How to Invest In Semiconductor Stocks In 2024, and How Top Chip Companies Make Money

How to Invest In Semiconductor Stocks In 2024, and How Top Chip Companies Make Money

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Hey all, welcome back to chip stock investor today. We are going to focus on how to invest in semiconductor stocks in 2024 and how top chip companies make money. And the way we're going to do this is we're going to focus on our semiconductor industry flow chart.

You've probably seen us refer to it in many of our videos, we did do a brief explainer on it, but since we have so many newer subscribers, you may have missed it. So here we are, the flow of the semiconductor industry, how these companies relate to each other and how they make money, which is info that is critical to making an informed long term investment. So first things first, looking at this chart, why did we organize the industry like this? Think of semiconductors as the engineering, manufacturing and infrastructure layer of the digital economy. We'll switch over to our inverted pyramid chart we have semiconductors in the middle above the base layer, which is raw materials. Beneath that infinitely scalable part, all the products and services we use every single day. So as any engineering manufacturing and general infrastructure industry goes, there's a flow within the semiconductor space and different steps are repeated over and over again.

And different companies within the space have largely specialized into different parts of the supply chain. This has become increasingly pronounced over time as the difficulty and expense involved with making chips has risen dramatically over the decades. Also, like any manufacturing process flow, once a product is made, some of the most advanced product gets recycled back into the top of the industry flow to further improve the process.

That's first, why we organized the semiconductor industry in this way. Second question, Kasey, why is understanding it so important? We believe that semiconductor importance has become critical at the very heart of the global economy and the bedrock of the new and still developing bull market. Also, our investment style follows secular growth trends. By 2030, estimates within and outside of the industry point to global chip sales to end markets, reaching 1 trillion annually. With 2023 sales expected to be around 515 billion, that would represent a nearly 10 percent compound annual growth rate over the next seven years, far exceeding expected global economic growth by a very wide margin.

We believe that there is a lot of room to make mistakes and pick sub optimal semiconductor stocks, but still wind up with sizable investment gains anyways. Now that we've covered those two very important reasons why we curated the semiconductor industry flowchart and why we're having a video specifically dedicated to this, let's start from the top with electronic design automation software, or EDA. Right. So you can see at the top of the chart, EDA and IP licensing, the point where software, some of that end product reenters the semiconductor industry flow. Let's start with EDA software, electronic design automation. So EDA software companies are the gears of innovation in today's semi industry.

They are foundational to the whole industry. As design complexity has really gone kind of parabolic, think billions of features on the most advanced chips, many of them just nanometers thick, or just tens of atoms in dimension, in many instances, it's impossible for an entire team of engineers to simply draft a chip design by hand. Thus, the automation part of EDA, Electronic Design Automation.

EDA companies also use specialized chips, often FPGAs, Field Programmable Gate Arrays, used in physical emulation and physical verification, of a chip before the design goes on to the manufacturing floor. And then once that design goes to the manufacturing floor, EDA also, of course, integrates with the manufacturing equipment itself so that the design is accurately transposed onto those silicon wafers and again, later diced up properly into chips. Later in the process, EDA is also used in the assembly and design of computing systems, arranging chips into packages and complex arrays like data center servers.

Big Tech and data center operators are fast growing EDA customers, as generative AI has ratcheted up complexity of systems designs. And finally, EDA companies also have their own portfolios of IP, intellectual property that often get bundled with an EDA software license for their customers to use. Let's talk about the companies themselves. You'll often hear us say that EDA is an oligopoly, meaning the industry is controlled by just a small handful of businesses.

In this case, it's three main EDA providers. The top three in the space, Synopsys, Cadence Design Systems, and Siemens EDA, which used to be called Mentor Graphics. Synopsys, the biggest player here, founded in 1986. Longtime CEO, Aart DeGuus, actually retiring on December 31st, 2023.

This company largely responsible for kicking off the semiconductor industry's transition away from CAD. As far as general sales breakdown, about 26 percent of sales tied to the IP intellectual property portfolio. Another 9 percent comprised of software integrity and security testing. And as far as the remaining EDA software core, much of that is hardware based emulation and verification software, an integral part of this business. Dropping down to the number two player Cadence Design Systems.

Very similar revenue breakdown, except they don't have that 10 percent security software segment. Instead, back in 2022, Cadence acquired a company called OpenEye Scientific as they are entering the molecular design market. They had an expanded software contract with Pfizer earlier in 2023.

So look for that as a big growth pillar for Cadence in the years ahead. And then as for Siemens EDA, they acquired Mentor graphics in 2017. So they round out this three company oligopoly. Mentor was actually founded all the way back in 1981. But fell behind a little bit, the top to Synposys, and Cadence Design.

Now that the old Mentor graphics is Siemens EDA, this EDA segment really only represents about 25% of Siemens, a 20. 6 billion Euro digital industries segment in fiscal 2023. And compared to the overall 78 billion Euro in sales, Siemens reported overall, you can see just how small EDA is, compared to the overall bit.

