brains of all electronic devices. They partially or semi-conduct currents. They are largely made of silicon, which is made from sand. Like beach sand. They're varying sizes, but most of them are, you can think about the size of your thumbnail or a postage stamp. These very small devices are packed with, in some cases, tens of billions of transistors.

Jason Moser: It's a lot.

John Rotonti: Yeah. Exactly right. Especially when you're packing them onto something the size of a postage stamp. These transistors amplify currents and actually turn electrical signals on and off. You've got these electronic brains that power devices. They are in everything from the remote control on your TV to the fastest supercomputers in the world, to healthcare devices, to our military's weapons systems. They are a matter of life and death, literally when it comes to healthcare, when it comes to national security.

They are the devices that power our modern digital economy and digital world. We would not have cloud computing without semiconductors, we would not have artificial intelligence or machine learning. We would not have video gaming. We will not have the metaverse if that comes to play. All of these things, EVs, 5G, all of these modern technologies, all of these innovations are powered by semiconductors. To sum up, I would say they are the critical infrastructure and modern building block of the digital economy.

Jason Moser: Yeah, it really does feel like we're only headed more and more in that direction. Their role, it really should only grow in importance. I think when we look at this industry, I find the actual value chain in semiconductors to be very interesting. I think there's a lot that goes on behind the scenes that maybe some folks don't realize in the market that comes to mind, it reminds me a little bit of the payments industry. If you look at it on the surface, you think it's just simple. Oh, well, companies make these semiconductors and boom, and it goes into your device and consumers use them.

But then when you look at the value chain behind the scenes and all of the different participants in this market. It's worth noting because there are a lot of different ways to capitalize on this as investors, so let's talk about the main touch points of this value chain. The semiconductor. Most people are probably familiar with names like Qualcomm or Intel. Those are semiconductor companies, but there are companies even before that, that are involved in making the actual physical material. I mean, you've got everything from foundries and the equipment companies and then designers. Walk us through that value chain if you could.

John Rotonti: Yeah, Jason, the value chain is fascinating because it is so complex and technologically advanced and capital-intensive that if you look at the value chain, which we'll go through in a second. At every step of the semiconductor manufacturing value chain, these global oligopolies or duopolies or in some cases, even earned monopolies have formed. Basically, the first stage of making a semiconductor, designing a semiconductor is designing it using software. You take a company like Nvidia or Apple that wants to design their next semiconductor, they're going to use software, very likely from one or two companies because these are the two companies that do it at scale globally. It's Synopsys, and Cadence Design Systems. If you think about a blue, an architectural blueprint for your house or building. This is the architectural blueprint for a semiconductor. Just much more complicated because like we said, there are tens of billions of transistors they need to map and blueprint onto the chip.

These two companies, they are electronic design automation software companies, really they're computational design software companies. This is highly, highly complicated. This software is using a combination of matrix algebra, multivariate calculus, AI, advanced geometry, and more. This is not a software that you take an online course in Python or something you learn how to use it. This is software run by specialists, masters and Ph.D.s in this software. That's the first stage is to, is to blueprint it out using this software. Then what happens after that is that software is is printed onto a mask, and then that mask, which is just like a stencil basically, or a model. That mask is then used to print the blueprint onto a silicon wafer, which is usually 12 inches in diameter. It's a circular, thin piece of silicon that's 12 inches in diameter.

To do that, you use extreme ultraviolet light and a series of lasers and mirrors to print that blueprint onto the silicon wafer. There's only one company in the world that does that extreme ultraviolet lithography. We'll get into that in a second, but it's ASML, a Dutch company. Then from there basically there's three main steps. You deposit a bunch of chemicals onto these chips and those depositions, there's basically three primary companies that do the deposition or deposit, and that's Lam Research, Applied Materials, and Tokyo Electron. Then you etch away or carve out little holes where the transistors go. That's called etch. There's basically three companies that do that and it's the same three. It's Lam Research, Applied Materials, and Tokyo Electron. So you have two main software companies.

