Taiwan – A Wildcard in the World of Chips

?Originally published at?Empire Financial Research.

? There was a time when most people who bought cars and toasters wouldn't know the difference between a semiconductor chip and a chocolate chip...?

Let alone what goes into manufacturing them.?

The companies that make the equipment used to make semiconductor chips – known as chip-equipment manufacturers – can be a good leading and lagging indicator for the broader chip business.?

They aren't generally the sexiest of names... and for years, their stocks just lumbered along in a tight range – following the fortunes of chips.

That began to change about five or six years ago, when demand for more sophisticated and complex chips started to rise... as chipmakers like Nvidia (NVDA) began evolving their focus to such things as artificial intelligence and more recently, the metaverse. Today, Nvidia is the poster child for this shift to high-end, higher-margin chips.

In response, the chip industry started putting less priority on the commoditized chips used in such things cars and toasters.

This was fine before the COVID-19 pandemic struck and before everybody suddenly bought new computers, kitchen appliances, and other electronics upgrades – the result of working from home and diverting money from travel and other things into their homes.

? The performance of the top three chip-equipment makers tells the bigger story...

As you can see in the chart below, the stocks of Applied Materials (AMAT), ASML (ASML), and Lam Research (LRCX) have roughly quintupled over the past five years and more than tripled since the start of the pandemic – reflecting the chip shortage that everybody talks about and the rush to build more chips.

It was like the perfect storm, with sharply rising demand for new technology meeting up with stay-at-home pandemic-sparked demand. Demand for chip equipment, already in overdrive, went into hyperdrive.

As veteran chip-equipment analyst Fred Ramberg explained when I caught up with him, "There was a pandemic need on top of the technology demand."

? This gets to the question... What happens next??

Normally, a buildup of capacity to meet rising demand, as is happening now, ends the same way every cycle...

Investors bail as the story behind the stocks – rising orders for the chip equipment – starts to fall apart. Historically, regardless of the time of year, this has been Christmas for short sellers.?

Since chip-equipment stocks and chip stocks tend to move in lockstep, chip stocks usually follow.

But this time, there's a big twist in the plot...

? That has to do with Taiwan...

More than half of all chip manufacturing is done in Taiwan. And there are constant rumblings that China will invade Taiwan, which it claims should be under its control.

That's where things get dicey... and where analysts like Fred, who has lived through a half-dozen cycles, come in.?

In Fred's view, reflecting on not just his years as an analyst but also working in the chip industry as an engineer...?

Hostilities in Taiwan would jeopardize these chip factories physically and subject any left undamaged to grudgingly destroy process secrets and even process tools to safeguard important technology.?

The uncertainty is so high that Fred knows of one chipmaker, currently a customer of Taiwan Semiconductor Manufacturing (TSM) – the oldest and biggest chip foundry – that is getting quotes from Korea's Samsung Electronics.?

? Even before the China concerns, the industry was starting to diversify away from Taiwan, reflecting in part the push for broader geographic diversity...

There's probably no better example of that than what has been going on at fabs and foundries. That's where chips are formally produced, making them the ultimate end market for the chip-equipment makers.?

Some companies, like Intel (INTC), make their own chips in their own fabrication facilities, or "fabs." Others, like Nvidia, don't... Instead, they farm out production to independent foundries. (If you're wondering, the difference between a fab and foundry is that a fab is owned by a chipmaker, a foundry is hired out... more like a contract manufacturer.)

While the headlines have been focused on chip shortages and the squabble between China and Taiwan, fab capacity has been rapidly expanding... helping further puff up the chip-equipment order books.?

By the nature of the business, much of that has been going on without fanfare or headlines. And much of that expansion has been happening in Europe and the U.S., prompting Fred to muse...

"When was the last time you heard Europe referred to as a leading-edge foundry supplier?"

? Even Taiwan Semiconductor is realistic about what's happening and is spending $12 billion on a new plant in Arizona.?

Not to be outdone, Samsung is spending $17 billion on a new foundry in Texas, just outside of Austin.

And let's not forget Intel, which is spending $20 billion on two new mega fabs in Arizona.?

The fab business is so hot that one of the hottest initial public offerings ("IPOs") from October... that is, an IPO that is still higher than its opening price, is GlobalFoundries (GFS), a New York-based operator of fabs around the world. "It was stunning that a foundry could go public," Fred says. "When was the last time a foundry went public?"?

The answer... at least 20 years ago.

The more fabs, the higher the demand for chip equipment, which is evident in their stocks.

? Which gets to the question... what happens if China invades Taiwan?

"Then," Fred says, "it's Johnny bar the door" as demand for new chip equipment spikes "in these non-traditional regions" outside of Asia.

If there is no invasion, Fred believes it will be "chip cycle as usual." This means that the stocks of chipmakers and foundries will continue to rise, as the chip-equipment makers take a breather as orders slow... that is, until the cycle starts over.

The only difference, this cycle may be longer than most... and you'll know it's over when there is no shortage of such things as toasters and car lots start filling up.

?If a drug has cleared Phase 3, for these emerging companies it can be like betting on a horse when it’s about to cross the finish line.

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