Moore's law and the strange case of semiconductors

For many months now, companies using electronic components have found themselves paying a specific semiconductor a multiple of the price paid before the pandemic. In an emergency phase where one or more components are needed to complete a product, it is necessary to prioritise the availability of the component over its cheapness and to purchase the component even if the asking price is the result of a competitive auction rather than a competitive market.

As the graph below illustrates, the interest measured by the search frequency of terms in the search engine Google search engine for 'Semiconductors' has increased sharply throughout 2021, eventually surpassing interest in the term 'Copper Price'. Over the course of this year, interest in 'Semiconductors' appears to be slightly declining, but this reflects more an 'acceptance' of the problem, rather than an overcoming of it.

Price increases along the value chain

The first point that requires further investigation concerns the stages of the value chain where the greatest increases have been realised. On the one hand, end-user companies accuse that they often pay multiple prices for a semiconductor compared to those paid before the pandemic. On the other hand, possible ex-factory price analyses report high increases, but not comparable to those reported by users. It follows that

the largest increases are realised by the distribution phase

The semiconductor purchased by a user company is the result of a complex value chain, within which each actor tries to gain increasing shares of value by competing with one another, while being careful not to cause a break in the chain.
It may be useful to analyse what are the characteristics of a value chain in which the rational behaviour of the actors is compatible with the capacity of the distribution phase to extract a very high share of the final value of the good.

The high technological obsolescence of semiconductors explains the high value generated by distribution

In this article, first the value chain of the semiconductor industry is described; then the facts describing the current situation are given. Finally, optimal strategies for manufacturers and the role played by distributors are examined.

The semiconductor industry value chain¹

The semiconductor industry value chain is very complex, starting with the production of polysilicon wafers and ending with the distribution of integrated circuits. It involves the following players:

• Raw material producers: are the companies that produce the raw materials of which semiconductors are made, primarily silicon, but also some rare earths;
• Manufacturers of polysilicon wafers: they are foundries that produce silicon ingots from which wafers are obtained. The production of the ingots takes place through a process of extraction of the ingot from a crucible of molten silicon at 1425 ° C;
• Manufacturers of semiconductor manufacturing machines: are the companies, mainly American, Japanese and Dutch, capable of producing the complex machines for manufacturing integrated circuits. This sector is growing fast. In 2021, the world demand for these machines reached 70 billion dollars, equal to over 20% of all industrial machines subject to international trade;
• Intellectual Property (IP) Designers: are companies that produce patents relating to semiconductors and / or software for chip design;
• Fabless companies: they are companies that design specific chips and integrated circuits, without however producing them. The main companies in this category that design computer chips are AMD, NVIDIA and Broadcom. In the world of smartphones, the two historical names are the Californian Qualcomm and the Taiwanese MediaTek. Apple and China's Huawei also fall into this category.
• Integrated device manufacturers (IDM) : are companies that design, build, test and sell integrated circuits. Examples of these operators are Intel and Texas Instrument;
• Fab manufacturers for third parties or Pure-Play semiconductor foundries: they are companies that produce semiconductors designed by others. The most representative of this group are the two Taiwanese companies TSMC and UMC (United Microelectronics Corporation), the Californian GlobalFoundries, the Chinese HSMC and SMIC, the Korean SK Hynix and Samsung;
• Testing and Packaging companies: These are companies, often external such as Outsourced Semiconductor Assembly and Test (OSAT), which test the correct functioning of the chips and package them;
• Manufacturers of electronic components: they are companies that produce electronic components other than chips (such as capacitors, diodes, etc.) which are mounted in electronic boards;
• Manufacturers of Printed Circuit Board (PCB): these are the companies that design, assemble and test electronic boards for third parties.

The current situation

The main facts that characterize the current situation of the world semiconductor sector are the following:

1. Strong increase in demand due to the ongoing global process of digital transformation.
   The pandemic has boosted digital transformation strategies across sectors and countries. Ninety percent of respondents in the Harvard Business Review Analytic Services 2021 survey said Covid-19 accelerated the timing of their companies' efforts towards process and product digitization.
2. Constraints to increase supply in the short term.
   The complexity of the value chain of the semiconductor industry and the high investments required to increase production capacity create high constraints on an increase in supply in the short term.
3. Constant increase in delivery times, which for some products at the beginning of 2022 was one year. This is the result of the interrelation between the two previous points, but also of the difficulties of world logistics and of the passage by many user companies to an organization of production from just in time to just in houses, with strong increases in upstream warehouses.
4. Increases in retail prices much greater than those in producer prices, due to the willingness of end users to purchase missing electronic components at auction prices in order to don't stop production.

Strategies of semiconductor manufacturers

Semiconductor companies have good profitability which leads them to be cautious in changing their strategies. One of the factors that has always characterized this industry is the strong technological progress. Its development speed is such that it complies with the rule that the complexity of a chip and its functional capabilities tend to double every 18 months, known as Moore's law.
Faced with such a fast technological process, semiconductor manufacturers favor the construction of new production capacity of technologically frontier products that can be successful over more consolidated products. The probability, in fact, that a product will become obsolete in a short time is high, making an investment to increase the production capacity of products already on the market highly risky. For this reason, production levels fail to align with demand when demand registers accentuated growth rates, such as those experienced in recent years.

In the semiconductor industry, capacity increases are driven more by technological progress than by increases in demand.

When demand exceeds supply for no short period, the market adjustment can only take place through prices. It is in these cases that the distribution phase, playing the role of the supply chain warehouse and making a scarce good available, can get prices that are much higher than costs. In a competitive market, however, the current situation is not in equilibrium. It is therefore likely that in the near future the global semiconductor industry will experience profound changes.

[1] For a more detailed description of the value chain of the Semiconductor industry and the strategies of manufacturing companies, see Strategies to lead in the semiconductor world by Ondrej Burkacky, Marc de Jong, and Julia Dragon, published on April 15, 2022 in McKinsey & Company.