You've got three main semi-capital equipment companies that do the etching and the deposition. You've got one company doing the light sourcing, that's ASML. Then you have a couple of companies that, that test it after the semiconductor is made. The two big ones there are Teradyne and Advantest, which is a private company. All of this takes place in a foundry. The big foundries are the largest foundry is Taiwan Semiconductor. Samsung is another leading player. There is a major player for lagging-edge semiconductors, foundry manufacturing, and that's GlobalFoundries. Then Intel's a fourth player trying to get into third-party manufacturing. That's the semiconductor manufacturing value chain in a synopsis.

Jason Moser: Well, very well done by the way and I appreciate it because I think you showed that this industry that just seems to be so simple on the surface as consumers we buy these devices, but the behind the scenes is just so much more involved. It's always great to know that from the investing perspective, knowing that value chain I think is key for whatever industry you're focused on. Semiconductors certainly you can see is a very involved value chain as well and it seems like there's a theme there in that. This is just very highly technically skilled work.

John Rotonti: Yeah.

Jason Moser: The barriers to entry just on understanding how to do this and getting the talent to be able to do this, and getting the equipment and the software to be able to do this. It just seems like those barriers to entry are very, very high.

John Rotonti: I would agree.

Jason Moser: Yeah. So you focus your coverage specifically on foundries and semi-cap equipment companies and so I wanted to dig into those a little bit more because that's where you pay most of your attention. Who are the major competitors? We talk about them a little bit but let's dig into the major competitors in that part of the value chain and the foundries and the semi-cap equipment companies and we'll talk a little bit about their advantages and their merits as investment ideas.

John Rotonti: Starting with foundries, we mentioned Taiwan Semi and Samsung. Those are the two leading advanced, leading-edge, semiconductor third-party manufacturing foundries. There's also GlobalFoundries, Intel, maybe a few smaller players, but you can't talk about foundries without talking about Taiwan Semi. The reason is because I think it's one of the if not the most indispensable company in the world. It has 50% market share of all of the outsourced chips manufactured in the world. That's roughly three times higher than the next-largest player, which is Samsung. They have so 50% market share of all chips manufacturered, but they have 85%-90% market share of the world's most advanced chips. Because of that, it generates 90% of global contract foundry profits. It really is this earned monopoly or duopoly with Samsung right now.

It got this position by investing heavily ahead of everyone else, heavily ahead of demand, and being an early adopter of extreme ultraviolet or EUV lithography machines by ASML. Taiwan Semi owns more ASML machines than anybody else in the planet and Taiwan Semi has more experience using these extremely complex machines than anyone else in the planet. Because Taiwan Semi has 90% market share of the world's most advanced chips, it has a much, much larger library of recipes or process knowledge or process technology for manufacturing these chips. Each chip has its own recipe and each node builds off the recipe of the prior node.

With semiconductor manufacturing, Jason, scale and market share beget more scale, and more market share, and faster and better process learnings. Process knowledge is extremely capital-intensive. I think Taiwan Semi is going to spend somewhere on the order of $40 billion in capex this year or next year, 40 billion in one year. It's going to be very hard for competitors to catch up. Finally, Taiwan Semi has built up an ecosystem and works extremely closely with all of the major players in the semiconductor manufacturing supply chain that we already talked about. If you go to Taiwan and you go to their facilities, well guess what, Lam Research is located right there, Applied Materials is located right there, ASML has teams right there so they built up these ecosystems around the business.

Jason Moser: I think it's very clear the pros. I think it's very clear the competitive advantages that these businesses possess and I think that either the follow-up to that that I'd really have for you is just what do you consider the threats for businesses like these and so you talk about, are there really any threats for Taiwan Semi?

John Rotonti: I think so and that ties into the valuation right now, Jason. Taiwan Semi is at I looked yesterday, I haven't looked this morning, I know stocks are down. I think it's around 72 down from 145 stock price, so it's down 50% from its 52-week high, has 2.5% dividend yield, Jason, this company that I just explained to you, that is integral to the world is trading at a forward P/E of 12.

Jason Moser: Why?

John Rotonti: I think and just let me just put that into perspective. The S&P 500, the market is trading at about 15 or 16, so it's had a three or four turn discount to the market. I think the reason you asked the risk, I think the market is concerned that it's located in Taiwan and that China claims to control Taiwan and there's been talk and rhetoric recently that China maybe possibly could invade Taiwan. That's the risk and that's why I think there's this overhang on the stock, Jason.

