A new tech cycle?

Weak Japanese exports for October were not a big surprise given that the yen has been strong and global trade remains lackluster. Yet buried within recent (dreary) trade releases is evidence pointing to a new semiconductor investment cycle. The first signal, from official data at least, came in Japan’s 3Q16 GDP report which showed growth at 0.5%, versus an expected 0.2%, with the difference explained by exports of electronic components and semiconductor production equipment.

Then, last Friday, Japan’s semiconductor trade association said that orders were at a post-2007 high, with especially strong demand coming from China.

Increased chip demand partly stems from the roll-out of virtual reality gadgets for the holiday season. These devices must handle intense three-dimensional graphics, which has upped the demand for ultrafast memory and caused DRAM prices to soar since the summer. Similar technology is also being bundled into gaming consoles and higher end personal computers; for example, Sony’s PlayStation VR has only been on sale in Japan for a few weeks, but sales have outstripped the PlayStation 4 by 70%. Carphone Warehouse, a UK electronics and telephony retailer, predicts a doubling of VR equipment ownership in the UK over the festive season to one in ten households.

In addition to a new class of entertainment and gaming devices being released, a constrained supply-side is being forced to respond to appreciable demand shifts in three other key market segments:

1) Automotive electronics is the fastest growing segment in the chip market at about 6.7% The average new car already has 50-60 processors and up to 600 microchips and that will only rise as vehicles acquire full autonomous driving capability. This should ensure that that the market for automotive chips rises from about $29 bln last year to about $44 bln by 2022, according to IHS Markit, a research firm.

2) The aftermath of Samsung’s Galaxy Note 7 exploding battery debacle has been to focus handset makers on the quality of componentry going into devices and manufacturing capabilities in low cost production locations. A number of Japanese equipment producers we have spoken to have cited this incident as a catalyst for handset vendors shifting to higher quality components, which in turn is forcing their suppliers to upgrade their production equipment.

3) Memory used in high-end servers is in short supply as the likes of Google, Facebook, Amazon, NTT and Alibaba continue to build out their cloud computing systems.

The big picture is that demand for IT componentry is rising at a time when the supply side is constrained. The memory sector is highly concentrated, with Samsung and SK Hynix controlling about 75% of the global DRAM market, while Samsung, Toshiba, Western Digital and Micron have about 85% of the NAND flash memory used in smartphones.

The source of fresh supply is likely to be China where the government has set a target of securing a one-third share of the global $300 bln chip market. To that end, the government is offering producers low cost loans and tax-free incentives over the next ten years that amount to RMB1.2trln ($175 bln).

As part of this expansion Chinese firms are making overseas acquisitions, and to a greater extent are tooling up factories at home—China’s biggest chip maker, Semiconductor Manufacturing International is presently building a 12” wafer fabrication plant in Shenzhen and will see its capital expenditure in 2016 rise 68% to $2.7 bln.

It will, however, take a fair time for such new capacity to come online so given the concentrated nature of the chip market and the apparent step change in demand, semiconductor firms look set to enjoy significant pricing power for a decent while to come. This looks like a good time to be such a producer or a maker of picks and shovels serving that business.