Structural growth in semiconductors outweighs geopolitics

The International Team is confident that our semiconductor holdings’ long-term prospects are far steadier than recent market reactions suggest. Here's why.

We’ve recently seen the semiconductor industry react strongly to geopolitical headlines. Ahead of the early August market correction, share prices fell for the likes of ASML, Tokyo Electron and, to a far lesser extent, TSMC in response to two stories:

• A Bloomberg article on 17 July reported that the Biden administration was considering wider application of the Foreign Direct Product Rule (FDPR) if the Netherlands and Japan did not implement stricter controls on the sales of semiconductor capital equipment to China. The FDPR allows the US government to claim jurisdiction over any piece of code, component or piece of equipment which has passed through the country or uses its technology. It can then prevent the sale of any product using these components – whether from a US company or not – to specific markets.
• Then we heard that former President Trump had suggested Taiwan should pay for US defense guarantees – a statement that led investors to worry how the small country’s chip industry could be impacted by geopolitical tensions.

Despite these developments, our outlook on ASML, Tokyo Electron, and TSMC has not changed. As we illustrate below, all three companies, to differing extents, control choke points in a very large, growing industry – making them compelling investments for the long term.?

The Chinese semiconductor industry remains limited

As background, China is not currently globally competitive in either the production of advanced semiconductors or the equipment required to manufacture them. It remains highly reliant on imports, despite the stated goal of 70 percent self-sufficiency in semiconductor production by 2025.

While Chinese foundry company SMIC has managed to produce a 7nanometre chip for Huawei phones, most of China’s fabrication capacity is for mature nodes at 130 nm and above. Meanwhile, less than 100 miles across the South China Sea in Taiwan, TSMC is pursuing the mass production of 2nm chips.

Despite being nowhere near that its self-sufficiency goal (estimates have it at less than 25 per cent nine years after that pledge was made), China has not been perturbed and is stepping up its investment, largely to semi-cap equipment. This is where China’s self-sufficiency is the lowest and its reliance on the West and Japan is the highest.

FDPR headlines do not impact investment case

By floating a potential extension of FDPR, the US seems to be attempting to lobby the Dutch and Japanese governments to go further in restricting the export of key pieces of technology to China. The Dutch government already prevents the sale of ASML’s most advanced EUV lithography systems to China. Japan also has restrictions on the export of certain pieces of semi-cap equipment, although these are less explicitly focused on China.

At this point, the talk of additional restrictions is pure conjecture, and the news stories are thin on detail.

There is a bear case scenario where this restriction is the start of a series of announcements around further restrictions, which lead to a surprise drop in sales to the Chinese market in the medium term or prompts more successful made-in-China policies in the semi-cap equipment industry.

Looking further out into the future, we assume Western and Japanese semi-cap equipment companies will lose share in China given the country’s self-sufficiency drive.

However, there is also a scenario where this is only being suggested to persuade equipment manufacturers like ASML to cease servicing their machines in China, with minimal impact on sales and profits. In a more bullish case, these comments prompt even more aggressive build out of contingency production capacity in the US, Japan and Europe, leading to better-than-expected growth for semi-cap equipment manufacturers.

Looking further out into the future, we assume Western and Japanese semi-cap equipment companies will lose share in China given the country’s self-sufficiency drive. At the very least, we assume China will become a smaller part of these companies’ revenues due to increasing restrictions. But even if the recent surge in Chinese orders is temporary, the long-term opportunity remains extremely compelling.

Continued conviction in the industry

Supporting generative AI and the increasing computing requirements of a whole host of applications necessitates increased global investment in semi-cap equipment. Indeed, the access to and supply of chips has become a matter for sovereign governments outside of China, suggesting that spending on this equipment will ramp up. The US and EU both have chips acts committing spending and support for domestic semiconductor research and manufacturing, while the Japanese government has earmarked funds to support production on its islands.

Our current view is that our holdings will navigate such an environment and continue to grow their sales and profits alongside growing demand for semiconductors at ever more advanced nodes. The fact that further restrictions are being considered for these companies highlights how powerful they are in the global supply chain.

Increased production requires increasing levels of equipment and the number of equipment manufacturers across the whole value chain is small. These are concentrated markets, and both the barriers to entry and switching costs are incredibly high. For the most advanced chips, the likes of TSMC, Samsung and Intel require ASML’s cutting-edge EUV machines. This walks hand in hand with increased demand for Tokyo Electron’s coating equipment, as well as equipment for etching and cleaning. Meanwhile, TSMC is diversifying geographically by building plants in Germany, Japan, and the US to mitigate geopolitical risks and meet customer needs.

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