The Moat Show Ep.3: Are Semiconductor Stocks Overvalued?

In 2022, the semiconductor industry and the wider tech sector underwent a significant market pullback. Almost as the proclamations of 'tech is dead' reached a crescendo, OpenAI released the debut of its large language model (LLM) and consumer-facing generative AI, ChatGPT. And now, Silicon Valley—aptly nicknamed in the 1970s for the companies in the region’s pivotal role in semiconductor production, is back in the limelight, and the innovation narratives around artificial intelligence and semiconductors seem ubiquitous.

This year, semiconductors are up a whopping 48%, represented by the MVIS^® US Listed Semiconductor 25 Index. So, is the chip sector back in boom times, or is it mostly an AI-fueled bubble? The answer is always nuanced, but on this week’s episode of The Moat Show: Are Semiconductor Stocks Overvalued? Brian Colello, Morningstar's Director of Technology Equity, tells us there are still quality companies at attractive prices in the semiconductor space This blog includes a recap of our full conversation with Brian.

• In the semiconductor industry, what types of economic moats exist?
• Is the semiconductor industry at fair value, overvalued, or undervalued in June 2023?
• Are there still attractive opportunities in semiconductors that are directly exposed to AI?
• What risks should investors be aware of in the semiconductor industry?
• How will the U.S. CHIPs Act impact the semiconductor industry?

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The Moat Show Ep. 3: Semiconductors with Morningstar's Brian Colello

Show Notes

00:00 Introduction

01:00 Different Types of Semiconductor Chips

03:23 Emerging Technology and Themes in the Semiconductor Industry

05:35 Types of Economic Moats in the Semiconductor Industry

09:05 Morningstar's Valuation of Semiconductor Space Today

11:26 Attractive Opportunities in Semi Stocks with Direct AI Exposure

14:01 Risks to the Semiconductor Industry Today

16:58 How Does the U.S. CHIPs Act Impact the Semiconductor Industry?

In the semiconductor industry, what types of economic moats exist?

"Economic moat” refers to a company's sustainable competitive advantage that shields it from competition. In the semiconductor industry, such moats are hard-earned due to the rapid evolution of technology, but a few companies manage to create and maintain them. A company with a "wide moat," Morningstar’s highest rating, is one Morningstar expects to generate excess returns for a decade and, more often, over 20 years.

In the semiconductor space, several companies fit the wide moat criteria. Texas Instruments Inc (Ticker: TXN), Analog Devices Inc. (Ticker: ADI), and Microchip Technology (Ticker: MCHP), for instance, are companies that produce peripheral chips used in a wide array of applications. These companies have tens of thousands, if not hundreds of thousands, of customers, and their products are used in almost every conceivable device. The low cost and high volume of these products create a high barrier to entry for potential competitors, making these companies virtually unassailable in their market segment.

Chip equipment manufacturers form another category of wide moat businesses. The highly complex and technologically advanced equipment necessary to produce processors and analog chips is not easily replicated, presenting a significant barrier to entry.

Companies like NVIDIA Corp (Ticker: NVDA), known for their dominance in graphics processors units (GPUs), also have a wide economic moat. Not only do they excel in hardware, but they've also built a robust software ecosystem. This dual expertise makes it difficult for competitors to match Nvidia, even if they could build comparable Central Processing Units (CPUs) in terms of transistor count or speed. Nvidia's graphics processors are a core component in gaming and artificial intelligence technologies, making them a tough act to follow.

However, not all well-known companies receive a wide moat rating. Companies like Intel Corporation (Ticker: INTC), Advanced Micro Devices, Inc. (Ticker: AMD), Qualcomm Inc (QCOM), and Marvell Technology Inc (Ticker: MRVL), for example, are rated as "narrow moat” by Morningstar. This is due to the uncertainty about the direction of their businesses over the next decade, among other reasons. Therefore, the wide moat rating represents a level of business stability and sustainability that's even higher than what many renowned tech companies achieve.

Is the semiconductor industry at fair value, overvalued, or undervalued in June 2023?

Morningstar believes the semiconductor industry appears slightly undervalued, although not significantly. There was a surge in the tech sector in 2023, providing more of a margin of safety earlier in the year. Morningstar is particularly interested in the automotive chip space, with companies such as NXP Semiconductors NV (Ticker: NXPI), Infineon Technologies AG (Ticker: IFNNY), and STMicroelectronics NV (Ticker: STM) appearing somewhat undervalued. These companies have benefited from a chip shortage in the automotive sector over the past couple of years, which has positively affected pricing and sales. However, this shortage appears to be nearing its end, making the short-term outlook less favorable than it was a year ago. Despite some investors exiting due to this change, it may be a worthwhile investment for the long term.

Conversely, Nvidia has seen a spectacular run recently, reporting an impressive quarter and outstanding guidance. However, Morningstar currently views it as overvalued. Justifying its trillion-dollar valuation would require not just a great year but the assumption of massive, continuous growth for a decade. As a result, the risk/reward balance for Nvidia appears less appealing at this time.

Are there still attractive opportunities in semiconductors that are directly exposed to AI?