So we tend to focus not so much on Siemens EDA, as much as we do Synopsys and Cadence Design Systems, when discussing this part of the semi industry. ANSYS gets an honorable mention even though it's not quite EDA. It provides physics simulation software, which is a critical component in the design process, and counts high tech, semiconductor and electronics engineering and manufacturing customers as about one third of revenue. Xilinx is now part of AMD since early 2022, and with its FPGAs, Field Programmable Gate Arrays, and accompanying software. FPGAs and the important accompanying design software used to reprogram the functionality of logic blocks in an FPGA chip, are also used by lots of computing system customers, from telecom to aerospace and defense, to automotive companies. Smaller EDA stocks include Australian based Altium, Japanese based Zuken, and privately owned Aldec.

One last point here, we think it's really important as you think about these different parts of the semiconductor industry flow, about how these different types of companies make money and any competitive advantages they have and any barriers to entry, they are able to throw up against smaller upstarts. So let's start with EDA companies. How they make money: so EDA companies make the bulk of their revenue as software subscriptions and licenses, usually on multi year contracts with their customers. IP licensing is often paired with those software sales so that those customers can use, those patents, those out of the box chip designs and customize them, to their specific needs.

And then also there are always some hardware sales for emulation and verification as part of the whole package. So that adds a lumpier revenue element to EDA companies. Overall though, EDA tends to follow the R and D, research and development spend of the semiconductor industry, which tends to be a smooth line up and to the right.

As far as competitive barriers to entry, we rank these as very high for EDA. EDA has moved beyond the low barrier to entry business model that often plagues the software space. To combat smaller competitors, the three main big players in this oligopoly have built large suites of design tools. They have specialized hardware sales and very large and robust portfolios of IPs. EDA companies also have long and well established relationships, with their customers and given the high and ever increasing cost of designing semiconductors, switching to an upstart EDA provider, it isn't exactly easy, nor is it exactly desirable for a semiconductor designer, manufacturer or big tech and data center operator. Let's move into the second top bubble in our industry flow chart.

Intellectual property or IP licensing and royalties. You can basically think of these as patents. Hardware, a physical design, or manufacturing process are often the easiest things to get a patent on. Many semiconductor companies have IP portfolios, which is what gives them a deep competitive edge. IP is usually used in tandem with EDA and manufacturing software.

But why have an IP portfolio? As the saying goes, there's often no need to reinvent the wheel. So using pre made designs, or IP, can often save an engineering team significant time in the design process. Some IP, like logic cores, for example, are customizable. IP development and management has a rich history.

Bell Labs, which still has remnants now part of Nokia was instrumental in getting the electronics industry to where it is today. but here we're going to focus on notable companies that specifically manage an IP portfolio as a major portion of their business. You can see from the chart , some recognizable names, but especially Arm Holding in 2023, which had a partial spinoff and IPO from its primary shareholder, SoftBank.

It's best known for its reduced instruction set computer or RISC based chips made famous by Apple. Apple's been using custom designed ARM based processors for the iPhone for many years and recently completely cut long time supplier Intel out of the mix for its PC business in lieu of the ARM based M series chips. Arm is already a huge beneficiary of the smartphone and secular growth trend And now a key to Arm's future growth will be getting its IP portfolio more into the PC and data center server markets, long dominated by the x86 processor architecture from Intel and AMD. I'll gloss over some smaller names in the IP segment of the semiconductor flow. We have Rambus, which has some IP surrounding high speed memory chip interfaces, including HBM three or third gen high bandwidth memory.

Also Ceva which is a very, very small player in IP. Market cap currently just over 500 million, but large IP portfolios, around 5g wireless, Bluetooth, wifi, and some other, mobile patents. As for everyone else, many companies have large IP portfolios, protecting their designs is integral to business and can give them a long term competitive edge.

Qualcomm is notable here as it breaks out its mobile technology IP licensing as a standalone financial segment called QTL, or Qualcomm technology licensing. High profit margin segment that effectively funds Qualcomm's dividend payments. Also of note in this space is one of our favorite IP licensing and royalty companies, Universal Display, which holds patents on base materials and manufacturing processes for the OLED, or organic light emitting diode display technology. Other IP companies include IBM, Faraday Technology, Imagination Technologies based in the UK and considering a US IPO and lots of small and private companies. Nick, tell us how IP licensing companies make money and what are the competitive barriers to entry. Well, there's usually two primary steps to this process.

The first is licensing a lump sum, or maybe an ongoing payment, which allows a customer to design the IP into their own system or own device. And two, royalties. That's when the IP company earns a small cut of every sale of chip or product sold, utilizing it's IP.

