The Essentiality of Semiconductors

Semiconductors. Semis. Microchips. For the busy among us, just “chips.”

These are some of the most common names you’ll hear in lieu of the syllable-heavy “semiconductors” to describe the miracle of innovation that powers our planes, computers, smartphones, gaming hardware, medical equipment, TV, fridge, coffee machine, camera, LED bulbs, washer and dryer…and even your toaster. (And if that seems like a long list, that’s just the tip of the iceberg.)

Instead of relying on ancient vacuum technology to make our world go ’round, we’ve condensed the ability to semi-conduct electricity into the billions of tiny transistors crammed into a space the size of a dime.

But…what is a semiconductor, actually – and why is the globe so damn short on them?

Semiconductors: A Quick Summary

In the scientific world, semiconductors are materials that conduct current – partly (hence the name). In particular, the tech sector uses silicon – which conducts electricity better than glass, but worse than copper – to produce semiconductive chips that take on essential roles in electronic circuits and devices.

By altering the silicon with impurities (other metals or chemicals) in a method called “doping,” manufacturers can produce chips that meet specific needs for the electronics in which it resides – for instance, by changing the conductivity of the chip, how the chip converts energy, or in which direction the energy flows.

Semiconductors do this by way of their transistors, or binary switches, billions of which are packed into the space of a dime. The creation process is incredibly time-intensive – it can take up to four months just to produce a single chip. And uniquely, the process requires the lack of a human touch, as the production line is comprised entirely of specially calibrated robots from start to finish.

In short, there are four types of chips produced on these lines:

  • Microprocessors, or central processing units (CPUs), contain the basic logic to perform tasks
  • Memory chips temporarily store data as it passes to and from a computer’s brains
  • Commodity integrated circuits, or standard chips, fulfill routine processing purposes (and are usually produced in huge batches by predominantly Asian-based manufacturers)
  • Complex SOCs, or “systems on a chip,” are all about creating an integrated circuit chip that contains an entire system’s capabilities

Each of these chips serves a vastly different purpose, and most technologies require specialized versions to perform essential tasks. As such, the semiconductor design and manufacturing industry is incredibly competitive – and at the same time, full of niche players that service a handful of companies or products.

Semiconductor Success: The Smaller, the Better

There are three main types of firms in the semiconductor industry:

  • Integrated device manufacturers, or IDMs, are companies that both design and produce their own chips – while these used to be the norm, many in the industry have outsourced one half or the other to maximize profits and streamline their process
  • Designers are “fabless” firms that focusing on drawing up new chips for other companies
  • Foundries are manufacturers that actually produce chips

Success in the semiconductor industry depends upon three factors: making chips smaller, faster, and cheaper. Tiny chips with greater numbers of transistors hold more power and work more efficiently, which makes them better at their respective jobs.

Thus, competition in the industry is all about producing chips as quickly and cheaply as possible – and innovating technology to make that happen. As a result, the industry is so fiercely efficient that new technologies to lower the cost of production spring up in just months, which can lower the price of even brand-new chips by half.

The Global Chip Shortage in a Nutshell

When the pandemic became “official,” so to speak, in the early months of 2020, the resulting lockdowns shocked the global supply chain. While cleaning supplies, masks, and computers were in high demand, the auto industry saw demand plummet so far that manufacturers canceled or put holds on their future orders of microchips.

As a result, fabs (chip manufacturers) shifted output to address the surging clamor for consumer electronics. Employees and employers found themselves ordering webcams and laptops galore; schools switched to a variety of virtual learning models; and the exponential innovation of cloud computing and the 5G rollout meant that the tech industry suddenly had the stomach to snap up chips – and a spot in the production line – that auto makers no longer needed.

Unfortunately, when the economy warmed up again coming into 2021, vehicle manufacturers began to realize the mistake they’d made in not placing orders before demand picked up again. In particular, three problems arose:

1. Since production lines had shifted to serve the needs of the tech industry, auto makers found themselves at the back of the line to nab even a few microchips.

2. Most modern vehicles require around 1,000 chips apiece to function fully. These chips do everything from aiding internal and external lighting and battery management to making emergency braking, automatic windows, and seat control possible. And that’s not to mention powering all the fancy upgrades like rear-view cameras, self-parking, and navigation systems.

