Motley Fool Hidden Gems Investing - Semiconductors 101

Episode Date: October 8, 2022

Your remote control, the fastest supercomputers in the world, and artificial intelligence applications have something in common: the semiconductors needed to make them work. 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  Companies mentioned: NVDA, CDNS, SNPS, ASML,  LRCX,  AMAT, TOELY, ASML, TER, INTC, TSM, SSNLF, AMD, QCOM,  KLAC Host: Jason Moser Guest: John Rotonti Producer: Ricky Mulvey Engineers: Rick Engdahl, Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

10 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. I'm Chris Hill, and that's Motley Fool's senior analyst, John Rotonti. He joined fellow analyst Jason Moser for an introduction to semiconductors, computers, 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 chip maker that's cheaper than the S&P 500. Let's just go ahead and start from the very beginning. What are semiconductors and why are they so important to the economy now? Jason Moser. Thanks, Jason. One of my favorite things to talk about. Semiconductors are the brains of all electronic devices. They partially or semiconduct currents, and they are largely made of silicon, which is made from sand, like beach sand. They vary in sizes, but most of them are, you can think about the size of your thumbnail

or a postage stamp. And these very small devices are packed with, in some cases, tens of billions of transistors. That's a lot. Yeah. Exactly right. Especially when you're packing them onto something the size of a postage stamp. And these transistors amplify currents and actually turn electrical signals on and off. And so you've got these electronic brains that power devices, and 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 weapon systems. And so they are a matter of life and death, literally, when it comes to healthcare, when it comes to national security. And they are

the devices that power our modern digital economy and digital world. So 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 are EVs, 5G, all of these modern technologies, all of these innovations are powered by semiconductors. So to sum up, I would say they are the critical infrastructure and modern building block of the digital economy. Yeah. And it really does feel like we're only headed more and more in that direction. So their role really should only grow in importance. And so 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 simple. Companies make these semiconductors and boom, it goes into your device and consumers use them. But then when you look at the value chain behind the scenes in all of the different participants in this market, it's worth knowing because there are a lot of different ways to capitalize on this as investors. Let's talk about the main touchpoints of this value chain. 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. You've got everything from foundries and the equipment companies and then designers. So walk us through that value chain, if you could. 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. And so, basically, the first stage of making a semiconductor, designing a semiconductor,

is designing it using software. And so, 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. and it's synopsis and cadence design systems. If you think about an architectural blueprint for your house or a 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. And so, 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 PhDs in this kind of software. So that's the first stage, is to blueprint it out using this software, and then what happens after that is that software 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 there's three main steps you deposit a bunch of chemicals onto these chips and those deposition there's basically three primary companies that do the deposition or deposit and that's lamb research applied materials and tokyo electron and then you etch away or carve out little holes where the transistors go and that's called etch and there's basically three

companies that do that. It's the same three. It's Lamb Research, Applied Materials, and Tokyo Electron. So you had 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. And then you have a couple companies that test it after the semiconductor is made. and the two big ones there are Teradyne and Advantest, which is a private company. And all of this takes place in a foundry. And the big foundries, 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 Global Foundries. And then Intel is the fourth

player trying to get into third-party manufacturing. That's the semiconductor manufacturing value chain in a synopsis. Well, very well done, by the way. I appreciate it. I think you showed 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. It seems like there's a theme there in that this is just very highly technically skilled work. 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. I would agree. Yeah. You focus your coverage specifically on foundries and semi-cap equipment companies. 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 talked about them a little bit. Let's dig into the major competitors in that part the value chain and the foundries and the semi-cap equipment companies. Talk a little bit about their advantages and their merits as investment ideas. 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 global foundries, 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 50% market share of all chips manufactured, but they have 85% to 90% market share of the world's most advanced chips. And because of that, it generates 90% of global contract foundry profits.

So, it really is this earned monopoly or duopoly with Samsung right now. And 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 on the planet. and Taiwan Semi has more experience using these extremely complex machines than anyone else on 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. So 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. So it's going to be very hard for competitors to catch up. And 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. And so, 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. I think it's very clear the pros, right? I think it's very clear the competitive advantages that these businesses possess. And I think the follow-up to that that I'd really have for you is just, what do you consider the threats for businesses like these? Are there really any threats for Taiwan Semi? I think so. And that ties into the valuation right now, Jason. So, 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. It 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 PE of 12. Why? So, I think, and let me just put that into perspective, the S&P 500, the market is trading at about 15 or 16. So, it's at 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 and that China claims to control Taiwan. And there's been talk and rhetoric recently that China maybe possibly could invade Taiwan. So that's the risk. And that's why I think there's this overhang on the stock, Jason. Yeah, the geopolitical risk. I mean,

