Games Without Winners Or Losers

[Carri Seargent]

Thesemiconductor business, in its current form, had its growth spurt as a consequence of the PC revolution of the 1980s, as personal computers transitioned from tools and playthings for geeks to everyday work instruments for the rest of us. In the last four decades, computer chips have become part of almost everything we use, from appliances to automobiles, and the companies that manufacture these chips have seen their fortunes rise, and sometimes be put at risk, as technology shifts.

It was the personal computer business in the 1980s that gave the semiconductor business, as we know it, its boost, and as technology has increasingly entered every aspect of life, the semiconductor business has grown. To map the growth, I started by looking at the aggregated revenues of all global semiconductor companies in the chart below from 1987 to 2023 (through the first quarter):

From close to nothing at the start of the 1980s, revenues at semiconductor companies surged in the 1980s and 1990s, first boosted by the PC business and then by the dot-com boom. From 2001 to 2020, revenue growth at semiconductor businesses has dropped to single digits, as higher demand for chips in new uses has been offset by loss of pricing power, and declining chip prices. While revenue growth has picked up again in the last three years, the business has matured.

While gross and operating margins have always been healthy, the pick up in both metrics since 2010 is a testimonial to the higher profitability in some segments of the chip business, even as competition commoditized other segments. As can be seen in the periodic dips in profitability across time, there are cycles of profitability that have continued, even as the business has matured.

It is worth noting that these margins are understated, because of the accounting treatment of R&D as an operating expense, instead of as a capital expenditure. The R&D adjusted operating margin at semiconductor companies is higher by about 2-4%, in every time period, with the adjustment to operating taking the form of adding back the R&D expense from the year and subtracting out the amortization of R&D expenses over the prior five years (using straight line amortization).

As the semiconductor business has acquired heft, in terms of revenues and profitability, investors have priced those operating results into the market capitalization assigned to these companies. In the graph below, I report the collective enterprise value and market capitalization of global semiconductor companies, stated in US dollar terms:

As you can see, the semiconductor companies have enjoyed long periods of glory, interspersed with periods of pain in markets, starting with a decade of surging market capitalizations in the 1990s, followed by a decade in the wilderness, with stagnant market capitalization, between 2000 and 2010, before another decade of growth, with market capitalizations surged six-fold between 2011 and 2020. Note that for the most part, semiconductor companies carry light debt loads, leading to enterprise values that either trail in market capitalization in some years (because cash exceeds debt) or are very close to market capitalization in other years (because net debt is close to zero).

As market capitalizations have risen and fallen, the multiple of revenues that semiconductor companies has also fluctuated, reaching a high in the dot-come era, with semiconductor companies trading collectively at more than seven times revenues to a long stretch where they traded at between two and three times revenues, before spiking again between 2019 and 2021. If prices are a reflection of what the market thinks about the future, the pricing of semiconductor companies seems to indicate an acceptance on the part of investors that the business has matured.

As the semiconductor business has matured, it has also changed in terms of both the biggest players in the business, as well as the largest customers for its products . In the table below, we show the evolution of the top ten semiconductor companies, in terms of revenues, from 1990 through 2023, at ten-year intervals

The cast of players has changed over time, with only two companies from the 1990 list (Intel and Texas Instruments) making it to the 2023 list. Over the decades, the Japanese companies on the list have slipped down or disappeared, to be replaced by Korean and Taiwanese firms, with Taiwan Semiconductors being the biggest mover, moving to the top of the list in 2022. After a long stretch at the top, Intel has dropped back down the list and ranked third, in terms of revenues, in 2022. Note that NVIDIA, the subject of this post, was eighth on the list in 2023, and has remained at that ranking from 2010. That may seem at odds with its rising market capitalization but it is indicative of the company's strategy of going after niche markets with high profitability, rather than trying to grow for the sake of growth.

