The Changing Nature Of US Semiconductor Companies by Eric Bush, Gavekal Capital
Over the past 20 years, the investment profile of US semiconductor companies has shifted from a very tangible capital intensive model to one that is much more focused on intangible investments such as R&D. In tandem with this shift, free cash flow generation has increased by a magnitude of three while valuation multiples have declined by half or more. In the tables below, we show how the US semiconductor industry has changed over the past two decades by looking at a variety of financial metrics and ratios. In each table, the conditional formatting is done horizontally. This means that the largest number in any row is the darkest green and the lowest number in any row is the darkest red. Whenever colors seem to line up vertically, this is by coincidence and highlights how the entire industry is experiencing certain trends together at the same time. Lastly, all data is on an intangible-adjusted basis.
From 1994-2000, US semiconductor companies spent about 16% of its sales on traditional capex on average. Recessions have a way of identifying excess capacity in an industry and so by 2002 this measure had dropped to about 8%. More than a decade later, the semiconductor industry is still working off this excess capacity of the late 1990s as they only spent 6.1% of its sales on traditional capex in 2014. If we look at capex as a % of operating cash flow (OCF), we can see this shift even more dramatically. Capex as a % of OCF from 1994-2000 averaged about 39%, while in 2014 this measure was just 12%. In two decades, semiconductor companies have shifted their investment profile dramatically away from traditional capex.
Capex as a % of Sales
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Capex as a % of Operating Cash Flow
Instead of adding to existing capacity in property, plant and equipment, US semiconductor companies have been spending more of its capital on intangible investments such as R&D. During the 1994-2000 period, companies were spending about 14% of its sales on R&D, so slightly less than what they were spending on traditional capex. However, since the tech bust, R&D as a % of sales has increased to about 19% or over twice the amount spent on traditional R&D.
R&D as a % of Sales
This shift in investment strategy has of course changed the composition of semiconductor company balance sheets. PP&E as a % of assets has declined from about 23% during the 1994-2000 period to just 12% of assets in 2014. Similarly, intellectual property as a % of assets has risen from 21% of total assets in the 1994-2000 period to 26% in 2014.
PP&E as a % of Total Assets
IP as a % of Total Assets
While the industry has become less capital intensive, it is not surprising that it has also started to throw off a lot more cash. OCF as a % of sales has increased from about 41% during the 1994-2000 period to over 53% in 2014. Free cash flow as a % of sales has increased at even greater rate. Free cash flow as % of sales from 1994-2000 average just around 7%. During 2014, it was nearly 24%. Semiconductor companies, who were once viewed as an investment with a lot potential and no cash flow, have completely flipped and are now a very heavy cash flow generating industry.
Operating Cash Flow as a % of Sales
Free Cash Flow as a % of Sales
So while the industry has become less capital intensive, more innovative, and is generating more cash, valuation ratios are far below levels reached during the tech stock craze of the late 1990s. From 1998-2000, semiconductor stocks traded at an absurd 30x cash flow. In 2014, they were trading at just 9x cash flow and hit just 4x cash flow during the financial crisis. Today’s price to cash flow valuation multiples are even about 50% below the valuation multiples these stocks were trading at from 1994-1997.
The story holds if we look at other valuation metrics as well. Semi stocks were trading around 8x book value from 1998-2000 and 4.7x from 1994-1997. Over the last five years, semi’s have traded on average around 2.4x book value.
Price to Cash Flow
Price to Book Value
Overall, semiconductor companies are more profitable, less capital intensive, more innovative than really any point over the past two decades. On top of that, semi stocks are still trading at some of the lowest multiples outside of financial crisis that they have ever been at over the past 20 years. Semis could be worth an extra look for anyone’s portfolio.
Disclosure: The above mentioned securities may be in our current portfolio. Please refer to our website for a current list of our holdings – http://www.gavekalcapital.com/ucits/