Chipmaker consolidation is good news: 5 picks – February 15, 2022

Sometimes when we talk about semiconductor shortages, we overlook the fact that these companies typically operate a just-in-time model, which means they are lean and medium-sized operations that typically produce to order.

So the shortage of semiconductors is not so much related to the supply chain (although there was initially some concern on that front as well), as to their operating model, which leaves little capacity free to meet a possible increase in demand. And the car market paid the price this time.

Companies generally pay very well to retain the highly skilled workforce they need. So labor has also not been a major issue during the pandemic, except for infections which have led to several plant closures.

A bigger factor in chip manufacturing today, and one that is likely to grow in importance, is the role of government in the industry. Semiconductors are at the heart of defense applications, making them an important factor in national security, especially in the age of artificial intelligence (AI).

In recent decades, most advanced manufacturing has shifted to a number of Asian countries, particularly Taiwan and South Korea, leaving American players to focus on design. Intel is an outlier here because it has its own manufacturing facilities. But since Intel lost its process lead to AMD, which has its manufacturing in Taiwan Semiconductor, the situation has now changed.

There is therefore a growing need to locate more advanced manufacturing on land. The CHIPS Act will give a boost to these efforts. But in the meantime, the government will try to influence Taiwan Semiconductor and Intel.

Taiwan Semiconductor has already agreed to set up a factory in the United States, and Intel recently announced it would invest $100 billion to build what could be the world’s largest chipmaking complex in Ohio. It’s a good move for Intel, because a strong foundry business will help fill unused capacity, generate revenue, and buy the time it needs to research and develop cutting-edge capabilities (and perhaps attempt to regain the market share it continues to lose to AMD).

Current mergers and acquisitions

Intel also shopped for capacity. After losing Globalfoundries, which decided to go public instead, he continued discussions with other players. The chipmaker has now announced its acquisition of Tower Semiconductor of Israel, which manufactures analog chips for the automotive, mobile, medical and aerospace industries.

Besides the fact that they don’t require the most advanced manufacturing technology that Intel doesn’t currently have, the company is positioning Intel in markets that will allow it to exploit the opportunity that the pandemic has presented to us. But there is still a long way to go before it can provide meaningful competition to Taiwan Semiconductor.

The other M&A news was the closing of AMD’s acquisition of Xilinx, which is a new segment within AMD called the Adaptive and Embedded Computing Group and led by CEO Victor Peng. This acquisition, however, is for cutting-edge chips for data center, cloud and AI applications where AMD still has a limited presence.

This agreement combines processor technology from AMD with SoCs and FPGAs from Xilinx, potentially helping AMD gain a foothold in these vertical markets. Other important markets served by Xilinx are 5G communications, automotive, industrial, aerospace and defense, all very important places.

Lisa Su, who will become CEO and president of the combined company, which now has 15,000 engineers, said the acquisition would be first-year accretive to gross margins, earnings per share and free cash flow. She also expects AMD to grow by more than 20% over the next few years. The deal is expected to yield $300 million in savings.

Why M&A is good for us

Semiconductor R&D is extremely resource-intensive. It has always been difficult to develop advanced chips and designs, not only because they are complex, but also because they require a lot of resources. Moreover, the devices that use them are often not very high-end. So there is pressure on companies to give more for less.

Scaling solves part of the problem because the cost can be spread over more and more units. And some segments (like enterprises) are willing to pay more for more power, lower cost per watt, and lower total cost of ownership. Thus, the problem of low-end markets is solved with high volumes, while high-end markets are where the most advanced logic chips go.

But development costs continue to rise with a lesser increase in what can be gained from it. Thus, pooling resources and capacities mainly through acquisitions remains a strategy for semiconductor players. And that has proven imperative for continued innovation. However, as smaller players continue to be taken over by larger players, the size of acquisitions has increased.

Enter the Russian-Ukrainian conflict

Russia and Ukraine going to war is simply not good news for chip availability as it could reduce the supply of key ingredients such as rare earth scandium or palladium, the Russia is the main supplier (it produces 45% of the world supply of palladium) and purified neon gas, of which Ukraine is the main supplier. They also jointly produce various industrial gases that are used in semiconductor lithography or etching processes. A showdown will increase the cost of these components, driving up semiconductor prices even further.

Semiconductor stocks are doing well today

In the semiconductor market, we are spoiled for choice. However, if we step in at this point, it’s easy to see that most of the good news has already been factored in. It can therefore be difficult to find a stock that is not too expensive.

One way to separate the wheat from the chaff is to find stocks with Zacks #1 (Strong Buy) or #2 (Buy) ratings that also have A or B scores for value and growth, as well as a positive trend in revisions to estimates. Based on these criteria, the following actions seem good-

WESCO International (COE Free Report): Zacks Rank #2 (Buy) Value and Growth Scores are A

United Microelectronics (CMU Free Report): Zacks Rank #2, A for Value and Growth

ASE technology (ASX Free Report): Zacks Rank #2, A for Value and Growth

Alpha and Omega semiconductor (AOSL Free report): Zacks Rank #2, A for Value and B for Growth

Silicon Motion Technology (SIMO Free Report): Zacks Rank #2, B for Value and Growth

One month price movement

Image source: Zacks Investment Research

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