While we and everyone else have been focusing on Washington, life goes on elsewhere. Without a doubt, the regime change in DC is dramatic. It is bound to significantly affect and alter the future course of our political, economic, and financial systems—well, at least for the next four years. However, the near and distant future may very well be even more significantly affected by what is happening in Silicon Valley.
Certainly, recent developments in autonomous cars, robotics, and artificial intelligence have captured the imagination of tech investors. One way they’ve played the future is by investing in the manufacturers producing the semiconductor chips that will run all of these new technologies. The S&P 500 Semiconductor industry index gained 42.9% over the past 12 months through Tuesday’s close (Fig. 8). The Semiconductor Equipment industry index gained even more over the same period, 72.4%, making it the second best-performing of the S&P 500 industries we track for the period (Fig. 9).
Semi stocks have also been boosted by lots of M&A activity and hopes that semiconductor revenues growth will pick up to the mid-single-digits this year. Gartner expects that last year’s lackluster 1.5% y/y sales growth will be followed by a 7.2% y/y increase in worldwide revenue to $364.1 billion in 2017, according to the company’s 1/23 press release.
The pickup in growth doesn’t come from traditional areas like cell phones and computers. Those segments have moved from growth mode to replacement mode. Instead, the growth is coming from new areas like self-driving cars, the Internet-of-things, and cloud computing. Here’s a look at some of the recent developments charging up the chip industry:
(1) Driving sales. The more our cars can do, the more computing power they must include. That’s good news for the semiconductor industry. “J.P. Morgan estimated that the total available market for semiconductors used in semiautonomous and fully autonomous cars will reach about $7.3 billion by 2025, a compounded annual growth rate of approximately 62.5% starting in 2017,” reported an 8/27 MarketWatch article. “That estimate assumes that semiautonomous and fully autonomous cars together will make up about 15.7% of a projected 109.6 million light vehicles produced globally. The total cost of all the chips per vehicle will rise to $400 to $500 a car, up from $300 to $400 from ADAS functions.” The total world market for automotive semiconductors grew to $30.3 billion last year, and is expected to hit about $41 billion in 2020.
(2) Game on. Nvidia has been one of the best-performing semi stocks over the past year, climbing 269.4% y/y through Tuesday’s close. Known for graphics processing chips that power video game machines, Nvidia’s shares have performed so well because investors believe the company’s chips will be used in gadgets that have artificial intelligence and in driverless cars.
Nvidia has “an ambitious goal of getting a Level 4 driverless car--an almost fully autonomous car--on the market by 2020, which it is executing through a partnership with Audi. It also announced an initiative with Bosch to enhance artificial intelligence in automobiles, e.g., cars that can sense when you are sleeping or texting while driving, as well as a smart home hub through its Shield brand that will be powered by Alphabet Inc’s Google Now artificial intelligence,” relayed a 1/7 MarketWatch article.
According to the FT, Nvidia has a technological lead over industry titan Intel. Nvidia “is widely credited with having developed the best chips for training the artificial neural networks built by companies including Google, Amazon and Baidu to do things like recognize images or understand language,” as a 12/30 FT article explained. It quoted Patrick Moorhead, a chip analyst at Moor Insights and Strategy: “I’ve never seen such agreement about a technology. I think they’re two to three years ahead of Intel.” But he added that Intel also has the same market in its sights and shouldn’t be counted out.
After their strong rally over the past year, Nvidia’s shares, at a recent $107.33, trade at almost 40 times Wall Street analysts’ 2017 consensus earnings estimate of $2.75 a share. If achieved, that would mark earnings growth of 13.6%.
(3) Stale chips. Not all semiconductor stocks have been moonshots. Intel shares, for example, have risen 25.7% y/y, modestly faster than the S&P 500’s 19.6% gain. The company has been held back relative to other semiconductor peers because more of its chips are used in personal computers, which have suffered from declining sales, and in servers, which have slowing sales. Worldwide PC shipments fell 3.7% y/y in Q4, and for all of 2016 they declined 6.2% y/y, estimates Gartner in a 1/11 press release. PC shipments have declined annually since 2012 and are expected to remain stagnant.
