By John Patrick Lee, CFA, VanEck Associate Product Manager
After a strong start to the year, semiconductor stocks have recently hit a rough patch. The storylines that helped to drive performance have become painful sources of concern. At the beginning of the year, positive sentiment around U.S./China trade relations helped to boost semiconductor stocks. Since early May, trade war worries have returned to the forefront for investors, with semiconductor companies paying the price.
Semiconductor Revenues Rely on China Growth and Trade
Semiconductor companies generate a significant portion of their revenues by selling their products to Chinese companies and consumers. Based on a geographical analysis of the revenues generated by constituents of the MVIS semiconductor index, over 30% of index revenues come from China, compared to approximately 21% from the U.S., as of April 30, 2019.
Semiconductor Stocks Depend on Chinese Revenues
Throughout the latter half of 2018, semiconductor stock prices fell as the U.S. and China ratcheted up trade war tensions, imposing heavy tariffs on raw materials and services involved in the global semiconductor supply chain. These tariffs were imposed by both sides, and semiconductor stock prices suffered as a result. In December of 2018, the two countries declared a temporary truce to de-escalate tensions.
Since then, the countries have engaged in multiple rounds of trade talks with the aim of securing a long-term deal favorable to both. Chipmakers rallied to start the year on the consensus that trade relations were moving towards normalization. However, newly escalating tensions have led to more volatility in recent weeks and a retreat from multi-year highs.
Separately, the Chinese government has been proactively supporting economic growth through a variety of monetary and fiscal policies, and global index providers have begun including onshore Chinese equities in benchmarks. These have also been positive developments for companies with heavy exposure to China.
Ultimately, a healthy trading relationship between the U.S. and China benefits semiconductor companies with a sizable revenue exposure to the Chinese economy. It’s important to note that China remains a key risk for semiconductors, whether that stems from a breakdown in trade relations, or a slowdown in the Chinese economy.
Qualcomm’s Moat Under Pressure
Generally speaking, the semiconductor industry is heavily invested in researching and developing new technologies. After a company develops a new technology, the company typically owns the patent, which means it may effectively box out competitors from using or leveraging the technology in their own products. This has historically lead to individual companies having a distinct, sustainable competitive advantage over others within the industry—in other words, a moat.
Moats are a defining characteristic of the semiconductor industry. On a weighted average basis, as of April 30, 2019, over 80% of the MVIS® US Listed Semiconductor 25 Index have either a Wide or Narrow Moat rating, according to Morningstar.1
Qualcomm has had a number of recent high-profile developments that have directly affected the company’s sustainable competitive advantage (both positively and negatively). Qualcomm recently settled a hard-fought lawsuit that spanned over two years against Apple.2 The litigation centered on Apple’s use of Qualcomm’s smartphone processors and modems, and the royalties that Apple would pay to Qualcomm for the use of the underlying technology. After the settlement announcement, Qualcomm’s stock rallied 56%, from $57.18 on April 15 to $89.29 on May 3, as investors saw the settlement as an affirmation of its moat in relation to Apple’s iPhone revenue.
Nearly one month after the settlement deal was announced, a Federal judge sided with the Federal Trade Commission (FTC) in its antitrust suit against Qualcomm.3 This may directly affect revenues from its patent-licensing business, which is the company’s biggest source of profits. While the terms of the Apple settlement are expected to be honored, the ruling is a direct threat to the sustainability of Qualcomm’s competitive advantage going forward. Qualcomm’s stock price has fallen roughly 26% since May 3 to $65.37 as of May 28.
While the FTC ruling is specific to Qualcomm, the ruling may potentially affect other chipmakers positively. Qualcomm has effectively restricted competing chip makers from using its technology, but under the new ruling, Qualcomm would be forced to license its intellectual property to competing firms.
Basket Approach Provides Diversified Exposure in Unclear Times
The outlook for semiconductors is heavily dependent on a healthy U.S./China trading relationship and the ability for these companies to leverage innovations by turning them into long-term profits. As it stands, a disruption in either of these key areas could have major repercussions for revenues and profitability. Many analysts view the semiconductor sector as a leading indicator and a forward-looking measure of the health of the global economy. Hence, a breakdown in broad market sentiment during the last few weeks has led to a sharp increase in volatility in these stocks, with some affected more than others.
A basket approach allows investors to express a view on a specific sector of the economy, without having to know which specific stock will outperform over the future. VanEck Vectors® Semiconductor ETF (SMH) tracks the MVIS US Listed Semiconductor 25 Index. This ETF invests in approximately 25 of the largest and most liquid U.S.-listed semiconductor companies.
1. Source: Morningstar as of 4/30/2019.
2. Source: The New York Times, Apple and Qualcomm Settle All Disputes Worldwide, 4/16/19.
3. Source: The Wall Street Journal, Qualcomm’s Practices Violate Antitrust Law, Judge Rules, 5/22/19.
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