The semiconductor supply shortage is here to stay, at least through the end of this year and into 2022. That has customers scrambling to procure available supplies. In this scenario, we find semiconductor companies and semiconductor equipment manufacturers benefiting until demand-supply imbalance normalizes, while customers in end markets such as auto are losing billions of dollar and having to shut down plants and idle factories.

U.S. tech companies are also facing the prospect of inflation, with cost inflation pervasive and noticeable in the second quarter. Another risk U.S. tech companies are dealing with is the potential for further antitrust action. Although S&P Global Ratings considers the possibility of significant break ups that would cause rating downgrades unlikely, the probability of these scenarios has increased. Here we examine how these developments could affect U.S. tech company ratings and outlooks and answer investors' frequently asked questions.

Frequently Asked Questions

How long will the semiconductor supply shortage last? Who are winners and losers?

While we believe we are near the worst of this chip supply shortage, the demand-supply imbalance, broadly speaking, will likely last until at least the end of this year and through a good part of 2022 for certain products.

Normal lead times, defined as the length of time between when customers place and receive their orders, has lengthened to about 18 weeks currently from a typical level of about 13 weeks in the beginning of 2021, indicating worsening demand-supply imbalance.

The chip supply shortage is broad-based, affecting supply for display drivers, power management chips, and microcontrollers that are typically fabricated in mature nodes, i.e., 40 nanometer (nm) or higher, on eight-inch wafers at foundries. Other components, such as discretes, optoelectronics, and passives, and materials such as substrates, are also in short supply. Back-end capacity constraints in wire bonding and materials and testing further exacerbate the crisis.

The chip supply shortage is also showing signs of spreading to larger wafer (i.e., 12-inch, and lower nodes, 28nm or lower), a result of strengthening demand following a macroeconomic recovery and pent-up demand from delayed purchases not made last year because of the COVID-19 pandemic.

While chip production could be increased to the extent existing fabs capacity is available, it typically takes up to six months from capacity addition to customers receiving the final products. The industry has been increasing its fab utilization but given the expectation for even strong demand for the rest of 2021, following typical seasonality pattern in the semiconductor industry, the current supply-demand imbalance is unlikely to fade until 2022. Semiconductor manufacturers have plans to build new fabs as they anticipate strong secular growth trends in digitalization, electrification, and connectivity, and increasing electric content in auto, factory automation, 5G, cloud computing, and the internet-of-things (IoT); however, higher demand for semiconductors cannot be met through increased utilization alone and production from new fabs is unlikely to provide any relief to the current chip supply shortage as it won't be available until years away.

We believe growth in semiconductor production should outlast overall growth in demand, as there will be a period of tech supply chain replenishing inventory levels to seasonal averages following declines over the past few quarters. This bodes well for semiconductor industry growth through at least early 2022.

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Not surprisingly, the winners of the chip supply shortage are the semiconductor companies. These companies saw robust demand across a broad range of end markets, an improved pricing environment, and higher factory utilization rates that should benefit margins over the next several quarters. Double-ordering, a term used to describe customers ordering more than they need when there is a shortage to ensure they receive higher allocation of products, likely exists within the supply chain but semiconductor companies are instituting new procurement programs with customers asking them to place firm orders for an extended period, which should minimize double ordering and lead to better visibility of true demand. While revenue growth could be stronger if not for the supply shortage, it could translate to a smoothing effect of the industry cyclicality over the next two years, which we view favorably for the industry. Over the longer term, we believe semiconductor manufacturers will have better bargaining power over their customers given the growing chip content in virtually all electronics, and relatively high barriers to entry which should limit competition within the semiconductor industry.

Another group of winners are semiconductor equipment manufacturers such as Applied Materials Inc., Lam Research Corp., and KLA Corp. They provide the equipment necessary to manufacture these complex chips and have significant competitive moats which result in strong pricing power and limited competition. We expect growth of these companies will outpace the overall semiconductor industry over the longer term given robust demand from various countries and regions that are investing heavily in domestic manufacturing to attain self-sufficiency.