So for example, every time Apple sells an iPhone. Arm Holding gets a very small royalty for that phone because there's an Arm based chip in it. Companies that get involved in extensive IP licensing and royalties, and especially those exclusively making a business out of IP walk, a fine line between trusted partner and unwanted operating expense from their customers. Some examples. this was something Rambus fell into back in the day, patent troll. And Qualcomm and Apple have certainly had their share of dustups in recent years between each other involving Qualcomm's IP licensing as for competitive barriers to entry for the IP part of the semiconductor flow, we rank this as highly variable.

Some IP is just some old commoditized chip design. It has an easy workaround, another company can quickly develop and patent an alternative. But more advanced IP or especially large and interrelated patent libraries, like what Arm Holding possesses, aren't that easy to shake and can have very sticky customer relationships. Base materials and industrial gases.

This is where raw materials and that engineering and infrastructure part of the economy meet. Because all things need to be mined and processed first before they get turned into materials, parts, and products, and later leveraged into services. Let's start with a list of raw silicon, germanium, gallium, or some other compound that is semi conductive material wafer producers. Silicon wafers later go on to have tiny features developed on their surface, which is front end manufacturing, and then later diced up into chips and packaged into an electronic system, which is the back end manufacturing. But the first step is the wafer itself, which starts with the production of a crystal silicon ingot or boule. Think about this like a log of salami.

This log of salami, or silicon, in this case is made using the Czochralski or simply the CZ method. This ingot is then sliced into those thin discs you often see someone in a lab bunny suit holding. In the following list, we exclude some other industrial conglomerates and IDMs that manufacture some of their own wafers. Nick, tell us about silicon wafer producers.

Some of the top standalone producers of raw wafers are Siltronic, based in Germany, we have Sumco in Japan, Global Wafers in Taiwan, SK Siltron, which is part of South Korea's massive conglomerate SK group, we'll talk about them later. Soitec, Shin-Etsu Chemical, and AXT, listed in the U. S., but operates actually in China.

How do these producers of raw silicon wafers actually make money? Well, it's pretty simple. They produce the material and then they sell it to more advanced manufacturers. There are some interesting startups in this space, like Atomera, which is taking the licensing IP route for some of its material patents and nanotechnology. But by and large, these wafer producers are pretty commoditized, they tend to have pretty low barriers, to entry. And that's why some companies like especially IDMs, which we'll discuss next, have actually added another layer to their vertical integration by bringing some of this raw wafer manufacturing in house.

Let's talk about some other base material suppliers that we like more. Besides semi conductive material substrates, various other elements, chemical concoctions, and industrial gases are needed as raw materials for the manufacturing process. For the sake of brevity, let's talk about just a few of our favorites here at Chip Stock Investor.

Our first one is Linde. Electronics and semiconductor manufacturers make up nearly 10 percent of Linde's revenue, and it has been one of the fastest growing end markets. Critical gases include nitrogen, oxygen, argon, hydrogen, helium, and carbon dioxide, as well as rare gases like neon, krypton, and xenon, and other gas mixtures for lasers used in the ultraviolet lithography wafer manufacturing step. Number two, Air Products and Chemicals. Similar to Linde, but Air Products comes to the high tech space from its leadership as a natural gas leader. It's also helping pioneer the use of hydrogen as a renewable fuel, which is helping power large scale manufacturing operations, including in the semiconductor space.

Additionally, Air Products supplies industrial gases and chemicals, lots of overlap here with Linde, for use in chip production. Entegris is our number three. This company purchased fellow electronics industry based material supplier CMC Materials in 2022.

As for competitive barriers to entry for this part, the industrial gases and other base material suppliers. We do think all on their own, different base materials don't have a very high barrier to entry either. However, like many manufacturing based industries, it does take a sizable chunk of capital and some Know-How to get started in supplying some of these base material.

However, much of these products, they tend to lack IP protection, and don't always carry enough profit margin to sell on their own. so it may be easy for competitors to pop up, but especially when you're talking about Linde and Air Products, they have breadth and depth to their portfolio of materials that they provide, as well as some extensive supply chains in place with their customers. So we rank these competitive barriers to entry more like a medium to high for these big companies versus some of the raw silicon wafer producers. I D M's integrated device manufacturers.

An I D M is a company that handles both design and manufacturing of semiconductors. The term I D M has lost some of its meaning over time, because some of these companies have adopted a more hybrid model. Some now handle the engineering and design, but outsource some of their commoditized manufacturing needs, like raw silicon or wafer production and front end development. Others choose to keep all of their manufacturing in house. IDMs are where we start to realize some of those final sales figures that make up the 515 billion in chip global sales for 2023, and the often cited 1 trillion in global sales by 2030 goal.

The IDM model was incredibly powerful in its heyday and produced some of the original giants, technological leaders and household names of the chip industry. Additionally, some big names we'll discuss in the fabless chip design section later are also technically IDMs. Chip giants Qualcomm and Broadcom are often called fabless designers, but that isn't completely true. Qualcomm owns some manufacturing operations for some of its wireless connectivity chips, and Broadcom, which says it sources 90 percent of its developed wafers from TSMC, , retains the other 10 percent of some of its proprietary chip manufacturing. Now you'll see from the flow chart here where we have IDMs at the intersection of the EDA and chip patents and licensing there at the top with the base materials and gases.

