The proliferation of electronic devices and an increasingly data-driven economy have significantly escalated demand for integrated circuits (ICs). In the past, these semiconductor chips, were mostly used for circuitry in personal computers and mobile phones but they're now used in many different applications. S&P Global Ratings believes semiconductors will be a crucial enabler of technology trends such as artificial intelligence (AI), Internet of Things (IoT), factory automation, advanced driver assistance systems (ADAS), and smart homes and cities. The broadening of IC use cases undoubtedly contributed to record merger and acquisition (M&A) transaction values for the global semiconductor industry and also led to record-breaking revenue for the semiconductor industry over the past few years (see chart 1). Based on these recent trends and our outlook on the semiconductor industry, we predict even more consolidation over the next year or two.

Chart 1

Large Semiconductor M&A Transactions Dominate

The dollar value of semiconductor industry M&A deals surged in both 2015 and 2016 (see chart 2), climbing to more than $80 billion, from approximately $30 billion in 2014. The substantial jump in values primarily stems from particularly large deals such as Intel Corp.'s $16.7 billion purchase of Altera Corp. (2015), Softbank Group Corp.'s $31 billion purchase of ARM Holdings PLC (2016), and Avago Technologies Ltd.'s $37 billion acquisition of Broadcom Corp. (2016). Remarkably, each of these deals on a stand-alone basis exceeded the total transaction value of completed deals within the semiconductor industry in 2007 (approximately $16.4 billion). Moreover, total transaction values for completed semiconductor M&A deals just five years ago, in 2013, was less than $20 billion.

Chart 2

Key Drivers Of Semiconductor M&A

We reviewed 14 large semiconductor M&A transactions with a purchase price of more than $3 billion since 2015 (see table 1). Our analysis pinpoints several key motives for M&A, including the ability to improve a company's market position, enlarge its scale, expand its total addressable market (TAM) and intellectual property portfolio, and diversify its products, applications, and customers.

Given the potential for valuable semiconductor content growth in key end markets such as the automotive sector (with the growth of ADAS), industrial production (with a need for factory automation), communications (with the rollout of the latest generation of wireless technology; 5G), and consumers (focused on IoT), many companies prefer acquisitions over organic growth as a way to narrow the competitive field, acquire a new customer base, and speed time to market.

We believe semiconductor companies are more confident in their industry growth prospects ahead and are more willing to pursue larger scale M&A. AI, IoT, and ADAS are expediting the rapid pace of technological change, causing several semiconductor companies to pursue pivotal technology through acquisitions rather than developing intellectual property through in-house solutions. Internal development would likely take longer and wouldn't necessarily result in assured customer design wins. Trends related to electronic content proliferation have also caught the attention of strategic buyers outside the semiconductor industry, such as Siemens AG and SoftBank Group. We believe the acquisitions by these strategic buyers highlight the secular growth trends in semiconductors and the broadening end market reach.

Table 1

Capital Allocation For Rated Semiconductor Companies

We believe the semiconductor industry consolidation trend will remain intact over the next several years. We reviewed capital allocation decisions by 32 semiconductor companies we rated as of June 29 (see chart 3), and found that their capital allocation policies were consistent with acquisition spending trends we've noted for the broader semiconductor industry. Acquisition-related spending by these companies increased more than five times in both fiscal 2016 and 2017, compared with that of fiscal 2015. Collectively, these companies have prioritized acquisitions and capital expenditures over shareholder returns for each of the past two years. We believe the synchronized global economic expansion and low interest rate environment (in addition to the favorable long-term semiconductor growth prospects) were catalysts for the active M&A environment in the semiconductor industry over the past few years.

Chart 3

Recent Rating Actions In The Semiconductor Sector

We reviewed our rating actions for all semiconductor companies from June 1, 2017, through June 29, 2018 (see table 2). There were eight upgrades, one downgrade, and three positive outlook revisions. Most of the upgrades and positive outlook revisions were consistent with improving industry fundamentals, which in many cases, led to stronger operating performance and lower leverage.

Table 2

We've generally seen improving credit metrics for most of the semiconductor companies we rate. The sector's strong operating performance over the past year was in line with the strong growth across several semiconductor-product segments tracked by World Semiconductor Trade Statistics (WSTS). In 2017, WSTS data showed that seven of the nine major semiconductor product segments grew in the double digits, and memory, sensors, and digital signal processor (DSP) reported the strongest growth (see chart 4 and table 3).