3. Automotive semiconductor technology is outdated by more than 15 years – which means automakers either need to invest in upgrading their technology, or foundries need to build more legacy chips.

Automakers: Stuck Between a Rock and a Hard Place

Let’s unpack that last point a bit (without getting too technical). In short, modern technology uses larger silicon wafers to spit out increasing numbers of increasingly smaller processors that most vehicle technology isn’t equipped to utilize.

At the same time, the old infrastructure to produce such chips doesn’t draw enough return on investment for industry leaders to focus on specific, out-of-date legacy chips. For instance, though the auto industry orders $39.5 billion worth of chips every year, it makes up less than 9% of total demand by revenue. Not to mention, each chip only generates a fraction of the profits of in-demand high-speed processors.

And lastly, because these chips are larger and less efficient than the tiny, high-speed processors on which your phone and laptop rely, there’s no way for the industry to repurpose and repackage them for other customers. As such, while these chips are necessary for the auto industry – and by extension, consumers – there’s limited incentive for chipmakers to actually address the problem.

Of course, not all is lost: currently, analysts seem to agree that the most problematic shortages will ease up by the end of the year. That said, they also note that these same chips may spend the bulk of 2022 working their way through the supply chain to end up in end-user products.

And unfortunately, many industries appear to be engaged in the institutional equivalent of panic-buying toilet paper: double-ordering chips to bolster their industry against future chip shortages. And while that may protect them in the long run, it also serves to make the short-term shortage that much worse.

How Has the Chip Shortage Impacted Business?

To help address the chip shortage, legendary chipmaker Intel announced in March that it would invest $20 billion into two new Arizona factories to expand its newest offering, Intel Foundry Services. And while this will give the microchip industry (particularly in North America) a much-needed boost, the factory won’t be producing for years yet.

Until then, it seems like the current problem will remain a problem – and what a spectacular conundrum it is.

For instance, a lack of chips is expected to lower global vehicle output by 3.9 million units in 2021 alone. And between vehicle production issues and model shortages, the global automotive industry is likely to suffer around $110 billion in lost revenue.

Ford alone expects to see Q2 vehicle production cut by 50%, with the full year forecast short 1.1 million units and roughly $2.5 billion in earnings. To compensate for projected losses, Ford is slashing North American vehicle production at six U.S. plants through at least August. Other carmakers are reportedly skimping on premium features like extra screens and navigation systems to extend their chip supplies as far as possible.

But it’s not just the auto industry.

Chipmaker Nvidia has already set about repurposing old GPUs into special cryptocurrency mining boards to free up supplies for new gaming technologies.

John Deere is projecting shortages lasting up to 18 months for their factories, setting back farm equipment needs at least two years.

Apple noted in its second quarter earnings report that it’s having issues “licensing [the] legacy nodes” it needs for current and upcoming projects.

And both China and Japan have reported industrial output delays and reductions as a result of the chip shortage – especially in the automotive industry.

How to Invest in Semiconductors

If ever there was a time to invest in the semiconductor industry…well, frankly, that was when the market crashed in 2020. But if you’re ready to hop aboard now, you can get started investing in individual companies at every step in the supply chain process, as well as funds that capitalize on various segments of the sector.

For instance, you may choose to invest in the iShares PHLX Semiconductor ETF, which tracks the PHLX Semiconductor Index, the benchmark for the semiconductor industry.

Alternatively, the Invesco Dynamic Semiconductors ETF tracks only U.S.-based small- and mid-cap funds; while the First Trust Nasdaq Semiconductor ETF tracks only liquid semiconductor companies with an emphasis on growth; and the VanEck Vectors Semiconductor ETF tracks 25 semiconductor chip companies around the globe.

Wherever you choose to invest, remember that the sector is highly cyclical, based on boom-and-bust cycles driven by underlying demand. When demand is high, profit margins skyrocket – and when the bottom falls out of the market, chip prices fall and domino down the supply chain.

And because semiconductor companies fund massive research and development budgets, their expenses may ultimately cut into your potential profits…even if the chips they create don’t pay off in the end.

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