This is the original semiconductor model where a company would design its chips, and it would also go and get the raw materials, combine those 2 things together and go out and sell the final product to software companies, device manufacturers and so on. This arena can therefore be broken down into a few categories. Memory chip.

IDMs, one of the biggest chip types, by end market sales, logic and other processor chip IDMs. Analog chip IDMs, and finally, we'll talk about optical and photonics IDMs. Memory chip IDMs first. So memory chips can further be divided up into other categories like DRAM, dynamic random access memory, and NAND, N A N D, which actually stands for not and, in reference to the logic gate for this type of memory, different topic. At any rate, here are some of the top designers and producers of various memory chips, a highly commoditized piece of the industry, meaning these chips can easily be replaced with a competitor's product and stuck into a computing and electronics system with similar results. So first up, Samsung, besides many other things.

this South Korean tech and industrial conglomerate is the world's leading memory chip maker. Second, we have SK Hynix, part of that SK group. SK Hynix holds second place again with leadership in DRAM and NAND memory. Notably here, NVIDIA's most advanced AI systems, SK Hynix is a key supplier of HBM3E or third gen high bandwidth memory, a type of DRAM. Third, we have Micron technology based on Idaho, the world's third largest memory chip producer, but the largest pure play memory IDM. Fourth, we have Toshiba, a Japanese tech conglomerate in 2017, Toshiba acquired both SanDisk and IBM's NAND flash business to solidify its position in memory chipmaking.

It then rebranded that segment as Kioxia in 2019, which is now jointly owned by Toshiba and Bain Capital, which brings us to Western Digital, another U S company, traditionally a maker of hard disk drives or HDDs, making a transition to flash memory, it acquired Sandisk in 2016, which is where Micron's current CEO, Sanjay Mehrotra, was a co founder and working as CEO at the time. Western Digital was actually in talks with merging with Kioxia, but after a deal fell through, Western Digital is now planning a spinoff of that NAND business later in 2024. And then finally, Yangtze Memory Technologies or YMTC, not publicly traded, it's a startup memory IDM in China. YMTC continues to receive ample funding as China makes this push towards semiconductor supply chain independence. Okay, now for logic chip microcontroller and other processor IDMs.

It's important to note that the following list of IDMs doesn't exclusively focus on logic and processor chips. Nevertheless, these are some of the leaders in this important chip type, the brains of the computing system. Number one, of course, is Intel, the old titan of the semiconductor world and one of the first true tech giants.

It's worth mentioning here that Intel, finally in the last year or so, has been admitting that it missed multiple pivots in tech trends and that a logic chip IDM may not be the best path forward. Over the summer of 2023, it laid the groundwork for its chip design teams and chip foundry businesses to act independently of each other. It is receiving US and European chips act funding to expand its operations, which it hopes will lead towards its return as the most technologically advanced semiconductor company. Number 2, STMicro Electronics. STMicro is a leading European IDM and a top supplier of automotive and industrial chips.

Besides sensors and power chips, STMicro is also a top designer and manufacturer of microcontrollers or MCUs, an integrated unit that includes a processor, memory, and ports for inputs and outputs. STMicro is also a leader in silicon carbide chips, striking a supply agreement with Tesla in 2017 for the Model 3. Number three is Infineon, and number four is NXP Semiconductors. Now these companies are both based in Europe as well, there is a lot of overlap with these two companies, as well as with STMicro. But we will point out one thing that is unique with NXP semiconductors.

It makes various security hardware, including chips that are used in touchless digital payments and secure gateways used in payment network infrastructure. Number five, Renesas Electronics. Renesas is Japan's leading IDM and has a product portfolio that has a lot of overlap with its European counterparts. Microchip is our number 6 and a U.

S. based company. It merged with MicroSemi in 2018, and it is emerging as an industry leader in MCUs, in FPGAs and other processors for many of its non tech savvy customers. Microchip employs a hybrid model retaining some of its own manufacturing, but increasingly relying on 3rd party fabs for its semiconductor supply. Okay, we'll move on to analog and power chips or sensors, IDMs.

Again, many of these companies have overlap. As IDMs they also make some embedded processors and microcontrollers like the companies Kasey just rattled off. We'll start with Texas Instruments though, the old industry titan, besides some embedded processing, TI is actually a power chip and sensor leader.

Most of its products are actually highly commoditized, but the company excels at manufacturing at scale at a very high profit margin, but its customers rely heavily on TI anyways, as it can quickly meet their demand needs. TI carries large inventory on its balance sheet to always be able to meet those needs. Many of TI's products cost mere pennies when bought in bulk. Rather than go the custom chip route, the company's built its competitive advantage with its low cost fabs. But after years of stoking higher profit margins and massive shareholder returns, It's undergoing big expansion in the U.

