INTRO: Semiconductor profit margins have become obscene.
Intel has a gross margin of 50%.
AMD has a gross margin of 48%.
Applied Materials has a gross margin of 47%.
Qualcomm has a gross margin of 58%.
And Nvidia has a gross margin of over 60%.
Also, keep in mind that that’s just the average across these entire companies.
So, if we look at the profit margins of their highest end products, it’s likely even higher
than that.
Take Nvidia for example.
Their highest end consumer product, the RTX 4090 was just announced a few weeks ago and
it starts at an eye watering $1,600.
Even if we use Nvidia’s average gross margin of 60%, this means that $960 is simply gross
profit.
But, if we’re being real here, it’s not like all of Nvidia’s products have a gross
margin of exactly 60%.
The more likely scenario is that the lower end cards like the 50 and 60 series have a
gross margin of 40 to 50% while the higher end cards like the 80 and 90 series have a
gross margin of 70 to 80%.
Even if we estimate on the lower end of this and call it 70%, this means that it only costs
Nvidia $480 to make the RTX 4090 and they sell it for $1600 leaving them with $1,120
worth of gross profit.
We should also mention that it’s not just these front facing companies that have obscene
margins either.
Backend semiconductor companies are also living it up.
ASML gross margins stand at 51% while TSMC’s gross margins stand at 55%.
Considering this, it’s unlikely that producing the 4090 costs even $200.
Yet, it’s being sold for 8 times that amount.
For perspective, even the iPhone which is likely the most criticized product in the
entire world for having high margins is estimated to cost $570 to make.
This means that even the iPhone is only being sold for 2 times its production cost while
chips are being sold for several times their production cost.
Now, you might be saying that we should look at net margin instead of gross margin, but
this doesn’t really change all that much.
ASML has a net margin of 30%.
TSMC has a net margin of 40%.
Qualcomm has a net margin of 30%.
And Nvidia has a net margin of 26%.
This means that even if you include all of the expenses of research, development, marketing,
and everything else that it takes to run these companies, both the suppliers and the front
facing companies are left with 30% margins each.
If you’re a shareholder of one of these companies, you’re holding pure gold.
I mean Nvidia stock is up 45X in the past 10 years even with the recent 63% sell off.
But, if you’re a customer of one of these companies, well it’s not as great.
Something that makes this even more suprirsing is that chips are not the new kid on the block
either.
Most of these companies have been around for 30 to 50 years, so you would think that their
margins would’ve worn off with time as new competitors entered the market.
Yet, here we are.
So, how in the world did semiconductor margins become so obscene.
FUNDAMENTAL RISK: Taking a look back, semiconductor margins
have always been on the higher side of things, and the main reason for this is the substantial
risk that’s involved in running a chip company.
You see, the chip industry is one of the few industries in which you always have to perform
simply because its so ruthless.
And the main reason for this is something called Moore’s law.
This law was created way back in the 1960s by one of the cofounders of Intel: Gordon
Moore.
Based on the historical progression of semiconductors, Gordon projected that the number of transistors
in a dense integrated circuit would double every year for the next 10 years.
After these ten years, he would revise his theory to say that the number of transistors
would continue to double every two years indefinitely.
This observation has since become the standard within the chip industry and has turned out
to be frighteningly accurate.
Over the years, there has been so many sceptics and even experts suggesting that Moore’s
law is dead.
But, you just have to take one look at this logarithmic graph to know that Moore’s law
is still very much alive.
The number of transistors on microchips has literally grown from a few thousand in the
1970s to tens of billions today.
Honestly, this growth is extraordinary and is simply a testament to just how much humans
can accomplish.
But, wait a minute, how is this relevant to high chip margins?
Well, the answer is that it’s extremely risky to be in the chip business because you
constantly have to innovate at record pace.
If you don’t, you’ll be dead within a few years.
Here’s a list of all of the prominent American chip companies that have gone bankrupt within
the past few decades.
I don’t think there’s any industry that his been so cutthroat for so long.
Take the iPhone for example which has only been around for 15 years.
I don’t know about you but the iPhone 14 definitely does not seem to be a 2X upgrade
from the iPhone 12.
Not only do you have to innovate like no other industry, but you also have an extremely small
margin for error.
Here’s the thing, chip companies are solely dependent on revenue from their chips.
If iPhone sales go down, Apple can pivot to services.
If Amazon sales slow down, Amazon can raise the price of Prime.
But, if chip sales go down, chip companies have nothing to pivot to.
Most of them have no contact with the end user and no forms of recurring revenue.
The only way they make money is by selling chips and the only way the sell chips is by
leading the innovation.
Their corporate customers have very little brand loyalty and are willing to switch at
anytime.
I mean, Apple literally ditched Intel.
Do you really think they’re gonna have a problem with ditching someone like Qualcomm?
The answer is no.
And if none of that convinced you that this business is risky, just take a look at Intel
stock which hasn’t made a new all time high in 22 years.
So, while the semiconductor industry can be extremely rewarding, it can also be brutally
painful.
And one of the main reasons these companies have such high margins is to compensate for
that risk.
UNPRECEDENTED DEMAND: While chip companies have always boasted solid
margins when they’re on top, the margins that we’re seeing today are higher than
anything we’ve ever seen before.