Jason Moser: Yeah, the geopolitical risks. It's something always to keep in mind, obviously out of our control. Nothing we can really control, but it's always something to acknowledge. You see, obviously what's going on with Russia and Ukraine. Those are things that happen. You can't very well predict them but then it also, it goes to show even market leaders like that. There's always going to be a risk that you need to identify and that certainly seems to be very reasonable with Taiwan Semi.

John Rotonti: Even if you take China and geopolitical risk out of the equation, there are other risks. Intel is spending billions of dollars to try to catch up, billions. Competitive risk is there, technological obsolescence to an extent is there, and then semiconductors, the industry has historically been cyclical. I think it's less cyclical now than it's been in the past and we can maybe talk about that now or another time, but there is some cyclicality as well. There's a risk that you could be buying a stock at the top of a cycle, I don't think that's a risk right now. But over a long period of time there is a risk you could be buying at the top and then you have to maybe wait a couple of years for the stock price to catch up, but I think those are the big risks.

Jason Moser: I'm glad you brought up that cyclicality risk because I think that's something that definitely is worth touching on. I run a couple of services here at the Fool that focus on immersive technology, 5G, stuff like that. I've got my share of chip companies and they're your Qualcomms and your AMDs, and your Nvidias of the world. It does feel to me like the cyclicality risk isn't what it used to be. I guess that really goes back to what you were talking about at the top of the show, in that this is the lifeblood of virtually everything we do now, this technology. It's an everything that we do.

John Rotonti: Exactly right. 

Jason Moser: It feels like the cyclicality now is more or less just based on where we are in the innovation cycle. But regardless, because this technology is so widespread all around the world, that cyclicality window just seems to be shrinking a bit.

John Rotonti: I think so Jason, 10-15 years ago the industry was largely driven by PC cycles and iPhone cycles, to be honest with you, but now like we said, they go into everything. Is demand for the cloud going to go away? I don't think so. Is demand for EVs and 5G going to go away? Is demand for AI and machine learning going to go away? The use cases, the end markets, the total addressable markets for semiconductors is just so much larger than it was. The other thing is that we've had a couple of major periods of consolidation across the industry. At some point in time there used to be 20-30 competitors, now you've got 3, 4, or 5 competitors. Because of that, I think the remaining competitors are much more rational in their pricing. That avoids the boom-bust pricing cycles of the past. Then if you look at the fundamentals, the last down cycle we had, I think was 2018, like real down cycle. We're in one now a little bit but if you look at the trough margins now and in 2018. The lowest the margins get at a down cycle, those are now higher than peak margins in previous cycles, Jason.

Jason Moser: Wow.

John Rotonti: The fundamentals of the industry have dramatically improved in my view.

Jason Moser: That's astounding. Another thing it's been in the headlines a lot lately, we've been talking a lot about it on the investing team, trying to get just a better idea of where we think, ultimately, how this plays out the CHIPS Act. This supply chain crunch that we've been going through, it's something that we see in virtually every earnings call because this technology is in everything, so it seems like every company on the face of the Earth has exposure to this.

John Rotonti: Sure.

Jason Moser: The CHIPS Act, I wonder, do you have an opinion there? We're talking about $50-plus billion ultimately, that's going to be devoted to spark domestic semiconductor manufacturing. It feels like on the surface, that's a smart idea, diversify that supply chain a little bit, yet I can't help but wonder if maybe this isn't money that's just disappear here and there and not really have as material an impact. I wonder if you have any strong feelings one way or the other on the CHIPS Act.

John Rotonti: I don't have strong feelings on how effective it will be yet, just because it's so new but I'd like to think, Jason, that it's a good start. If we want to build a homegrown semiconductor domestic supply chain, 50 billion is not enough and we talked about Taiwan Semi is going to invest 40 billion on its own this year.

Jason Moser: Just one year.

John Rotonti: Just one company in one year, Jason. The U.S. used to manufacture a lot more of the world's chips, so it used to be 30% or 40% of the world's semiconductors were manufactured in the U.S., now it's 12% and so that's a national security risk. It really came into play during the pandemic when we had all the supply chain bottlenecks, we could really feel it tangibly, you couldn't buy it. Auto manufacturers, for example, couldn't make new cars because they couldn't get the semiconductors because nowadays cars are just chips on wheels. What happened was everyone started buying used cars and that drove up used car pricing. I think it's a good first start, I think it's going to take a decade or more if we're going to be successful and it's going to take hundreds of billions of dollars but we have to start somewhere and so I'm hopeful, Jason.

