What it means
Strictly speaking, a semiconductor is a material whose ability to conduct electricity can be precisely controlled, which is what lets it act as a switch. In business conversation, "semiconductors" or "semis" means the integrated circuits (chips) made from such materials, and the companies that design and manufacture them.
The industry has several business models. Integrated device manufacturers design and make their own chips, fabless companies design chips but rely on others to make them, and foundries manufacture chips designed by customers.
Each model has a very different balance sheet, with foundries carrying enormous factories and fabless firms staying relatively light on assets. Semiconductor companies are known for being capital intensive and cyclical.
Building a modern fabrication plant costs very large sums and takes years, so manufacturers must commit before they know what demand will be. When demand surges and capacity is tight, prices and profits rise; when new capacity arrives or demand cools, inventories build up and margins can fall sharply.
Why should a non-specialist care? Because chip shortages and gluts ripple through the economy, as carmakers, appliance makers and electronics retailers have all discovered when they could not get components.
If your company buys products that contain chips, your costs, lead times and ability to deliver can depend on conditions in this industry. Analysts look at a handful of ratios when assessing the sector.
These include gross margin, research and development spending as a share of revenue, capital expenditure relative to sales, and days of inventory on hand. Government policy, including export controls and subsidies for local manufacturing, also plays a large role and can change a company's market access with little warning.
In practice
Real-world examples.
Example
An automotive parts supplier cannot finish a batch of engine control units because a single type of chip is on long back-order. The operations director tells finance that deliveries will slip by eight weeks. The CFO reforecasts revenue, warns the bank about a possible covenant pressure point, and approves paying a premium to a broker for scarce components.
Example
A consumer electronics retailer sees its supplier lift prices after memory chip costs rise. The buying team asks finance to model the impact on margin before agreeing to the new price list. The model shows a 3-point fall in gross margin unless the retailer raises shelf prices.
Example
A pension fund analyst compares a chip designer with a chip foundry. The designer has high margins and little debt, while the foundry spends heavily on new factories and carries large depreciation charges. The analyst adjusts her valuation approach for each, using earnings multiples for the designer and cash-flow measures for the foundry.
Formula
Calculation
R&D intensity = research and development expense / revenue
Suppose a fabless chip designer reports revenue of $2,000,000,000 and research and development expense of $300,000,000 for the year. R&D intensity = 300,000,000 / 2,000,000,000 = 0.15, or 15%. A figure like this tells an analyst how much of each revenue dollar the company reinvests in new products. If the same firm's gross profit was $1,100,000,000, gross margin = 1,100,000,000 / 2,000,000,000 = 55%.Case study
Seen in the real world.
Brightwave Devices is an illustrative, fictional maker of smart home thermostats. Its entire product line relied on one controller chip bought from a single supplier, and the purchasing manager held only three weeks of stock to keep working capital low.
When the supplier announced a long delay, Brightwave could not ship during its busiest season. The finance director calculated that each lost week of sales cost about $650,000 in revenue and that holding a six-month stock of chips would have tied up roughly $1,200,000 in cash.
The board chose a middle path of three months of stock and a second qualified supplier, accepting a modest rise in inventory cost. The illustrative lesson is that supply security has a price, and finance should weigh it against the cost of an interrupted business.
Watch out
Common mistakes.
- Assuming demand for chips only grows, when the industry has repeated boom and bust cycles that heavily affect pricing and profits.
- Treating all semiconductor companies as alike, when a fabless designer, a foundry and an integrated manufacturer have very different capital needs and margins.
- Ignoring chip supply when forecasting costs for products that contain electronics, then being surprised by price rises or delivery delays.
Questions
People also ask.
What is the difference between a semiconductor and a chip?
A semiconductor is the material and the broader industry, while a chip is the finished circuit made on it, though people use the words interchangeably in conversation.
Why are semiconductor businesses so capital intensive?
Because manufacturing plants and equipment cost very large sums and must be built years ahead of demand, which creates heavy depreciation and funding needs.
Does a fabless company own factories?
No, it designs the chips and pays a foundry to manufacture them, so its balance sheet is far lighter than a manufacturer's.
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