The cycle looks set to turn for the booming global semiconductor market. The main drag will be the stall in for chip-laden consumer products, amid spikes in inflation and other macro risks. Given capacity expansions in the recent upcycle and inventory stockpiling to avoid another round of COVID-related disruptions, downside risks abound.

Our ratings leave headroom for cycle changes in cyclical sectors, such as semiconductors. However, the coming cash crunch could be larger than usual. We view the volatile macro movements, capacity additions, and inventory behavior as the key swing factors for the foundry industry.

Long accustomed to fast market changes, many sector companies have taken steps to diversify exposures. The market for foundry service (see table 2) could continue to expand amid a potential semiconductor downturn. Taiwan Semiconductor Manufacturing Co. Ltd. (TSMC) and Samsung Electronics Co. Ltd. look best positioned to expand outsourcing due to entry barriers in the most advanced products.

End Demand Has Weakened; Semiconductor Demand Is Next

Consumer tech demand weakness among TV, PC, and smartphones now appears widespread. At the same time, weaker-than-expected consumer demand in China could also cause a meaningful downshift in demand for large tech categories such as iPhones or automotive, decisively changing the perception of tech end demand. More than half of foundry demand still comes from consumer products.

Enterprise, automotive and datacenter demand remain strong and support the global IT spending. However, risks are also rising for enterprise tech demand. We see the slowdown in enterprise spending, including reduced datacenter investments, as a worrying signal for the semiconductor sector.

Possible weaker enterprise demand trends in the second half of 2022 could lead us to revise down forecasts on the semiconductor market. Should increased cautiousness persist, we could further lower our 2022 forecasts. Our latest forecasts put semiconductor growth at 8% for the year, and IT spending growth at 4.3% (see table 1).

Table 1

Rated semiconductor players have generally stable ratings supported by favorable market conditions during COVID (see table 2). Major foundries such as TSMC, Semiconductor Manufacturing International Corp. (SMIC) and Vanguard International Semiconductor Corp. still reported very strong results with nearly full utilization and increasing product average selling price in the first quarter of 2022. These companies have not yet seen widespread order cuts and expect relatively strong performance through 2022.

Table 2

Inventory Strategy Will Determine The Market Downturn

Behavior changes since COVID could raise risks in a downturn. Inventories among the semiconductor supply chain have been rising over the past few quarters, due to supply disruption concerns, such as China's lockdowns and foundry supply tightness. However, as end demand trends continue to deteriorate, the China supply situation improves, and more foundry supply comes online from late 2022, integrated circuit (IC) design clients will start work down their inventory. This could lead to widespread order cuts at foundries.

We believe clients' inventory strategies will also determine the magnitude of the foundry downcycle. Both foundries and their fabless clients are holding high inventory level due to supply disruption concerns and foundry supply tightness. Once the inventory behavior of foundries' fabless clients starts to normalize, we could see severe inventory correction and widespread order cuts at foundries. This could be worse than in prior downcycles.

In addition, over past two years fabless vendors signed long-term agreements (LTAs) with foundries to secure capacity for strong demand, which partly explains the glut of inventory. We expect some downside risk for foundries' utilization over the next quarters, as those clients are likely to default on part of those LTAs as demand weakens.

Chart 1a

Chart 1b

Gradually Easing Chip Shortage: And Strategies To Cope

Against the backdrop of weakening demand, the chip shortage especially for mature nodes (see table 3) could gradually ease. Several mature node semiconductors have been in tight supply since mid-2020 when market demand jumped amid increased remote communications and work. This included demand for complementary metal–oxide–semiconductor image sensors, microcontrollers, display driver integrated circuits (DDICs), and power management ICs (PMICs).

Table 3

Client commitment will help Vanguard

We expect some downward adjustment on DDICs given the inventory pressure among fabless vendors and the continue declining panel prices due to soft demand from downstream markets. This could bring some downward pressure for related companies' strong performance such as Vanguard as the company's exposure to DDICs is about 35% to 40%, though declining. Nevertheless, we still expect Vanguard's average selling prices (ASP) to grow by about 15% in 2022 before a likely weakening in 2023. The still increasing ASP in 2022 will be supported by a client willingness to pay for Vanguard's capacity.

In addition, Vanguard's still-strong operating cash flow will support the company's higher capital expenditure (capex) needs and cash dividend payout over the next one to two years. This, plus the company's cash on hand, should enable it to sustain very low financial leverage over the same period.

Diversification efforts

Mature node foundry players also tried to shift their DDIC business to more PMIC with more diversified downstream applications over the next two years, and this could help them to sustain utilization rates. However, their PMIC clients are also likely to face growing inventory issues if weakening demand becomes more comprehensive and spreads into auto and other industrial markets; that could in turn affect the foundries' performance, especially for companies with less diversified product portfolios.

Capacity Increases Are Progressing As Planned

In addition to large integrated device manufacturers' accelerating capex plans, capacity expansion in foundries is more aggressive, with the majority of new capacity starting to come online in late 2022.