Chart 4

Table 3

Worldwide Semiconductor Product Growth 2017
Product segment	Change over last year (%)
Memory	61.5
Logic	11.7
Analog	10.9
MPU	2.7
Opto	8.8
Discretes	11.5
MCU	12.2
Sensor	16.2
DSP	14.5
Source: WSTS and SIA estimates.

Fundamental trends revealed in our study of 32 semiconductor companies we rate (see table 4) include:

• Two consecutive years of EBITDA and free cash flow growth in fiscals 2016 and 2017.
• Positive revenue growth in fiscal 2017 for 29 of the companies, with 22 generating double-digit revenue growth.
• EBITDA margin improvement in fiscal 2017 for 24 of the companies, with 15 expanding their margins by more than 400 basis points (led by Micron Technology Inc., Cavium Inc., Advanced Micro Devices Inc., Nvidia Corp., and Cypress Semiconductor Corp.).

Table 4

Rating Actions Following Semiconductor M&A Completions

We also reviewed our ratings on companies that have pursued large semiconductor M&A transactions (see table 5). There were several noteworthy findings: Of the 14 large transactions discussed previously, the completed and pending deals resulted in one upgrade and three downgrades, the rest of the transactions did not affect our ratings on the companies. These rating outcomes reflect our positive view of the semiconductor industry and our belief that companies will be able to reduce leverage to an amount appropriate for the ratings. In particular, we note that these rating outcomes demonstrate our belief that the companies will benefit from increased diversification to end markets with strong secular growth drivers.

Table 5

Fragmentation In Analog Suggests More Consolidation

We find the analog subsector to be fragmented (see table 6) and most poised for consolidation. Long design-in cycles and long product lives, which result in sticky customer relationships for analog firms, and the opportunity to gain scale efficiencies have provided firms in this subsector with incentives for pursuing M&A. On the other hand, the memory and logic subsectors have completed their consolidation phases, in our opinion, and we don't expect significant M&A action in these areas due to the regulatory agencies' concern for antitrust issues.

Table 6

So what can derail the elevated M&A activities over the near term? We think the relatively high equity valuations are significant hurdles that could slow the pace of M&A. The median price-earnings (P/E) ratio for a semiconductor industry peer group composed of 18 companies reached 22.9x at the end of June 2018--substantially higher than the median P/E ratio just a few years ago (see chart 5 and table 7). We believe the higher hurdle rates associated with elevated equity valuations could cause some semiconductor firms to refrain from pursuing sizable acquisitions over the next few years.

Chart 5

Table 7

We also believe U.S. national security concerns and the current trade dispute with China represent additional near-term risk factors for semiconductor M&A. In our view, large-scale cross-border M&A is most at risk of being delayed (e.g., Qualcomm/NXP Semiconductors N.V.) or canceled altogether (e.g., Broadcom/Qualcomm) given the required regulatory approvals across multiple jurisdictions. Qualcomm's announced deal to acquire NXP Semiconductors has been approved by all regulatory bodies globally except by China's regulator (see table 8), which we attribute to rising U.S.-China political tensions. Furthermore, as cited in the U.S. Government's rejection of Broadcom's deal to acquire Qualcomm, semiconductor chips have increasingly become linked to national security as the potential use cases have multiplied rapidly. Although we mostly view the current escalation in U.S.-China trade tensions as transitory, the extent to which it will continue to impact large-scale cross-border M&A within the semiconductor industry remains uncertain.

Table 8

Still, we find the near-term prospects for continued M&A to be a more dominant force. As we review the historical performance of the semiconductor industry, it's evident to us that the industry is in a long-term secular growth trend, with ebbs and flows influenced by global economic trends. The current global economic bull cycle is in the late stages with above-average growth and early signs of inflation. While interest rates are rising, they are still low by historical standards. S&P Global economists forecast global GDP to grow 3.9% in 2018 and 2019, and this economic backdrop should bode well for continued semiconductor revenue growth over the next two years, despite a stellar year of 22% revenue growth in 2017. In addition, the passing of the U.S. tax reform removes uncertainty related to capital planning, providing further support for semiconductor M&A.