/The U.S. Still Dominates In Semiconductors; China Is Vulnerable (Pt 2) (via Qpute.com)
The U.S. Still Dominates In Semiconductors; China Is Vulnerable (Pt 2)

The U.S. Still Dominates In Semiconductors; China Is Vulnerable (Pt 2) (via Qpute.com)


  • “The US risks losing its superiority in semiconductors that are critical for commercial and military success.” – The Financial Times (2021)
  • China’s success in semiconductor markets has direct relevance to China’s  geopolitical power as well as its military and espionage capabilities.” – Center for A New American Security (2019)
  • “A misapprehension of the business reality can usher in myth-based policies that end up doing more harm than good.” – The Economist (2021)

Discussions of America’s competitive position in semiconductors are often based on gross misunderstandings of the nature of the technology and the structure of the industry. Questions like whether the U.S is “at risk” of losing (or has already lost!) technological supremacy, or whether we are “vulnerable” to possible pressure from, let’s say, the Chinese (!) – are posed, spun up and chewed over without a clear sense of how things really work in this sector.  

The urgency is valid. Semiconductor technology is correctly seen as critical for the rapidly developing digital economy. 

  • Semiconductors will enable all the other “wonderful” new technologies coming our way: machine learning, artificial intelligence, quantum computing, fintech, self-driving vehicles, even biotech breakthroughs (e.g., Deep Mind’s cracking of the protein-folding problem). 
  • Military advantage is in the balance – advanced avionics, the “battlefield of the future” and all the other high-tech national security systems depend on semiconductors. 
  • And of course many of the products we already rely upon – computers, smartphones, the Internet, non-self-driving vehicles – are powered by silicon.

The problem – is that the “semiconductor industry” is often presented as an undifferentiated whole. For example, here is a chart published by the Semiconductor Industry Association (SIA) in its 2020 Factbook:

  

Reassuring? Well, compare it with this chart, drawn from the Washington Post’s description of the geography of “semiconductor manufacturing” – 

 

And here is how the Boston Consulting Group sees it:

 

Despite the fact that these three charts all seem to address aspects of the same general question, they point to very different conclusions. Is the U.S. vulnerable? Is the Chinese position in semiconductors a threat to our economic position or our national security?

The Four Basic Business Models In The Chip Industry

The source of the confusion is not in the underlying data. It is a failure of categorization. 

All three charts shown above are basically meaningless – because the phrase “semiconductor industry” is basically meaningless. It is an incoherent category that lumps together apples and oranges and elephants and streetcars – muddling important truths, and suggesting conclusions that are manifestly incorrect.

The global silicon chip industry is a vast and highly differentiated eco-system, encompassing thousands of companies doing very different things. There are important structural fault-lines in the value chain, which determine which players, and which nations, enjoy greater or lesser economic power. What is needed, first, is a proper taxonomy of the companies that dominate the industry.

Business Models & Value Creation

A company’s economic power and political influence derive from the nature of its Business Model, which drives and is driven by the creation of economic value.

The semiconductor industry has four major segments, corresponding to four different business models, as described in a previous column.

  • Design: firms that design integrated circuits (IC’s) to perform a particular function
  • Fabrication: firms that physically fabricate these IC’s, traversing the designs into silicon 
  • Assembly/Packaging/Test (APT): firms that “package” the IC into a “chip” – a form factor suitable for a product manufacturer to incorporate into a smartphone, a TV set, an automobile, etc. etc.   
  • Semiconductor Manufacturing Equipment: firms that produce the capital equipment used by the other segments to perform and automate their functions

Some companies – notably Intel, the industry leader by sales and profit – have complex business models that combine the design, fabrication and packaging functions. These are called Integrated Device Manufacturers (IDM). We might view them as “un-evolved” — IC companies started out this way in the early years of the industry. But the last several decades have been marked by a strong trend towards differentiation and specialization. IDM’s have often split into a Design company (called a Fabless IC company) and a Foundry. (For example, in 2008 AMD split into a fabless IC company, which retained the AMD name, and a manufacturer, GlobalFoundries.) (In a previous column, I have discussed the reasons driving this trend.)

However, most “semiconductor” companies now operate exclusively in only one of the four segments of the supply chain. There are 

  • pure-play design companies, which develop software and intellectual property but do not manufacture anything – the so-called Fabless IC companies – 
  • pure-play manufacturing companies – called Foundries – which do not design their own chips but perform contract manufacturing for the Fabless IC companies. 
  • the chip packaging segment, which is largely separate, and more commoditized 
  • the equipment manufacturing companies, which are completely separate from the other segments.

This specialization trend has drawn out the economic differences between these four functions, and helps clarify who really has the upper hand in the industry.  

Value Creation By Segment 

A successful business model creates value in two ways: for customers, and for shareholders. 

