Strategies to Lead in the Semiconductor World

Semiconductor Companies can take different paths to capture new opportunities as demand continues to outstrip supply.

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· Even with fabs operating at full capacity, they have not been able to meet demand, resulting in product lead times of six months or longer

· The shortage is now so concerning that it is prompting more large technology companies and major automotive OEMs to move chip design in-house

· Fab construction and production ramp-up for semiconductors are extremely costly and time consuming—often requiring a year for significant expansion or more than three years to build a new facility

· The industry includes many different segments: memory, logic, analog, discrete, optical components, and sensors

· All semiconductor companies could benefit by rethinking their approach in six critical areas: technology leadership, long-term R&D, resilience, talent, ecosystem capabilities, and greater capacity.

Based on the numbers alone, this appears to be the ideal time to be a semiconductor company. With chip demand soaring, annual revenue increased by 9 percent in 2020 and by 23 percent in 2021—far above the 5 percent reported in 2019. Even before the pandemic, capital markets were rewarding the industry’s surging profitability, with semiconductor companies delivering an annual average of 25 percent in total shareholder returns (TSR) from the end of 2015 to the end of 2019.

Last year, shareholders saw even higher returns, averaging 50 percent per annum as remote work became the norm and consumers and businesses upped their technology purchases, helping to accelerate the digital revolution.

Behind the scenes, however, today’s semiconductor companies are facing a host of challenges. Even with fabs operating at full capacity, they have not been able to meet demand, resulting in product lead times of six months or longer. The ongoing semiconductor shortage now routinely makes headlines, especially when it forces automotive OEMs to delay vehicle production. What’s more, semiconductor companies are grappling with increased design complexity, a talent shortage, and pandemic- related issues that are disrupting the complex, global supply chain that links players in different markets. The shortage is now so concerning that it is prompting more large technology companies and major automotive OEMs to move chip design in-house—a trend that could have major implications for the market.

In other industries, manufacturers often respond to shortages by increasing output. But fab construction and production ramp-up for semiconductors are extremely costly and time consuming—often requiring a year for significant expansion or more than three years to build a new facility—which makes it difficult to increase semiconductor volumes quickly. While increasing capacity may sometimes help, it will not produce immediate results and typically requires a significant investment for many years before additional revenues—if any—will appear.

To help semiconductor companies develop a comprehensive plan for success, we quantified the benefits of capacity expansion to determine when construction may be justified. We also identified other strategies that can help semiconductor companies improve productivity and revenues, such as increasing the focus on leading-edge chips, pursuing innovations that go beyond node size, making bold long-term investments, developing greater resilience, improving the talent pipeline, and collaborating within the semiconductor ecosystem.

Understanding the semiconductor industry

Although headlines about the semiconductor shortage often discuss the situation in broad terms, the industry includes many different segments: memory, logic, analog, discrete, optical components, and sensors. Individual semiconductor companies and their manufacturing sites tend to focus on select segments. Their end customers, by contrast, typically require products from all semiconductor segments and thus rely on multiple suppliers. The absence of a single specialized chip can bring the manufacture of end products to a halt, even if all other components are available.

The production process is also more complex and multilayered than headline writers often choose to acknowledge. When all production phases are considered, the entire process extends from material procurement to back-end manufacturing (Exhibit 1). (Some may choose to take a narrower view, in which the value chain begins at the design phase.) For each product segment, most companies specialize in three or fewer steps and may outsource some activities, such as printed- circuit-board assembly, to partners. After back- end manufacturing, semiconductors become part of the electronics value chain.

The industry has become increasingly consolidated within many of these value chain segments over the past 20 years, and a few champions have emerged in each area (Exhibit 2). As a result, expertise is often concentrated in certain markets (for instance, the United States has the highest presence of fabless players—that is, chip design only—and equipment manufacture). No local market has all the capabilities required for end-to-end semiconductor design and manufacturing, and the concentration of expertise has created a web of interdependencies along the value chain (Exhibit 3).

The concentration of expertise conveys some advantages because it often allows companies to share resources, such as power supply, even if they are rivals, which helps keep costs down. Employees with the right skills may also gravitate to expertise clusters, creating a strong talent pool. But the interdependencies also mean that local shocks can have a global effect, such as when a flood in Thailand in 2011 stopped production in multiple memory backend fabs in the country and pushed prices of memory chips 30 percent higher.

Factors behind the semiconductor shortage Semiconductor fabs were already operating at close to full capacity before the pandemic because they try to avoid investing in new capital equipment beyond that required to meet demand from customers. Uncertain trade dynamics also motivated several players to increase their semiconductor stock levels to secure supply. The pandemic, which spurred purchases of computers and other devices for remote work, then took demand to even greater heights.

For automotive OEMs and other companies, one response has been to deviate from their typical “just in time” ordering. Instead, they have started to order more chips than necessary so that they can build their inventory and have reserves on hand. In the short term, however, this move has magnified the gap between supply and demand. Over the longer term, some companies may consider requesting binding “take or pay” contracts in which they can either accept a certain quantity of chips or pay a fee if they decline to do so. This arrangement helps companies align chip demand with manufacturing capacity more accurately.

Customers may also consider coinvesting with semiconductor companies in projects designed to increase fab capacity. Such projects can allow semiconductor companies to reduce their up-front investment, relieving potential capital expenditure constraints. But coinvesting will not immediately improve the semiconductor shortage, given the long timelines for fab construction and production ramp-up.

Achieving and maintaining a leading position in the semiconductor industry

Despite the current uncertainty, the semiconductor industry is poised for additional growth, as more and more products and services become increasingly digitized. More than half of the semiconductor industry’s current enterprise value is based on earnings-growth expectations, as is reflected in current valuations: investors expect long-term growth of 7 to 8 percent per annum, assuming the recent margin trajectory.

But what strategies can help the industry meet these targets? While the answer may vary based on a company’s strengths and weaknesses, all semiconductor companies could benefit by rethinking their approach in six critical areas: technology leadership, long-term R&D, resilience, talent, ecosystem capabilities, and greater capacity. The final area here will not provide immediate benefits, of course, but it could be an important part of a long-term strategy. We have quantified the costs associated with fabs of different sizes to help semiconductor companies determine if capacity expansion is right for them.