something always to keep in mind, obviously out of our control, right? 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 goes to show you, 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. 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. So, you know, competitive risk is there. Technological obsolescence, to an extent, is there. And then, you know, semiconductors have

historically, the industry has historically been cyclical. I think it's less cyclical now than it's been in the past. And we can, you know, maybe talk about that now or another time. But there is some cyclicality as well. So, there's a risk that you could be buying a stock at the top of the cycle. I don't think that's a risk right now. But over a long period of time, there's a risk you could be buying at the top, and then you'd have to maybe wait a couple of years for the stock price to catch up. But I think those are the big risks. Now, 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 technology, immersive technology, 5G, stuff like

that. So I've got my share of chip companies in there, your Qualcomm's and your AMD's and your NVIDIAs of the world. It does feel to me like the cyclicality risk isn't what it used to be. And 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. So it's not like we, it's in everything that we do. It's exactly right. So it's something that it feels like the cyclicality now is more or less just based on where we are sort of 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. 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. You know, is demand for EVs and 5G going to go away? Is demand for AI and machine learning going to go away? And so, 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. So, where, you know, some of these, you know, at some points in time, there used to be 20, 30 competitors. Now, you've got three, four or five competitors. And 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. And then if you look at the fundamentals, the last down cycle we had, I think, was like 2018. It's like a real down cycle. We're kind of in one now a little bit. But if you look at the trough margins now in 2018, so the lowest the margins get at a down cycle. Those are now higher than peak margins in previous cycles, Jason. The fundamentals of the industry have dramatically improved in my opinion. That's astounding. Another thing that'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 this 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. It seems like every company on the face of the Earth has exposure to this. The CHIPS Act, I wonder, do you have an opinion there? We're talking about $50 plus billion ultimately that's going be devoted to spur 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 going to disappear here and there and not really have as material impact. I wonder if you have any strong feelings one way or the other on the chipset.

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. We talked about Taiwan Semi is going to invest $40 billion on its own this year. Just one year. Just one year. One company in one year, Jason. If you look at the U.S., it used to manufacture a lot more of the world's chips. It used to be 30% or 40% of the world's semiconductors were manufactured in the U.S. Now, it's 12%. 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. 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. Yeah. I think that's a good way. I'm hopeful. To me, it absolutely feels like it's just a start, because like you said, it requires so much investment. 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. So, 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. Those three large semi-cap equipment companies, Lamb Research, Applied Materials, Tokyo Electrons in the East, but let's throw in Teradyne, and let's throw in KLAC. Four huge semi-cap equipment companies, all located in the West. And 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.

So, there is this dichotomy of the IP versus the manufacturing. We're just trying to bring back some of that manufacturing. Yeah, and 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, an article 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. Well, Nvidia says, no longer. Really quickly, what's Moore's Law, and what did you think about this article? Jason, Moore's Law states 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 the chip performance doubles every two years. If we look back in the 1970s, Intel was the 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 and their data centers. It has 30 billion transistors on it. And so the question is, Jason, how many of these transistors can we continue to pack onto something the size of your thumbnail? Well, that's right. I mean, we run into a physics problem at some point, right?

I mean, the edge of physics, right? The edge and edge of physics. And so what we do is, we do two things. One is we make 3D chips and we start building transitions on top of each other. it's like a skyscraper and then the other thing is we use extreme ultraviolet light and and these machines by uh by asml the reason is the reason you have to use this extreme ultraviolet light is because you need extremely small wavelengths of light in order to trace the pattern of the transistors to try 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 and so you know who's going to be you know I think in that article, Intel was talking about getting to 100 billion transistors on

a chip. We're at 50 billion today. Once again, that's doubling from 50 to 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. To get around that, going to have to make highly, highly specialized chips used for highly, highly specialized devices and purposes. And that's what NVIDIA, you know, 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, I, you know, NVIDIA is an amazing company and Intel is a company that was once amazing and is trying to turn itself around. And I think if anyone could do it, it's Pat

Gelsinger, their new CEO. So it will be fun and interesting to watch. It will indeed. 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 to us, Sean. It was great, great talking with you today. I want to make sure before we wrap up, you're a good tweeter. You've got a great educational investing Twitter feed there. Where can people find you on Twitter? I am on Twitter at JROGrow. So, at J-R-O-G-R-O-W. And thank you for having me on the show, Jason. It's always fun. As always, people on the program may have 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. Thank you for watching.