For customers, a company creates value in the product or service it sells. It converts inputs (raw materials or semi-finished goods) which cost $X into a finished product that it sells for $Y. Y minus X equates to the value-added that the company adds to the product. If we examine the value-added by each segment of the supply chain, the first important fact becomes clear. The lion’s share of the value-added comes from companies in the design segment.

For shareholders, a company creates enterprise value, increasing the value of they investment. There are several ways to get at this concept, but the most informative metric is the simple price/earnings ratio. The P/E – which is effectively “normalized” to eliminate the effects of company size and sector – indicates how much enterprise value is created for each dollar of profit that the company earns.  

Not surprisingly, the P/E for the different industry segments parallels the differences in the value-added to the product. (The P/E figures cited here are based on an average of the forward price/earnings ratios calculated for the last 5 quarters for groups of companies in each segment. The companies that make up these categories are listed in the footnote to this column.) 

The pure-play Fabless Business Model creates 40% more enterprise value for each dollar of profit earned than the pure play Foundry Model. Perhaps surprisingly, the IDM model is even less effective at creating enterprise value. The Fabless Model generates 2 times more enterprise value per dollar of profit than the fully integrated IDM Model (e.g. Intel), and 3 times more than the IC-Packaging Model. In short, the financial markets place a huge premium on the pure-play companies that control the design of the IC’s. (Why these striking discrepancies exist is a separate question which will be explored/explained in a subsequent column. For now, these figures stand as Facts.)

The Price/Sales ratio may be an even better basis for comparison. It shows how much enterprise value is created by each dollar of sales. The P/S is more closely aligned, conceptually, with the product value-added by each segment in the supply chain shown in the previous chart. It is a better indicator of a company’s market power than the P/E.  

Once again, the pure-play design companies dominate. For each dollar of product sold, the fabless IC companies generate

  • 56% more value than Foundries
  • 4 times more value than IDM’s
  • 11 times more value than IC Packaging companies

Finally, if we compound the effects of the Value-added metric and the Enterprise Value metric – by multiplying the product value by the market value – the dominance of the fabless segment increases. 

 

Observations 

Design Dominates: Value creation correlates with economic power, and even geopolitical power. The dominance of the design segment and especially the pure-play fabless business models is obvious. The recent humbling of Huawei has made this very clear. Despite Huawei’s strong leading position as a product manufacturer in the wireless industry (as of 2019), the U.S. was able to deny Huawei access to the intellectual property (IP) controlled by American fabless IC companies (and other IP related to the Android operating system) – reducing Huawei’s smartphone sales by nearly 90% – that is to say, virtually wiping out that line of the company’s business – in just two years. 

Packaging Carries Little Weight: The minimal value-creation potential of the packaging industry results in weak market power. This segment is the proverbial tail of the dog, and it can’t even wag by itself, let alone influence the overall balance of power in the industry. 

National Positions: The next column will map these power-pockets onto the global national checkerboard. As a preview, we can summarize:

  • The U.S. dominates the Fabless IC segment; China’s position in this segment is negligible 
  • Taiwan dominates the Foundry segment; China’s position in this segment is negligible 
  • The Manufacturing Equipment segment is shared between suppliers based in Japan, The Netherlands, and the U.S.; China’s position in this segment is negligible 
  • China has a modest but vulnerable position in the low-value IC Packaging segment, but is not strong enough to exercise significant economic influence

Choke-Points: There is a missing element in this analysis – the positional strength of certain firms that control key links in the supply chain within these segments. These may constitute true bottlenecks, which may become a third source of market power (and supply chain vulnerability). Bottleneck status is reflected in elevated value-creation metrics for certain companies, raising them well above their segment averages. Two prominent examples are Taiwan Semiconductor Manufacturing Corporation (TSMC), which has well over half the Foundry market, and ASML (NL) which is the dominant supplier of photolithography equipment.  

Summary

The entire semiconductor industry comprises an extraordinarily complex supply chain. This makes it vulnerable to disruptions from natural shocks (pandemic lockdowns, or a factory fire). In terms of the potential for political pressure, it can seem like a classic Mexican standoff. All these segments and the firms within them are subject to mutual dependencies, as suppliers and as customers. In principle almost everyone has a potential monkey wrench to throw into the system.

But not everyone has the same size wrench. The real question is: How easy is it to work around the failure or denial of a particular company’s products within this complex network? Some links in the chain can be replaced quickly and easily; some with time and trouble; some are essentially irreplaceable. Power, and value, accrue to firms which are the most difficult to substitute for. 

To mix all the metaphors: Whoever holds the high cards sits in the driver’s seat…  

Right now, it’s the U.S. which currently controls the dominant share of the high value, irreplaceable assets — as the Huawei episode demonstrates. China, by contrast, currently controls no significant hard-to-replace part of the semiconductor value chain, and is a non-player in all of the important high-value segments. They are the vulnerable ones. Which may make them dangerous.

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