The losers appear to be the auto original equipment manfacturers (OEMs), and to a lesser extent tech OEMs that cannot procure sufficient parts to meet demand. Apple Inc. mentioned about $3 billion to $4 billion of lost revenue in fiscal third-quarter 2021 due to component shortages that prevented the company from meeting demand for their iPad and Macs. Samsung Electronics has also mentioned that sales of display panels to smartphone OEMs have suffered as these customers have been unable to access various semiconductor chips needed to manufacture smartphones, although, in our view, the impact from chip supply shortage on overall tech sectors have been relatively modest thus far. On the other hand, GM, Ford, Volkswagen, Daimler, and other automakers have announced plant shutdowns and estimated losses in the billions of dollars as they've had to idle factories due to chip shortages. Foundries and semiconductor manufacturers have announced capacity additions. Prioritization to end markets with worst supply shortages, such as auto, which typically use chips that carry lower profit margins for semiconductor companies, will be key for the auto industry. One silver lining is that auto OEMs have been able to pass along higher input costs to customers through higher vehicle prices.

We believe the chip supply shortage serves as a rude awakening for the auto OEMs, tier 1 suppliers, and semiconductor companies, prompting them to better align their short- and longer-term forecasts. There could be more direct collaboration between the auto OEMs and semiconductor companies as a result. We already saw trade associations and industry participants in both the auto and semiconductor industries jump to action with SEMI, formerly Semiconductor Equipment and Materials International, and the Center for Automotive Research (CAR) recently signing a memorandum of understanding to advance collaboration between the semiconductor and automotive industries.

Other behavior changes could include higher inventory levels along the supply chain for certain semiconductor products that are at higher risk of bottleneck, such as those manufactured at legacy nodes utilizing smaller wafers and are less flexible in adding capacity in short notices. We could also see auto OEMs and tier 1 suppliers incentivize semiconductor manufacturers to allocate and guarantee higher capacity to them through committed long-term contracts.

How has inflation affected the tech sector?

The tech sector is seeing higher cost pressure on account of COVID-19-related factory shutdowns in Malaysia, Taiwan, and China, increasing logistics costs, and rising component pricing due to demand significantly outstripping supply. This is after having to contend with the power outages across Texas and the earthquake in Fukushima, Japan, in February that caused about a month of lost production at certain semiconductor manufacturers. Cost inflation is pervasive and noticeable in the second quarter, affecting chips and components that go into auto, consumer, enterprise, industrial, and other end markets.

That said, the impact to tech companies has been benign thus far. In some cases, longer-term customer arrangements prevent tech companies from raising prices immediately. However, for the most part, end-customer demand is strong and appears likely to remain so over the near term, allowing tech companies to pass along higher costs to customers, preserving their profitability. We've observed that tech companies have been able to pass along higher costs to customers because their products and offerings either lack substitutes, help customers improve productivity that can be justified at even higher prices, have tremendous brand loyalty, or are viewed as mission critical to business operations.

Not all tech companies are passing along the higher costs though. Cisco Systems Inc., for example, stated that because that the rising cost pressure from supply chain shortages will likely remain through the end of 2021 but be temporary, it is opting to absorb some of the incremental costs to ensure the business momentum seen over the past two quarters continues. However, if management concludes that the cost increases will be sustained, it will then consider strategic price increases.

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Could the U.S. be successful in achieving legislators' intended goals in pursuing more onshore manufacturing?

The push by the U.S. government to develop new strategies and provide financial incentives to the domestic semiconductor industry aims at preventing the U.S. from falling further behind Taiwan and Korea in leading semiconductor manufacturing processes because such a lag could have national security implications. While the U.S. currently leads in semiconductor chip designs and IP, it lags Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) and Samsung Electronics Co. Ltd. in process technology with TSMC alone accounting for over 50% of global semiconductor foundry services and over 80% if only counting technologies at the leading-edge nodes. Moreover, China publicly announced its ambition to close its advanced semiconductor technology gap with the U.S. and has been closely aligning its national interests with its domestic semiconductor manufacturing companies.

The U.S. Senate recently passed the U.S. Innovation and Competition Act, a bill that includes a provision that allocates $52 billion to fund semiconductor R&D and manufacturing initiatives. The bill will head to the U.S. House of Representatives for approval over the coming months. Alignment between the U.S. government and the private sector to promote domestic semiconductor design and manufacturing will be beneficial to U.S.-based tech companies. Additional U.S. semiconductor manufacturing capabilities would strengthen the supply chain of U.S.-based companies through diversification away from existing foundry services providers such as TSMC and Samsung that have a semiconductor manufacturing presence concentrated in Taiwan and Korea. It would also diminish any impact from natural disasters, as TSMC is subject to risks of earthquakes, or geopolitical concerns from neighboring countries, such as China and North Korea. Furthermore, the tighter integration between chip designs and the semiconductor manufacturing process is important to continuous improvements, an idea Intel would surely concur as it recently announced plans to spend $20 billion to build a semiconductor fab in Arizona to boost capacity and, separately, plans to provide foundry services at another "mega fab" in the U.S. or Europe to manufacture chips for others.