S. to meet long term demand needs. It's also relying on significant U.

S. Chips Act funding to offset some of those costs. We also have Analog Devices, ADI, another giant in power and sensor chips and specifically a leader in mixed signal processing, that's converting an analog signal into a digital one. If you're a musician, you might recognize Analog Devices, in your electronic music equipment, , it converts your instrument into sound through your amplifier. We also have Murata manufacturing in Japan, another big industrial conglomerate focused on various electronic components, large market share in ceramic capacitors used in various power applications. On Semiconductor, one of our favorites undergone massive change since 2020 when new management was brought in.

Company is now making a concerted push into silicon carbide power chips. It and STMicro are the two top leaders in supplying silicon carbide at the moment, especially to the automotive industry, which leads us to Wolfspeed. Rounding out the list of silicon carbide producers, this company was formerly known as Cree. Cree was known for its light bulb business and related chip technology, but it split from that, rebranded to its current name in 2021, building several brand new silicon carbide fabs, which is a very expensive endeavor.

But one Wolfspeed thinks can make it far and away the silicon carbide chip leader later on down the road. We also have a couple of Connectivity IDM's Skyworks solutions known for riding Apple's coattails for many years supplying the iPhone. To this day, Skyworks still makes most of its money in radio frequency or RF front end modules and power amplifiers for smartphones and other wireless devices. In 2021, it did acquire the infrastructure and automotive business from Silicon Labs, to try and diversify its revenue streams.

Also Qorvo, another diversified IDM that provides wireless connectivity and power chips. It also acquired a small silicon carbide business in 2021. This company it's highly diversified, has an extensive fleet of chip fabs, but actually lags far behind many of its IDM peers in operating profit margins. Photonics IDMs. It's worth noting that the photonics market is a highly disaggregated and commoditized part of the industry, which supplies basic components that can fairly easily be swapped out for a competing product, similar to memory chips.

Nevertheless, photonics are an important part of networking, moving massive amounts of data within a computing system. We'll list off just a few of the photonics IDMs, The first one is Coherent. Coherent was acquired by II-VI in 2022, which won the bidding war for Coherent against Lumentum and rebranded to Coherent after that merger. We also have Lumentum, Hamamatsu Photonics, Macom Technology Solutions, IPG Photonics, nLight and Infinera.

Let's briefly talk about how IDMs make money and their competitive barriers to entry. IDMs pretty simply make money by designing and manufacturing chips and then selling them to their product partners. Some IDMs focus on off the shelf or merchant silicon, while others also provide custom engineering to meet specific needs of their customers. So by and large, IDMs do well when they're able to efficiently manage their extensive supply chains and maintain efficient manufacturing operations.

IDMs, that remain profitable throughout industry cycles are the best investments to focus on, in our opinion. As far as competitive barriers to entry, we rank these anywhere from medium to high. Chip design and manufacturing does take a great deal of expertise and additionally requires a lot of capital to get started. Many IDMs have overlapping and competing products, so it doesn't leave a lot of room for smaller upstarts. That being said, some parts of the industry, especially older analog chips, like power semiconductors that are sold in bulk to industrial markets, is facing competition from new fabs in places like China, but competitive advantages for these highly commoditized chips include the ability to manufacture at a far lower cost, ample supply to meet customer demand and ease of design and self serve sales like an e commerce site. All right, let's move on to one of the most famous parts of the chip industry, fabless chip designers.

Like IDMs, this is where final chip sales tend to get measured. Fabless chip companies are the sexy names of the semiconductor world. AMD co founder and longtime CEO, Jerry Sanders once said, real men have fabs.

Current AMD CEO, Lisa Su is ironically proving the statement false as are a myriad of other fabless chip designers. Think of fabless companies as the world's most advanced engineering businesses. They outsource manufacturing and assembly to third parties, but realize the final sale to their device manufacturing partners. But because they have no manufacturing in house, they are asset light. Many of them have little to no debt since managing fabs and industrial equipments is not a factor. And they have the ability to generate very high profit margins.

Big tech is also delving into this space. Apple was an early entrant here and particularly successful with its custom chips using ARM IP. Other big tech companies designing in house chips that get a steady beat of media hype include Alphabet's Google, Microsoft, Meta and Tesla . Nick, kick us off with the Logic and Accelerated Computing fabless chip designers. Thanks to NVIDIA. fabless logic and accelerated computing is now basically the largest valued part of the semiconductor market. No introduction needed for NVIDIA, big year for AI and accelerated compute.

The rest, as they say, is history. AMD, a fabless company since spinning off Global Foundries in 2009. And as Kasey said, CEO, Lisa Su picking up all sorts of market share from Intel since she took over in 2014. We have Qualcomm, which technically not completely fabless. They do still have some small operations, but famous for also the IP licensing.