The customers for semiconductor chips have also changed over time, with the shift away from personal computers to smartphones, with demand emerging from automobile, crypto and gaming companies in the last decade. Over the last few years, data processing has also emerged as demand driver, and it is safe the say that more and more of the global economy is driven by computer chips:

The forecasts for the future (2030), were for faster growth in automobile and industry electronics, but the potential surge in demand from AI products was largely underplayed, showing how quickly market forecasts can be subsumed by changes on the ground.

NVIDIA was founded in 1993 by Jensen Huang, but it remained a niche player until the early parts of this century. Much of its rise has come in the last decade, just as revenues for the overall semiconductor business were starting to level off, and in this section, we will look through the company's history, looking for clues to its success and current standing.

There are two impressive components to NVIDIA's history. The first is that it has been able to maintain impressive growth, even as the industry saw a slowing of revenue growth (3.97% between 2011-2020). The second is that this high revenue growth has been accompanied not just with profits, but with above-average profitability, as NVIDIA's gross and operating margins have run ahead of industry averages. NVIDIA has clearly embraced a strategy of investing ahead of, and going after, growth markets for the chip business, and that strategy has paid off well. Thus, its current dominant positioning in the AI chip business can be viewed as more evidence of that strategy at play.

There is one final component to NVIDIA's business model that needs noting, both from a profitability and risk perspective. NVIDIA 's core business is built around research and chip design, not chip manufacturing, and it outsources almost all of its chip production to TSMC. Its margins then come from its capacity to mark up the prices of these chips and it is exposed to the risks that any future China-Taiwan tensions can disrupt its supply chain.

While NVIDIA's growth and profitability have been impressive, the value cycle is not complete until you bring in the investment that the company has had to make to deliver that growth. With a semiconductor company, that reinvestment includes not only investing in manufacturing capacity, but also in the R&D to create the next generation of chips, in terms of power and capability. As with the sector, I capitalized R&D at NVIDIA, using a 5-year life, and recalculated my operating income (since the reported version is built on the accounting mis-reading of R&D as an operating expense). That results in a corrected version of pre-tax operating margin for NVIDIA that was 37.83% and a pre-tax return on capital of 24.42% in 2021-2023:

I also computed a sales to capital ratio, measuring the dollars of sales for each dollar of capital invested. In 2022, that number, for NVIDIA, was 0.65, indicating that this is definitely not a capital-light business and that NVIDIA has invested heavily to get to where it is today, as a company.

I know that there are many who are regretting their lack of foresight, in not owning NVIDIA through its entire run, but recognize that this was not a smooth ride to the top. In fact, the company had near-death experiences, at least in market value term, in 2002 and 2008, losing more than 80% of its market value. That said, I owe my lucky run with NVIDIA to one of those downturns in 2018, when the company lost more than 50% of its market value, and it is a lesson that I hope will come through this chart. Even the biggest winners in the market have had periods when investors have turned intensely negative on their prospects, making them attractive as investments for value-focused investors.

Since much of the run-up in NVIDIA in the last few months has come from talk about AI, it is worth taking a detour and examining why AI has become such a powerful market driver, and perhaps looking at the past for guidance on how it will play out for investors and businesses.

I am old enough to be both a believer and a skeptic on revolutionary changes in markets, having seen major disruptors play out both in my personal life and my portfolio, starting with personal computers in the 1980s, the dot-com/online revolution in the 1990s, followed by smartphones in the first decade of this century and social media in the last decade. What set these changes apart was that they not only affected wide swathes of businesses, some positively and some adversely, but that they also changed the ways that we live, work and interact. In parallel, we have also seen changes that are more incremental, and while significant in their capacity to create new businesses and disruption, don't quite qualify as revolutionary. I won't claim to have any special skills in being able to distinguish between the two (revolutionary versus incremental), but I have to keep trying, since failing to do so will result in my losing perspective and making investing mistakes. Thus, I was unable to share the belief that some seemed to have about the "Cloud" and "Metaverse" businesses being revolutionary, since I saw them more as more incremental than revolutionary change.

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