Russia-Ukraine War will Boom Western Semiconductor Prod.

The Russia-Ukraine war has brought globalization in distributed industrial supply chains to the forefront. Semiconductor equipment manufacturers have built very distributed supply chains all over the world. Justifiably much of the focus has been on the war’s impact on oil, however we believe its impact on semiconductors is likely to become significant.

The challenges surrounding global semiconductor equipment supply chains, still trying to recover from the impact of Covid-19, will begin to intensify because of the war. These disruptions impact industries reliant on chips such as the automotive sector, which can’t build enough vehicles to satisfy current demand levels. Prices for both new and used car prices are at record highs.

The semiconductor industry has reached a critical point. The return of strong supply chains will require the transition to more localized production in the U.S. and Western Europe. According to TrendForce, Taiwan accounts for 65% of the global foundry market share and Taiwan/South Korea/China account for a combined 88% of foundry market share based on revenue.

The surge in gas prices underscores how serious the semiconductor issue could become. According to IEA, Russia accounts for 11.4% of the global oil supply, which makes it the third largest supplier globally. Consider that chips produced in Asia make up a much larger percentage of the global total than the percentage of oil produced in Russia; consequently, the impact on chip prices if the U.S. and Western Europe do not increase production could be unprecedented.

In fact, Intel [Nasdaq: INTC] CEO Pat Gelsinger told the Silicon Valley Business Journal that in a technological age, semiconductors have become “the new oil,” and encourages the U.S. government to subsidize efforts “to produce more” of them here in the U.S., to not be vulnerable to supply “disruptions” in China and elsewhere in Asia. Micron Technology [Nasdaq: MU] CEO Sanjay Mehrotra recently told Nikkei Asia that it’s “extremely important” that the U.S. pass “the so-called CHIPS Act to support semiconductor research and manufacturing” and “catch up” in semiconductor manufacturing capability.

Recognizing the critical role the U.S. semiconductor industry plays in America’s future, in 2021 Congress enacted the CHIPS for America Act to promote domestic production. Similarly, in early 2022 the EU implemented the European Chips Act. However even with this government support, the barriers to domestic production are high. Semiconductor companies need to invest $10 billion and two to three years to build a leading-edge node fab from zero to completion.

The main beneficiaries of this increased investment in localized domestic production are the suppliers of the equipment required to manufacture semiconductor chips. These companies are called Wafer Fabrication Equipment vendors and the top five companies are:

•    ASML [Nasdaq: ASML]
•    Applied Materials [Nasdaq: AMAT]
•    KLA Corporation [Nasdaq: KLAC]
•    Lam Research Corporation [Nasdaq: LRCX]
•    Tokyo Electron [8035.T]

Of these five, ASML is in a leading position because of its strong monopoly position in EUV lithography systems, which are used to print the most intricate layers of a chip. ARI currently holds positions in ASML on behalf of its clients. Additionally, we have exposure to leading edge semiconductor manufacturer, TSMC.

While increased domestic production is likely to be a significant job creator in the U.S. and the UK, we should note that the catalyst for the Chips Acts was the external geopolitical forces along with the pandemic – not specifically a push for job creation. Interestingly, both Democrats and Republicans are in favor of the idea. So, it’s no surprise that semiconductor CEOs support the idea of the government giving them $52 billion in subsidies.

Globally, we can expect to see more semiconductor manufacturing to become localized in the U.S. and Western Europe instead of distributed the way it is now with a disproportionately large percentage in Southeast Asia and China.

What the market has learned is that it’s not just about supply, it’s also importantly about the security of that supply. Countries that strive to have secure and reliable sources of energy in good and bad times must invest in internal manufacturing capacity and/or trade with countries with stronger diplomatic ties.

At Applied Research Investments, we continue to advise clients to focus on secular growth for the next three to five years while actively managing risk.

Jonathan Mzengeza serves as portfolio manager at Applied Research Investments. For more than a decade, Mzengeza has been a leader in investment management, bringing deep experience in guiding portfolio management and stock selection across multiple global equity mandates. Before joining Applied Research, Jonathan spent a decade at CIBC, where he occupied various positions, most recently serving as lead portfolio manager of global equity funds.

Throughout his investment career, Jonathan analyzed Technology and Consumer industries as well as financial services, communications, and REITs. He had also worked as an analyst at Chubb Insurance Company, where he focused on business and system technology needs and supported production and development environments including design documentation and implementation plans. He began his career as a network analyst at Nortech Efficient Business Solutions. Jonathan holds a Bachelor of Science degree in electrical and computer engineering from the University of Capetown, where he graduated with honors and an MBA in Investment Management from Concordia University’s John Molson School of Business. Jonathan is a CFA Charterholder and a member of the CFA Society.