But often what gets attention these days are those Snapdragon processors, integrated graphics and NPUs or neural processing units, for smartphones. Mediatek originally part of United Micro Electronics, but spun off in the late nineties, similar to Qualcomm, but by volume of chips sold actually surpassed Qualcomm a few years ago. We also have Lattice Semiconductor, the last FPGA pure play stock left standing. We'll have more to say about them as we move into 2024 and Ambarella which gained notoriety for its high definition video compression chips for GoPro.

But now they design all sorts of chips for video processing, as well as, sensors, specifically cameras, as they help try to sustain the development of self driving cars. Networking Chips and Custom Silicone or ASIC's fabless designers. On this list, we have Broadcom, Marvell Technology Group, and Silicon Motion. As many viewers have noted, we favor Broadcom heavily in this space and have a lot of videos regarding this company, it just finally completed the acquisition of VMware, which is one of the largest tech merger and acquisition deals ever. Broadcom is a very unique business featuring a 60 40 split between semiconductor sales and enterprise software. Marvell Technology, which we affectionately call baby Broadcom, is a top developer of the D P U, the data processing unit, which is a key part of networking infrastructure for data centers and enterprise compute systems.

Silicon Motion is one of our favorites in the small caps space. This company was supposed to merge with MaxLinear. That deal was scrapped by MaxLinear in 2023, and Silicon Motion is left to forge its own path. It's a top designer of NAND memory controllers, and that is a custom chip that acts as an interface between the processor, computing system, and long term storage. Next in the fabless design world, we have connectivity and radio frequency chips. Not a ton of companies and the fabless space here, we already talked about Qualcomm.

In addition, we also have Silicon Labs, which is a leader in designing MCUs for IOT or internet of things. They also do quite a bit of custom software design for their customers. MaxLinear, supposed to merge with Silicon Motion, top designer of wired and wireless chips used in the internet and data center infrastructure. We have a Nordic Semiconductor and Semtech, another smaller IOT chip designer. Finally, we have sensors, powerChips and MEMS, fabless designers.

First up, we have Allegro Microsystems, which was a spinoff from Japan's Sanken Electric in 2020. They are a leader in designing power management, motor drive, and other electromagnetic based analog chips and sensors. Number two, Monolithic Power Systems. They focus on power management chips and systems, and they have a lot of market share in high performance and small size form factors. Number three, SI time.

This is a purePlay fabless designer of MIMS chips. Number four, Synaptics. Synaptics is a leader in designing human interface solutions and specifically, these include popular consumer electronic and smartphone features like touch sensors, voice recognition, audio, and haptic feedback chips. We have also companies like Cirrus Logic Power Integrations, and indie Semiconductor all fall within this power management sensor and MEMS fabless designers.

Now, how do these guys make money and what are their competitive advantages? Fabless designers hire a third party chip fab to handle the manufacturing and a lot of the supply chain work as well as final assembly of their work, but fabless designers make revenue from the final sale of those chips and systems to manufacturers. Many of them also make some revenue from some I. P. Licensing and, many of them, again, famously NVIDIA and Broadcom also have sizable software libraries that run on their chip designs. And we have those custom chip developers, those ASIC developers like Broadcom and Marvell. As far as competitive barriers to entry, these are also highly variable, much like an IP only business, fabless design companies often find strength in building, large portfolios of related or interrelated IP that they can use to develop chips for their customers.

The more advanced the designs or larger, and the more breadth and depth you get in an IP library, the better, the higher, the barrier to entry. Managing global supply chains and manufacturing partners are also critical for fabless company success. Companies like NVIDIA and like Broadcom are also demonstrating how software can become a very key competitive advantage over their peers, as well as a key revenue driver. Let's head into the wafer fab packaging and assembly equipment. Before we go to that critical manufacturing stage of the semiconductor industry cycle, let's address another critical choke point in the industry flow. Wafer and chip packaging equipment.

There are two primary phases in semiconductor manufacturing that these equipment specialists address. Front end manufacturing, which is the wafers, and back end manufacturing that chip packaging and testing. No one gets past the engineering and design process without these highly specialized industrialists.

There are dozens of companies that develop and make these technological machines, but the industry is dominated by five of them, which we call the "Fab Five." Together, these five businesses control 70 percent of revenue spent on chip fab equipment. Taking a look at the chart that we have used frequently from Applied Materials, it shows the market share of these fab five companies and what position they hold within this part of the industry. We of course have ASML Holding the lithography specialist, Applied Materials, which is the industry generalist, LAM Research, another equipment generalist, but with particular market share leadership in wafer etch equipment.

Tokyo Electron, which is similar to LAM, but Tokyo Electron leads in wafer cleaning and chemical deposition. KLA Corp number five, it's another specialist and a giant in metrology, which is a fancy word for measuring stuff. There's also some smaller companies Onto Innovation, Nova, Camtek and Cohu that we follow in this space. Besides those small cap stocks that we follow there is everyone else of course.