Jason Moser: Yeah. I think that's a good way, I'm hopeful. It absolutely feels like it's just a start because like you said, it requires so much investment.

John Rotonti: Yeah. One more quick thing, Jason. When it comes to manufacturing, the U.S. is at a deficit, most of the chips are manufactured in the East, that's just a fact. Two-thirds to 70% of the world's chips flow through the island of Taiwan. They're made in the East but we should also point out that the IP, Jason, exists in the West, so those two software companies, Cadence and Synopsys, those are U.S. companies.

Jason Moser: Oh, yeah.

John Rotonti: Those three large semi-cap equipment companies, Lam Research, Applied Materials, Tokyo Electron is in the East but throw in Teradyne and let's throw in KLAC, four huge semi-cap equipment companies all located in the West. Then ASML, maybe the most important of the semi-cap equipment companies, that's a European Dutch company, so a lot of the IP, the majority of the IP is in the West. There is this dichotomy of the IP versus the manufacturing, we're just trying to bring back some of that manufacturing.

Jason Moser: Yeah. That makes a lot of sense. Given that, let's wrap up the show today. You and I were reading an article the other day, from CNBC, it was just an interesting view. It struck me as the past versus the future. This was an article that dug into Intel and Nvidia. Intel is saying that Moore's law is still alive and well, Nvidia says, no longer. Really quickly, what's Moore's law and what did you think about this article?

John Rotonti: Jason, Moore's law states that the number of transistors on a chip doubles roughly every two years. If we assume the price of the chip stays the same, then the cost of that chip falls in half every two years. Basically, Moore's law says, that chip performance doubles over two years. If we look back in the 1970s, Intel was a chip leader. The chips it was putting out in the 1970s had between 2,000 and 6,000 transistors on them. Today, the Apple M1 Chip, which was pretty revolutionary, Jason, has 16 billion transistors. A chip, the Graviton2 that goes into Amazon Web Services that runs their cloud in their data centers, it has 30 billion transistors on it. The question is Jason, how many of these transistors can we continue to pack onto something the size of your thumbnail?

Jason Moser: But that's right, we run into a physics problem at some point? It's what should be a physics problem.

John Rotonti: Yeah. The edge of physics. What we do is, we do two things. One is we make 3D chips and we start building transistors on top of each other, it's like a skyscraper. Then the other thing is we use extreme ultraviolet light and these machines by ASML. The reason you have to use this extreme ultraviolet light, it's because you need extremely small wavelengths of light in order to trace the pattern of the transistors. You have to bring the transistors closer and closer together and the only way to do that is to use extremely small wavelengths of light. I think in that article, Intel was talking about getting to 100 billion transistors on a chip and we're like 50 billion today.

Once again, that's doubling from 50-100. Can we get there? I hope so because I want to see what the world looks like with 100 billion transistors on a chip. Nvidia is saying, we're up against the limits of Moore's Law and so to get around that, you're going to have to make highly specialized chips used for highly specialized devices and purposes and that's what Nvidia. Nvidia doesn't make commodity chips, Jason, Nvidia makes chips that only it can make and so who's going to be right? I really don't know but I tell you what, Nvidia is an amazing company and Intel was a company that was once amazing and it's trying to turn itself around. I think if anyone could do it, it's Pat Gelsinger, their new CEO, so it will be fun and interesting to watch.

Jason Moser: It will indeed, this is an amazing space, tremendous opportunities for investors and really appreciate you taking the time to go through it and explain it all. John, it's great talking with you today. You want to make sure before we wrap up, you're a good tweeter.

John Rotonti: Thank you, sir.

Jason Moser: You got a great educational, investing Twitter feed there. Where can people find you on Twitter?

John Rotonti: I'm on Twitter @JRogrow. @ J-R-O-G-R-O-W. Thank you for having me on the show, Jason, it's always fun. 

Chris Hill: As always, people on the program may have an interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Chris Hill. Thanks for listening. We'll see you tomorrow.