The foundries, particularly in manufacturing mature products (28 nanometer [nm] and above), could face severe oversupply in 2023, if the inventory correction from weaker demand is severe. This could drag on companies such as United Microelectronics Corp. (UMC) and SMIC. These companies have meaningful sales exposure to mature node products in 12-inch fabs.

Chart 2a

Chart 2b

Most semiconductor manufacturers improved their financial strength over the past two years due to favorable market conditions. While SMIC does not have a history of generating positive free operating cash flow, it sustains its net cash position via government support and a secondary listing. We expect the company to continue to receive strong financial support from state-backed integrated circuit funds, local governments, and other enterprises for its three new fabs of about US$19 billion over the next few years.

Leading edge has the edge

Leading-edge capacity does not look oversupplied thus far, since most of it is concentrated at TSMC and Samsung, and generally built to order. We think the most advanced supply is likely to remain relatively tight, despite significant capacity additions such as for high-performance computing (HPC). This is because good demand growth prospects for end-demand of applications such as internet of things and artificial intelligence (AI).

Chart 3

The Foundry-Service Market Looks Promising, Led By TSMC

We expect semiconductor companies will continue to seek efficiencies and adopt fab-lite operating models, resulting from the material rising costs and high capital intensities for shrinking geometries by using expensive equipment such as extreme ultraviolet lithography tools. Foundries have expended at a compound annual growth rate of 10% over the past decade, compared to 4% for the global semiconductor market. The trend of outsourcing is likely to continue over the next few years, especially for manufacturing leading-edge chips.

TSMC could lead the foundry expansion given robust demand for its advanced technologies. This is not to say TSMC doesn't face the same general risks as other foundries amid stalling demand for consumer products. Smaller peers such as UMC and Globalfoundries Inc. are turning their resources to develop specialty technologies for mature nodes, adding to competition.

Nonetheless, the structural increase in semiconductor demand from 5G, AI, electric vehicles, and high-performance-computing related applications require TSMC's leading-edge technologies. We expect TSMC's revenue will rise above 30% in 2022. Our base case analyses for rated companies provides a similar view to TrendForce's forecast in April 2022 (see chart 4b).

Chart 4a

Chart 4b

TSMC And Samsung Could Dominate In Leading-Edge Technologies As Moore's Law Is Getting More Expensive

We believe TSMC and Samsung will benefit from the fast-growing market in high-performance computing over the next two years, while Intel's role is less certain.

Table 4

Intel's product roadmap now appears aggressive given its track record in process technology; and therefore execution will be key as it pursues both integrated design manufacturing and foundry services strategies simultaneously. Our base case for Intel indicates US$25 billon-US$30 billion annual capex over 2022 to 2024, representing a significant bet on scaling its foundry business to catch up with industry leaders. We believe this carries high execution risk for Intel, especially given TSMC and Samsung's scale and their own aggressive expansion plans. However, Intel has a strong balance sheet, which provides a buffer against its weak cash flow outlook.

Competition for technology leadership between Samsung and TSMC is intense. Samsung has lost market share to TSMC in leading technologies over the past few years as the company trailed TSMC in the launch of most advanced nodes and delayed in boosting the yields. However, the company just announced its production of 3nm process node applying Gate-All-Around transistor architecture in June 2022, while TSMC's 3nm process isn't expected to go into mass production until later this year.

We believe technology leadership is the key for TSMC to maintain its relatively strong performance, particularly amid the market downturn. As there are only three players that can offer 7nm or more advanced technology nodes, we do not expect Samsung's announcement of its 3nm schedule to pose a major threat to the foundry business of TSMC. That's because of TSMC's stronger eco-system, which provides better technology variety and services, as well as better yield and product performance to a more diverse client base than just top-tier clients.

We also believe that Samsung has a good strategic position as semiconductor clients always need a second source even for the leading technology nodes--although conflict of interest could be an issue for Samsung's foundry business development in certain applications. In mobile applications, Samsung designs its own application processor (AP) chips, which are in direct competition with current and potential customers such as Apple and Qualcomm.

Despite this, we believe the company's leading position in technology, large order backlog as of first quarter 2022, tight supply-demand dynamics and high growth in HPC could more than offset the near-term decline in PC and mobile demand and support favorable trends for Samsung's foundry business' growth prospects. While Samsung's foundry business consists of less than 10% of the company's overall revenue, the importance of the business within the company could increase in the coming years given the strong growth prospects.

In addition, the company has good market position, with a very large and well-diversified business portfolio. For instance, it comprises memory semiconductors, smartphones, and other consumer electronics, which could bring additional operating stability during the market downturn. We believe Samsung will generate robust free cash flow and sustain a large net cash position of more than US$80 billion over the next two years, despite its sizable capex and high shareholder return policy.

What Is Underpinning Our Mostly Stable Outlooks?

Strong profitability over the past two years has reinforced balance sheets and resilience to business volatility for our rated semiconductor companies. This supports a generally stable credit outlook in our rating pool. However, clearly the risks are rising.