There's lots of smaller companies that are involved with various equipment. Some of it a bit commoditized, others highly specialized and making waves in the industry. Notable call outs include general equipment leader, European based ASM International, and Aixtron. Lithography, photomask makers like Dai Nippon Printing, Toppan and Photronics , Ion implant specialist, Axcelis Technologies, and silicon carbide test and burn in leader Aehr Test Systems.

Okay, so that is the whole front end manufacturing equipment part, but there's this whole back end chip packaging and testing part of the equation. This is the step after wafers are cut into chips packaged onto circuit boards and then move on to final assembly into a device or some sort of electronic system. Front end development has received tens of billions of dollars in R and D over the years, but we're starting to reach those physical limits again, the features on the most advanced chips, sometimes just nanometers in dimension.

So now packaging is getting a lot more attention. We'll discuss this a bit further when we talk about OSATs or outsourced semiconductor assembly and test providers. As far as the equipment goes, that the equipment that those OSATs need put the chips together. Here's a rundown of three of the top players, BE Semiconductor based in Netherlands, actually has similar historical roots to ASML but this is the technological leader in advanced packaging and die attach equipment. We also have Kulicke & Soffa, another packaging specialist. As well as Mycronic, which also does some work in the lithography photo masks, but there's a little bit in packaging as well.

Now, whether it's front end wafer development, or backend chip packaging, how do these companies make money? Well, they develop test and then sell the machines for making chips. So increasingly the fab five are building out also service and software revenues based on their global installed base of equipment. So there's this small, but growing recurring revenue component to their business models.

And that also adds another layer to the competitive barrier to entry, which is quite high for these businesses. Generally speaking, chip fab and packaging equipment has a lot of protection from patents, from IP portfolios. And it's just hard to get into. You need to have a deep know how of the chip making process, which includes chemistry, physics, mechanics, increasingly quantum level mechanics.

And it's expensive to build these machines. Now, if you find a workaround to all of these and you get a fully functioning piece of equipment up and running, now, you have to take it to a chip fab and try to get them to buy it. And we're talking about a very expensive piece of equipment that could ruin a manufacturing process, which would be highly costly and financially disastrous. These chip fab customers are not likely to part ways with their longstanding fab equipment partners, especially those fab five. So barrier to entry in this market, it's high.

That's why we call this segment, a critical choke point in the semiconductor industry and an oligopoly. Next part of the industry chip fabs and contract manufacturers. These companies are the new workhorses of the economy and critical to the fabless designers of the semiconductor industry chip fabs and contract manufacturers handle the bulk of semiconductor wafer production as well as final packaging, assembly and system test services.

Intel is positioning itself as a trusted third player in contract manufacturing offering to open up its internal manufacturing to other companies as an alternative to leaders like TSMC or Taiwan Semiconductor Manufacturing and Samsung in South Korea. Besides the number one leader, Taiwan Semiconductor Manufacturing and second Samsung, we have Global Foundries, which was spun off from AMD in the wake of the great financial crisis of 2008, 2009. Global Foundries stopped competing in advanced manufacturing nodes a few years ago, and has built a successful business as a mature node and specialty manufacturer. A few others are United Microelectronics, which is based in Taiwan as well. Semiconductor Manufacturing International or SMIC.

SMIC was removed from US OTC markets after it was placed on the US entity list in 2020 for allegedly having close ties to China's military. Nevertheless, it's been key to China's homegrown chip independence goals. Tower Semiconductor. This is one that Intel was attempting to acquire earlier this year, but that fell through. It's a specialty fab, especially for RF and other connectivity devices.

Nick, tell me a little bit more about the OSAT providers. So the fabs, largely responsible for some of the front end work wafer development. Let's talk about the back end, the chip packaging and outsourced semiconductor assembly and test providers, or OSATs. We have Hon Hai Precision Industry or simply Foxconn, technically a contract manufacturer, Most notable customer is of course, Apple. This is a giant of the industry. It assembles everything from chips to batteries and a whole lot in between.

Some other big players we have in Taiwan, ASE group or Advanced Semiconductor Engineering Group, Amkor Technology. We have JCET group, listed in Shanghai. In the U. S. Jabil and Flex. Then moving again back to Taiwan, we have Power Tech technology and Chip Mos Technologies.

Now, these companies, both the front end and the back end packaging contract manufacturers, how do they make money? They tend to strike agreements with fabless designers, and also to a certain extent, some of the IDMs that are looking to take more of a fab light approach contracts tend to be long term. Pricing depends on the order volume, either for wafers or for how much packaging assembly and test is needed. Pricing also tends to depend on how advanced a manufacturing processes.