Initially, any new manufacturing capacity in the U.S. will likely be less cost efficient than those operated overseas by industry leaders TSMC and Samsung, given the high construction cost of fabs in the U.S. as well as higher logistics and labor costs. Also, the supply chain would be more complex at first until the full front- and back-end semiconductor manufacturing is built out in the U.S. That's the reason why the $52 billion financial incentives the U.S. government plans to provide would be a critical first step to entice U.S. semiconductor companies to commit to a greater domestic manufacturing presence. We believe that additional incentives such as tax breaks and grants will be necessary to increase the chance of longer-term success of this onshoring of semiconductor manufacturing initiative.

We believe that TSMC and Samsung are committed to their foundry leaderships and will continue to allocate significant investments in this secular growth market. While there are no guarantees that U.S. foundry will ever catch up to TSMC's leadership in process technology or cost competitiveness, a greater U.S. domestic manufacturing presence would, at the very least, reduce reliance on foreign suppliers.

What's S&P Global Ratings' latest view on Big Tech regulation?

The risk of antitrust action in the U.S. is increasing. We continue to believe that significant break ups that would cause rating downgrades are unlikely but the probability of these scenarios is increasing. In addition, the prospect for new antitrust laws with more rigorous enforcement seems likely but we expect that tech companies such as Alphabet, Amazon, and Apple will be able to manage any potentially negative impacts while preserving their credit ratings.

U.S. lawmakers have introduced five bipartisan bills aimed at beefing up antitrust law, which currently has a narrow focus on consumer prices and exclusionary conduct requiring a high burden of proof. If passed, these bills would provide muscular regulators like new FTC chair Lina Khan additional tools to strengthen enforcement. They would prohibit discriminatory conduct, increase scrutiny on acquisitions that could stifle competition, restrain companies from favoring their own products on their platforms, require data portability, and raise merger fees to fund enforcement. For example, the bills could prohibit Google from promoting YouTube videos in search results, Amazon from selling its branded products in its own marketplace with other third-party sellers, and require Apple to allow customers to access apps through alternative app stores. Merger fees seem to have the most support; the other pieces will be hotly contested.

The big tech companies have raised concerns that these laws would harm small businesses, jeopardize privacy and security, and weaken the U.S.'s competitiveness vis-à-vis China. Many Republicans worry about giving too much power to government regulators. We think some of the proposed provisions are likely to pass, but that the most aggressive portions are likely to be moderated to the point that businesses will be able to make changes to their business practices that will bring them into compliance. Such changes would require additional costs and may even include shutting down certain revenue streams, but they are unlikely to be significant enough to materially weaken tech companies' credit profiles. Although adverse outcomes that require significant breakups that would result in downgrades have a low probability of occurring in our view, the risk is rising. Regardless, we think the tech companies will be able to challenge any new laws in the courts, which would lengthen the time to reach final judgements.

In addition, in the U.S., politicians of both parties have proposed modifying rules that limit the liability of platforms for user-generated content. If these safe-harbor protections were revoked, it would open the possibility for significantly increased litigation risks and costs to moderate user content. But the two parties differ in their focus. Democrats worry about disinformation and harassment, and they want platforms to moderate user content more aggressively. Republicans worry about political bias and believe the platforms censor conservative views more harshly; they support encouraging less moderation. We think this difference in focus makes compromise on a bill that significantly undermines liability protections unlikely, although minor carveouts are possible.

In the privacy area, we believe that new restrictions will be manageable. In May 2018, the EU implemented the General Data Protection Regulation (GDPR), creating new compliance obligations aimed at giving EU residents more control over their personal data. Violations could carry fines of up to 4% of global annual turnover for the preceding financial year for the most serious infringements. Tech companies have changed their business practices and added costs to comply with the law, and these actions do not seem to have affected business performance. Nevertheless, we believe new cases from the Irish data regulator are likely on the horizon this year. U.S. federal and state lawmakers could consider adopting similar regulations, as California and Virginia have done. Increasing transnational, national, state, and local privacy regulations would increase operating cost and complexity, but they could also create barriers to competition because the capacity of smaller challengers to deal with these regulations would be much weaker than that of the big tech players.

Tech rating actions have been overwhelmingly positive year-to-date. What is expectation for the rest of the year?

