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Piper Jaffray Predicts Semiconductor Super Cycle With Internet TV, Manufacturing Plant Underinvestment, And Infrastructure Driving Growth

TWST: Give us a broad overview of where semiconductors are now.

Mr. Richard: I think the industry is in the early innings of a super cycle. There was a super cycle in the late 1970s and early 1980s, and then one in the mid- to late 1990s, and I think we entered one exiting the Great Recession.

The chip industry is highly cycle- and capital-intensive. A new product comes along, like a digital watch or a calculator, and everyone wants one. Companies like Texas Instruments (TXN), Hewlett-Packard (HPQ) and National Semiconductor (NSM) jumped into the calculator market. Moore's Law drives new features for a while, keeping pricing stable. But ultimately pricing falls and the market reaches saturation. In the case of calculators, the PC market emerged as the calculator market was in decline. However, the Japanese wanted to own the DRAM market at the time and invested for market share and not profitability. This created a significant overshoot in chip-making capacity. For this reason, after 1984 the chip industry was relatively weak even though PCs were growing rapidly.

Another super cycle occurred from about 1993 to 2001 driven by the Internet, corporate IT and Microsoft (MSFT) Windows. Underinvestment in chip-manufacturing capacity in the 1980s caused a lack of supply in the 1990s. This drove pricing and profitability within the chip supply chain during the 1990s.

In 2001 the semiconductor industry had the mother of all overbuilds in chip-making capacity, and the dot-com bubble burst. The supply chain idled back on investment now for almost 10 years, punctuated by the worst recession since the Great Depression. During the last decade, the industry consolidated and many companies went fabless rather than building a new $4 billion manufacturing plant. However, the foundries, like TSMC (TSM), haven't invested enough and there is more demand than supply, and that takes several years to fix.

This underinvestment was punctuated by the recent recession. In the recession, chip-making and other related capacity was shuttered; existing equipment was cannibalized as spare parts to conserve cash and inventory was purged across the supply chain. At the same time, the fall-off in demand wasn't as bad as people thought it would be. The industry has been struggling to catch up with inventory since, and the industry is still not back to where the supply chain is running smoothly. I also believe that the investment community is also underestimating demand.

When the global economy is considered, there are a couple of obvious observations. One is the developing economies are growing rapidly. The second is that in the developed world, there is too much debt and not enough value creation. I would expect nominal GDP in the developed world to grow by 2%. However, China, India, Brazil, Russia and most of the emerging economies have growth rates of 6% to 12%.

The Chinese didn't loosen the renminbi relative to the dollar to be nice guys; they did it to drive the standard of living in China. Wages are starting to increase in China as well, driving a growing global middle class that will use its increased discretionary income to buy TVs and PCs. Demand for these items has been much stronger than expected. One of the best anecdotes, in my view, is the World Cup. I've watched semiconductors for 26 years; every Olympic year, Japanese consumer electronic suppliers have a great first half due to demand for Blu-ray recorders or VCRs or TVs for the event. Super Bowls also drive some TV sales - these are developed-world economy activities.

Soccer, on the other hand, is a developing-world sport; all you need is a soccer ball. So the point is that disproportionately soccer is a developing-economy sport, and the World Cup drove very strong TV demand for the first time. In the first half of this year, there was a shortage of 32-inch TVs due to this demand. So you can tell that this global demographic shift is driving incremental demand.

Finally, in the U.S., Apple (AAPL) came out with an iPad. It is a cool new product. The forecasts have done nothing but go up. There is demand at the high end for the next new thing. There always is. Finally, there has been an almost 10-year hiatus on investment in technology infrastructure. As an example, how is your iPhone coverage in New York or San Francisco? There needs to be a build of infrastructure for new smartphones, like the transition from voice to data in wireline. You are seeing that cell phones today are driving demand for infrastructure.

Not only that, there are other new drivers of demand, such as connecting the Internet to TV. Google (GOOG) TV has been announced, and Apple is going introduce an Apple TV next year. Whenever Internet Protocol, IP, gets connected to something like a cell phone or a telephone or a computer, it is very transformative and new ways of doing things emerge, driving demand for all things tech. To summarize, there is a combination of underspending in infrastructure, telecom, corporate IT, data centers, an emerging middle class, and rich people in the developed economies are still spending money. This is coupled with a decade of underinvestment in semiconductor manufacturing capacity. While there is a lot of angst regarding the overall economy, things in the chip business haven't been this good since 1993.

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