So the more advanced the manufacturing node, the more expensive it's going to cost the fabless company to hire the contract manufacturer. There's often also some contract engineering and design work revenue being generated here as well. For example, if you're Apple designing a new processor with Arm patents and probably using an EDA provider, you definitely want to make sure that your contract manufacturer, TSMC, is going to be able to handle the making of that new chip. So that's why there's a lot of integration and co design with EDA software providers here. Again, EDA kind of filters into the whole industry.

That's why we call it foundational and a little bit of revenue made from some of the contract manufacturers here as well for that co design work. Barriers to entry tend to be medium to high. Building a chip fab, it's technically easy to do. All you need to do is round up enough capital and then go to the chip fab equipment companies and fill up your facility with machines that you buy from them. That's easier said than done though.

So that's why we often say a lot of the money being spent right now on building these new chip fabs, in China, in the US, in Europe and so on and so forth, it's flowing through the actual chip fab equipment companies. We think that cycle will really start humming along later in 2024. Specialty energy design and service equipment. Now, this section is highly competitive and disaggregated, and we decided to break it out separately from the chip fab equipment segment of the industry.

Contained in this segment, there are smaller, but still very critical equipment types related to making wafers or chips, but not as competitively positioned as the capital intensive, and IP heavy parts of the market. Specialty devices that address energy needs of chip fabs and heavy equipment, ancillary parts and disposable products used in chip test and assembly big diversified manufacturers of electrical connectors and other components and related services tied to them are all of the things that make up this segment. Some of the companies that are part of this part of the industry, Keysight Technologies, FormFactor, Advanced Energy Industries, Teradyne and Amphenol. How do they make money again, as is the case with some of the chip fab equipment companies, they develop test and then sell equipment. Oftentimes they also have a service component as well.

Some of these, like Keysight Technologies, sell software, Form Factor tends to have more of a disposable parts business. Advanced Energy Industries, as the name implies, they sell equipment that manages the flow of power to heavy equipment. Again, you get the idea, the sale of parts and pieces to the industry. Many of these companies do not have highly differentiated portfolios of equipment.

It with a bit of capital, it's easy for a new manufacturer to break into this market. However, delivering adequate supply in quick fashion to your customers, and all along the way, doing so at a high rate of profitability to yourself is a totally different story. So the best stocks in this segment have endured the test of time. They've dug competitive moats by supplying their customers when and how they need in good times and in bad. So we do measure the competitive barriers to entry here as low to medium, but some companies have still dug out a pretty competitive niche anyways. Tech, equipment, devices, and systems.

Data centers, ISPs, and internet infrastructure, mobile and satellite networks, computing devices like PCs, smartphones, industrial equipment, and everything else. This is all at the start of the top of our inverted pyramid where chips proliferate through the economy to make infrastructure in support of software and services. This supports consumer software, such as video games and e commerce and enterprise software for businesses.

Some of the advanced enterprise software powered by some of the most advanced chips flow back into the semi industry flow at various points. This completes the virtuous cycle of semiconductor development and manufacturing. As illustrated by this inverted pyramid, this is obviously the largest part of the market by end sale.

The trade off with that barriers to entry here tend to be low to medium. There are of course, a few exceptions, most notably big tech companies. Competitive barriers to entry have to be built over time, and exists when a company can build breadth and depth to their product and service portfolio, spanning hardware and software. What many companies in this department lack in competitive advantage make up for it with sheer scale and size of their addressable market.

This is huge. This is where you often hear people talk about businesses with so called infinite scalability. We've covered a ton of information here, and maybe you just skipped to this part right here.

This chapter where I asked Nick, how do we invest in semiconductor stocks in 2024? If you did, shame on you go back and watch the rest of the video, so you understand this material. But, if not, Nick is going to tell us how to invest in 2024. We do think it's going to be harder in 2024 than it was in 2023. We were coming off of a pretty sizable industry downturn over a year ago when we started this channel.

The good news is, we still very much like those critical choke points that we called out. The EDA portion of the industry, the software design, where the software starts to flow back into the industry, as well as that critical choke point that is the actual chip fab and packaging equipment. Now, because of valuations, we have put some of those companies on hold as our best buy now. There is a new downturn starting in some pockets of the industry, specifically in industrial and automotive.

And so some of the companies that we weren't huge fans of in the IDM space, we think might present a pretty good buying opportunity. It also looks like some of the actual chip fabs, are starting to heat up again, most notably TSMC. So we'll have more to say about this real soon we're going to put together a list of our top semiconductor stocks for us personally in 2024. And so some of the companies, again, that we put on hold in the chip design and chip manufacturing space, we actually think look pretty attractive at this point. So brief pause for us here on those critical choke points, EDA and chip fab equipment, starting to look more at some of the IDMs, manufacturers and some fabless companies stay tuned for that.

We're going to be making a specific video for each segment of the industry and doing more of a deep dive into the companies that we mentioned in each of these sub industries of the semiconductor industry flowchart. If you haven't yet, make sure you hit the subscribe button. Also make sure that bell is turned on for notifications so that you don't miss a video.

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2023-12-19 15:04

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