Semis for servers kick in about a third of Intel’s revenue, and that market is also undergoing radical change. Fewer companies are buying servers because they’re using cloud services from Amazon.com, Alphabet’s Google, and Microsoft. Those cloud companies are certainly buying servers, but their large size gives them a better bargaining position. “Their growing market clout gives them the ability to push Intel for more specialized designs, which raises Intel’s costs. The data-center group’s operating earnings fell 1.6% year over year for the 12-month period ended Oct. 1, despite a 7% gain in sales in that time,” noted a 1/23 WSJ article. Shares of Intel, which reports earnings today, trade at 13.4 times Wall Street analysts’ fiscal 2017 consensus earnings estimates.
(4) M&A boost. The semi industry has been blessed with a torrid M&A environment as small companies specializing in some of the new technologies are getting snapped up by larger competitors. A 11/14 WSJ article reported: “Semiconductor companies have capped more than $240 billion worth in mergers and acquisitions in the past two years, according to Dealogic. This year’s total to date--$130.2 billion--is a record, 16% above the previous high set last year. Big deals skew the dollar total, but there have been plenty of those, too. Six transactions in the past two years have been worth more than $10 billion and three topped $30 billion.”
More normal years since 2000 have seen only $20 million to $40 million of deals done annually. The author’s conclusion: The pace of M&A will likely slow as the best companies have been purchased and those with the ability to do a deal have already done so. That conclusion leaves us wondering how much of an acquisition premium remains in smaller stocks and whether that premium will dissipate.
(5) The numbers. Analysts expect the S&P 500 Semiconductors industry to grow revenue by 8.9% this year and 4.4% in 2018 (Fig. 10). The industry’s forward profit margin has increased by 4.2ppts to a record high of 24.2% since the beginning of 2016 (Fig. 11). As a result, earnings are thought to grow 15.9% this year and 8.3% in 2018 (Fig. 12). Net earnings revisions have been positive since the second half of 2016, with readings of 15.6% in January, 17.1% in December, and 15.6% in November (Fig. 13).
The S&P 500 Semiconductors industry’s forward earnings multiple has ranged between 10 and 20 times over the past 20 years, with the exception of the 1999-2000 Tech bubble when the multiple soared much higher (Fig. 14). With a forward P/E of 15.2 and earnings still growing, this industry looks like it still has room to head higher.
(6) Shovel-makers. Another way to invest in the sector is to purchase stocks in the S&P 500 Semiconductor Equipment industry, composed of companies that make the equipment to manufacture the chips. However, this strategy is far from a secret. As we mentioned above, the industry has gained 72.4% over the past year, and one of its largest stocks, Applied Materials, gained 99.6% over the past year. That leaves Applied Materials’ shares trading at 14.4 times 2017 expected earnings and leaves the industry’s forward P/E at 13.8.
Normally a below-market multiple would be a good thing. However, semi equipment companies are typically cyclical. Earnings multiples are high at the bottom of the cycle when earnings are low and shares are undervalued. Conversely, multiples are low when earnings are high at the top of the cycle. The S&P 500 Semiconductor Equipment industry cycle, Joe informs us, lasts about a year or two, and the current cycle is long in the tooth, having begun in 2015 (Fig. 15). Earnings are at record levels, as are margins (Fig. 16 and Fig. 17).
In the past when forward earnings peaked, the industry’s forward P/E was between 10 and 15. There were two exceptions: During the tech boom of 1999-2000, when the forward earnings multiple exceeded 30 and earnings were hitting a peak, and in 2002, when the excesses of the tech boom were still being shed (Fig. 18). So while the technology being developed seems awfully cool, the numbers are warning that there have been better times to buy this industry.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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