Yes, but in the realm of AI, certain semiconductor companies are more directly exposed than others. Notably, Nvidia has emerged as a leader, experiencing strong demand for its graphics processing units (GPUs). However, while the market has recognized this, it may have overvalued the company, leading to hesitation to buy in at its current valuation. Nvidia was a more attractive opportunity six to nine months ago during the crypto crash, and a similar drop in the future could present another chance to invest.

However, to bet against Nvidia, one must place faith in a competitor. With Nvidia reaping significant profits from the AI trend, every major tech player – from Microsoft Corporation (Ticker: MSFT) to Amazon.com, Inc (Ticker: AMZN) to Alphabet Inc (Ticker: GOOGL) - and competing chip makers are keen to enter this space. AMD is stepping up, producing a competitive GPU, and while the company's software isn't currently on par with Nvidia's, this gap will likely close over time. As the tech giants seek alternatives to Nvidia's GPUs and software, AMD may emerge as a strong contender, making it a possible undervalued bet for the future.

Intel, another player in the AI space, is considered fairly valued but isn't generating significant enthusiasm as an AI investment. Other investment opportunities may arise from companies linked to Nvidia's supply chain. Taiwan Semiconductor (Ticker: TSM), a key supplier to Nvidia, is an undervalued wide-moat company that could present an attractive opportunity. As the supplier for a market leader like Nvidia, TSMC is well-positioned for success. This suggests that looking beyond the direct players to those indirectly involved in the Nvidia ecosystem could yield fruitful investment opportunities.

What risks should investors be aware of in the semiconductor industry?

While the semiconductor industry has promising opportunities and tailwinds, it is vital to recognize the potential risks and headwinds in this space. These include geopolitical tensions, trade disputes, and the intricacies of the global supply chain, which all should be concerns for investors.

One of the risks recognized during the COVID-19 pandemic was the industry's reliance on overseas manufacturing, particularly in Taiwan. TSMC, a foundry, produces approximately half of the world's semiconductor chips. The U.S. government, realizing that 90% of semiconductors are built overseas, enacted the U.S. Chips Act to bring some of this manufacturing back onshore.

However, transitioning semiconductor manufacturing is not a straightforward process. TSMC’s advanced manufacturing processes are not easily replicated by injecting capital into the problem. This task remains challenging despite Intel's efforts to carve out its share and catch up. It is a widespread desire, not just from the U.S. but also from Europe, to bring more chip manufacturing within their regions. This desire is leading to increased investment in semiconductor fabrication plants, or 'fabs,' which are highly expensive and can cost tens of billions of dollars each.

A further issue is that once a fab is built, ensuring it produces the best chips is another challenge. This complexity is part of the risk. Even leading companies like Nvidia or Apple Inc (Ticker: APPL) rely on TSMC for their processors, which depend on EUV (extreme ultraviolet) lithography machines from ASML Holding NV (Ticker: ASML) based in the Netherlands. This interconnectedness creates a "three-headed monster," where the failure of any one part could be detrimental to the whole tech sector due to the highly interwoven nature of the global supply chain.

The geopolitical implications are significant too. For instance, if China were to invade Taiwan or if any conflict disrupted TSMC’s operations, it would be catastrophic for the global supply chain. Even if a company had no direct relationship with TSMC, its products likely sit on the same electronic board as another chip produced by TSMC.

This was evidenced during the recent automotive chip shortage, where an inability to obtain a single necessary chip (the "golden screw" problem) could halt car shipment. This disruption could occur again, underlining the industry's vulnerability to potential global crises.

How will the U.S. CHIPs Act impact the semiconductor industry?

The recent passing of the chip act in the U.S. aims to increase the domestic supply of semiconductors, a shift that could have both positive and negative effects on the industry.

Chip equipment manufacturers are likely winners as they stand to benefit from constructing new fabrication plants (fabs). Most chip manufacturing has traditionally been concentrated in Taiwan due to efficiencies in running large, fully occupied fabs. Idle or partially filled fabs are seen as a waste of capital, hence the limited number of such facilities globally. With the U.S. trying to build and fill these fabs, the growing demand for semiconductors may help ensure their capacity utilization over time.

However, the shift poses questions for companies like TSMC and Intel. Building fabs involves high costs, and it's uncertain whether these companies will generate enough demand to fill their fabs and justify these costs. Making chips in the U.S. and Europe is expected to be more expensive than in Taiwan, leading to potential pricing challenges.

The effects on customers could also be mixed. Companies like Apple, for example, might have preferred the status quo of having all their chips made efficiently in Taiwan. The move to build factories in the U.S. and elsewhere could result in higher processor costs, which may eventually be passed on to consumers.

The shift reflects a global trade-off between efficiency and risk diversification. The world had previously leaned towards efficiency, potentially leaving it vulnerable to geopolitical disruptions. The realization that semiconductors are vital for commercial purposes and national defense has prompted a global awakening. Whether it's artificial intelligence, cybersecurity, or processors used in missile systems, controlling the production of these key components has become an issue of national importance for countries like the U.S., China, and Europe. The CHIPs Act and resulting industry changes underscore the growing recognition of this issue.

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