We've seen an overwhelmingly positive rating bias among U.S.-based tech companies, with 50 positives versus 13 negative rating actions in the first half of 2021. Prior to that, many of the positive rating actions were due in part to a reversal of negative rating actions taken stemming from pandemic-related business weaknesses. The positive rating actions taken in 2021, however, were predominately reflecting improving credit profiles but also a result of debt reductions or corporate action such as IPOs.

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Our S&P Global U.S. economist recently raised our real U.S. GDP growth forecast for 2021 and 2022 to 6.7% and 3.7%, respectively, from 6.5% and 3.1% in our March report. This is consistent with our view that U.S. tech companies' revenue growth is gaining momentum amid a strong demand environment not seen since 2018, which should allow their credit metrics to improve further, potentially leading to more positive rating actions.

The biggest risk to our favorable view on U.S. tech credits is aggressive M&A. Valuations for tech companies have gone up significantly over the past few years and excessive exuberance on business outlook could lead to credit profile impairment even if the rationale for an acquisition is sound. Mitigating factors include tech companies' strong cash flow generation, which was further helped by lowering financing costs via refinancing actions over the last 12 months, good liquidity positions, and an increasing appetite to use equity for acquisition financing.

We expect there to be more M&A announcements in the hardware and software sectors than in the semiconductors industry. Although it is very compelling for semiconductor companies to pursue M&A to further scale efficiencies and broaden the product portfolio that would otherwise be very difficult to achieve, we believe large transactions will be limited given regulatory scrutiny. For example, competitors may be interested in a potential tie-up with NAND semiconductor memory company Kioxia but regulatory roadblocks could be a gating factor.

In the hardware sector, pressure to increase functionality of product offerings could result in companies' search for acquisition targets with software capabilities such as data analytics and security to be incorporated into, or simply broaden, their product offerings. Xerox acknowledged it would pursue small and large M&A in areas such as artificial intelligence, augmented reality, predictive analytics, and robotics to develop new digital workflow and services to drive long-term growth and diversify print revenue streams.

We also find the payments and fintech area to be ripe for consolidation. We saw the three mega-deals in 2019 between Fiserv and First Data, Fidelity National Information Services and Worldpay, and Global Payments and TSYS. However, the fintech space is still highly fragmented with blurring lines between hardware and software, core transaction processing and additional functionality such as security and analytics, U.S. and cross-border, and adoption beyond financial services to other industries such as health care, retail and hospitality.

Software M&As, we believe, tend to carry lower execution risks because deal-sizes tend be smaller and acquisition targets tend to have product offerings that are complementary, limiting integration risks. Areas that are experiencing above-average growth and could be higher M&A activities include security, data analytics, devops, collaboration, software management tools.

Lastly, while we don't believe there will be a wholesale shift by tech companies to more aggressive financial policies, shareholder returns in excess of free operating cash flow generation could lead to negative rating actions. We recognize tech companies are comfortable with their near-term business trajectory and, in some case, enjoy an improved credit profile after having suspended dividends or share repurchases last year due to macroeconomic uncertainties. On one hand, for example, we view Qualcomm and NXP's sizable share buybacks in 2021 to be higher than usual but reasonable given the strong revenue growth and cash flow generation trajectory such that the shareholder returns would not lead to significant deviations from their current leverage levels. On the other hand, we view Oracle and Seagate's significant share repurchases to be shifts to a more aggressive financial policy. In the case of Oracle, it continues to repurchase shares materially in excess of its cash flow generation, which led to our two-notch downgrade on our rating on the company to 'BBB+' with negative outlook from 'A' with a negative outlook in early June. For Seagate (BB+/Stable/--), it pursued debt-funded share buybacks in December 2020, which led to downgrades by other rating agencies from investment-grade level to our 'BB+' equivalent. The action signaled the company's preference for shareholders' interest over other stakeholders including bondholders.

Financial policy shifts are difficult to predict but are of utmost importance in our ratings assessment, especially for investment-grade rated tech companies, as they tend to have significant cash on hand and could reclassify a portion of their cash as in excess of necessary to operate their business and thus available to return to shareholders.

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Related Research

• Economic Outlook U.S. Q3 2021: Sun, Sun, Sun, Here It Comes, June 24, 2021
• Semiconductor Supply Shortage and U.S. Policy Response Mark A Renaissance For Domestic Manufacturing and Equipment Investments, April 26, 2021
• Chipping Away At Intel Corp.’s Manufacturing Strategy And Credit Risk, Jan. 25, 2021
• In And Out: Computing The Impact Of Apple's Chip Insourcing, Intel’s Outsourcing, Jan. 13, 2021