Take Nvidia for example.
Before 2016, the company had a much more modest and reasonable net margin of 10 to 15%.
But, between 2016 and 2019, these margins skyrocketed to 38%.
A similar trend can be seen at AMD as well.
Up until 2016, AMD was actually consistently losing money.
But, between 2016 and 2019, AMD’s margins flipped from -20% to positive 5%.
TSMC enjoyed a similar boost as well just during a slightly different time frame.
So, what happened in the mid 2010s that caused semiconductor margins to rocket across the
board?
Well, the answer is unprecedented spikes in demand.
Within the broader market, the source of this spike is obvious.
It was the smartphone revolution.
Between 2009 and 2018, the number of smartphones sold per year rocketed from 172 million units
to 1.5 billion units.
Many companies saw this opportunity before it happened.
TSMC’s founder, Morris Chang, literally came out of retirement just to make sure TSMC
didn’t screw up this gigantic oppurtunity.
Under Chang’s guidance, TSMC would eventually score a deal with Apple and the company would
proceed to go vertical shortly after.
The smartphone boom wasn’t the only surge in chip demand either.
We saw another boom within the PC gaming space thanks to AMD.
With the launch of their Ryzen line of CPUs in 2017, AMD made PC gaming more accessible
than ever before by bringing down the cost of building a gaming PC.
Shortly after the launch of Ryzen, you could build a solid gaming PC for well under a $1000.
And when you combine this with the insane popularity of Fortnite, you had a bunch of
casual mobile and console gamers switch to PC.
But, unfortunately, this honeymoon period didn’t last that long because gamers weren’t
the only ones that were trying to secure GPUs.
You see, around the same time that PC gaming was blowing up, so were cryptocurrencies.
Between 2015 and 2017, Bitcoin would literally 100x from $200 to $20,000.
Bitcoin dragged along the entire crypto market along with it which made it extremely profitable
to mine ethereum using Nvidia GPUs.
And these crypto miners weren’t just buying 1 or 2 gpus at a time.
They were buying dozens because this wasn’t just entertainment to them, this was a business.
Soon enough, Nvidia wouldn’t be able to keep up with demand which led to gpus selling
on the secondary market for insane markups of 50 to 100%.
Despite this, miners kept buying GPUs because it was still profitable, and this is when
a light bulb went off in Jensen Huang’s head.
If people are willing to pay 50 to 100% more for our gpus on the secondary market, why
not just charge 50 to 100% ourselves?
With the launch of the 2000 series, this is exactly what Nvidia would do.
Initially, this actually backfired for Nvidia because the 2000 series came out during the
depths of the 2018 bear market.
But, Nvidia kept the high pricing for the 3000 series which put them in the perfect
position for the 2021 crypto bull market and the rest is history.
THE END IS NEAR: Though all of these demand factors were building
up throughout the entire decade, the grand slam didn’t come till 2020 which was of
course the beginning of the supply shortage.
As the pandemic took hold and factories and logistics channel around the world began to
shut down.
And if you know anything about manufacturing and scaling, you know that its way easier
to shut down the supply chain than it is to bring it back to full capacity.
And this recovery has simply been worsened by inflation and recession fears.
You see, when manufacturers have to pay insane amounts for raw materials and when they’re
fearful that demand is going to slow, they’re going to be hesitant to comes to pumping up
production.
Initially, this was a disadvantage as companies couldn’t meet market demand, but over time,
this has actually become an advantage.
When there’s a discrepancy between supply and demand, companies can further raise prices
and simply blame it on inflation and supply constraints.
Everyone from milk supplies to Apple has been doing this, so it’s no surprise that chip
companies have jumped onto the trend as well.
But all of this brings up the question: how long can this actually last.
Whether it’s next year or 3 years from now, the supply shortage will eventually come to
an end.
Not to mention, all of the growth factors that we previously discussed are also slowly
coming to an end as well.
In terms of smartphone adoption, everyone already has a smartphone.
Global smartphone sales literally peaked 4 years ago and with the differences between
each smartphone iteration becoming less and less discernable, it’s likely that smartphones
sales will not only stagnate but decline.
So, chip suppliers like TSMC will have less and less pricing power over customers like
Apple.
At the same time, the crypto community is moving away from mining as a whole and switching
over proof of stake.
Ethereum just switched to proof of stake just a few weeks ago, and that probably set a precedent
moving forward.
Now, none of this is to say that the chip industry is going to collapse.
Semiconductors have become an essential part of modern society, so the industry as a whole
is not going anywhere anytime soon.
But, with that being said, the chip industry is extremely cyclical and it looks like we
may have just completed the boom phase at the end of last year.
This means that we’re probably just at the beginning of a long and nasty bust phase.
Nvidia had one of these phases after the dotcom boom and it took Nvidia 15 years to get back
into another boom phase.
As a customer, this is probably a good thing.
As demand levels out and supply issues are resolved, we’ll probably see significantly
better value per dollar.
If you’re an investor, however, you better buckle up because regardless of how long this
phase lasts, one things for sure: it’s gonna be volatile.
But that’s just what I think.
Do you think semiconductor margins are too high?
Comment that down below.
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