Morningstar - Q2 2021 - 66

Investors

Sea Change
A surge in semiconductor demand
is the wave of the future.

SECTOR RAP

Laura Lallos

During the pandemic, the semiconductor industry
has secured its position as an integral part
of daily life and industrial activity-and vital to
U.S. economic interests. Surging demand has
outpaced supply, and lawmakers are responding.
At the end of 2020, Congress passed the
CHIPS for America Act providing for investment in
U.S. semiconductor manufacturing and design,
and in February, President Joe Biden signed
an executive order calling for a review of supply
chains to increase production.
Technology strategist Abhinav Davuluri covers
some of the biggest names in the industry
for Morningstar Research Services. He says that
consolidation and an expanding end market
leave industry leaders well positioned for
long-term growth. We spoke on Feb. 25, and
the conversation reflects performance and
valuations as of that date.
Laura Lallos: A year into the pandemic, how has the

landscape for the semiconductor industry changed?
Abhinav Davuluri, CFA,
is a technology equity strategist
at Morningstar Research
Services LLC.

Davuluri: A lot of the trends that we've
seen impact the semiconductor space in recent
years-artificial intelligence, 5G, cloud
computing-have been accelerated during the
pandemic because of everyone working
and learning from home. These were things that
were going to happen sooner or later. The

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Morningstar Q2 2021

shift to the cloud has been ongoing for the
last couple years, as fewer businesses
and enterprises control their own data centers
and outsource that to major cloud vendors
like Microsoft MSFT and Amazon.com AMZN and
Google GOOGL. But what may have taken
five to 10 years was condensed into one year.
As a result, many firms in the semiconductor
space did extremely well.
Lallos: Now there's a shortage of chips. What led to
this supply/demand imbalance? How might government
intervention affect the industry?

Davuluri: When everyone's at home, not only
do you see a massive increase in demand
for laptops for education or work, but also for
gaming and other consumer electronics,
such as smart speakers or other smart devices.
The overall ocean of demand has risen quite
a bit. Then you have the supply-chain disruptions
that occurred during the outset of the
pandemic, stemming from initial lower demand
from automakers, for example.

Automakers and parts suppliers for automakers
were looking to keep a lean inventory level
and expecting to be in this situation for quite
some time. Now, they're feeling the brunt
of this shortage. They have very long lead times,
and while their parts can be quite complex,
they are not as expensive as, say, a chip for
an iPhone. So, they are a lower priority at some
of the manufacturing facilities for chips.
Then automotive demand snapped back sooner
than anticipated, as people wanted to drive
as opposed to fly. When that happened,
automakers were caught flat-footed and unable
to get enough chip supply to meet that
production demand. That's why they're in dire
straits right now.

The automotive side is feeling the most heat, but
the shortage is impacting every aspect of the
semiconductor supply chain and every end market.
The executive order sheds a light on the fact
that the U.S. has outsourced a lot of this
manufacturing. Much of it happens in Asia. There
are still some domestic champions like Intel
INTC and Micron MU, but for the most part, they
make the chips that they sell, as opposed
to making third-party customers' chips. Most chip
designers have outsourced the manufacturing
to Taiwan Semiconductor Manufacturing TSM. All
the Apple AAPL iPhone chips are made there.
PC graphics chips for Nvidia NVDA and Advanced
Micro Devices AMD are made there. Qualcomm
QCOM smartphone chips are made there.
The U.S. doesn't really have a domestic foundry
to make those chips.
The Biden executive order should ideally get
the ball rolling for the U.S. to have more domestic
manufacturing going forward, not only from
a security standpoint, but also for diversification
of the supply chain. There's a kind of funny
adage in the semiconductor space that building
a fab-a manufacturing facility-is kind of
like playing Russian roulette, except you don't
know if you died for four or five years. There
are extremely long lead times to invest in
these $20 billion facilities and get them running.
The government will assess the current
supply-chain situation and see where there are
opportunities to either reduce reliance
on foreign firms or build up the domestic fabs
as necessary.
Lallos: How does China fit in here? Is it more of a threat
or an opportunity?

Davuluri: The U.S. and the companies based
here have made a practical decision to outsource.
That wasn't China's doing. China's taken
advantage of our outsourcing and built lower-cost
production facilities for manufacturing devices,
like the iPhone, and, increasingly, built the
chips themselves. But China's still far behind the
most advanced chip production players
in Taiwan and South Korea, and even here in
the U.S.

The U.S. is trying to limit China's advances from
a technological standpoint. The Trump
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