As Russia continues it war against the Ukraine, a number of Chinese manufacturers have been forced into the spotlight with their products being mentioned by Russian military authorities, or being shown in compromising situations in the media.  Last month SMIC (688981.CH), China’s largest semiconductor foundry, answered investor questions about it ties with Russia stating that it “ …has never had customers in Russia, and remains in compliance”, in order to keep from generating more ill will with the US government, as the company is already on the trade restriction list limiting its ability to purchase advanced semiconductor tools and materials.. 
Chinese drone producer DJI (pvt) also has spent time trying to allay fears that its drones are being used by the Russian military after a statement of praise by a Russian official began circulating in social media concerning the company’s products.  Now, China’s Unitree Robotics (pvt), a producer of a $2,700 robotic ‘dog’, is trying to disarm the chatter that occurred when one of its robotic dogs was seen at a military hardware exhibition in Russia with a rocket launcher attached.  While the robotic dog was covered in black cloth, it was quite similar to the company’s household robot dog, the GO1, and while the Russian engineers who developed their implementation said it can be used in both civilian and wartime scenarios to deliver medications, they also noted it could be used to carry and fire weapons.
Boston Dynamics (pvt) has been building commercial quadruped robots since 2004, brothers of the dancing robots we have seen in a number of demos and segments on 20/20, but there is always the inevitable corruption of such devices for use in the military, singled out in a number of dystopian Sci-Fi thrillers that feature ‘Spots’ with weaponry and a mindless focus on killing hapless civilians.  While companies are very careful to disassociate themselves from the current worldwide bad guys and are hopefully careful not to sell directly to any military organization (other than our own) that might adapt them for warfare, it would be hard not to imagine that the human mind would not look at such devices as potential weapons, especially if they are able to be reverse engineered and easily copied.  Covering them with a black cloth (as shown in the first video below) does little to hide their origin and sets a depressing tone to what are certainly feats of engineering, so we also include the second video to put things in a better light…
https://youtu.be/WZlMq5LpN8Q
https://youtu.be/fn3KWM1kuAw
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​As of today the US Department of Commerce, Bureau of Industry & Security, has implemented additional export control rules concerning semiconductors based on Gallium Oxide and diamond, and CAD software specifically designed for developing GAA (Gate-All-Around) FETs, along with certain technology associated with the production of gas turbine systems.  As we have noted previously, the US government has been in discussions with various government’s whose companies might be affected by this new ruling, particularly the government of the Netherlands, where EUV tool vendor ASML (ASML) is located.
The substance of the new rules are as follows:
GaO and diamond based  semiconductors are able to operate at higher temperatures and voltages as opposed to those based on Gallium Nitride or Silicon Carbide and are therefore more applicable to military applications.  Exports to countries that have been singled out by the US government as having aspirations in conflict with the US would now be required to be licensed. 
While there are no current devices using PGC (Pressure Gain Combustion), a process that increases combustion pressure while consuming the same amount of fuel as conventional gas turbine engines, the BIS has cited the large amount of research being done in the area.  Citing the use of this technology in missiles, rockets, and military engines, the new rule will require licensing for any technology utilizing PGC, when they might occur in the future. 
ECAD systems used to design IC layout and lithography artwork necessary for the production of semiconductor devices has already been included in the EAR rules however the new additions are explicit in that ECAD tools that are for the design of GAA devices, which is a process that is used for complex chip production at nodes below 5nm and allows for the reduction of gate control issues that increase as device size decreases.  The application of GAA technology allows for faster, more power efficient, and smaller devices, again with applications for the military being cited in the rules and the BIS is asking for comments from the semiconductor industry as to the scope of the new rule, asking for details as to a variety of design functions in order to make sure all of the possible GAA related CAD design software modules are covered.  In order to receive these external suggestions, the implementation of the GAA rule is delayed for 60 days and items that have been previously licensed and are on loading docks or enroute are able to proceed as long as they are received before November 14.
At least on the surface the new rules would not add to the limitations already placed on ASML, given that the government of the Netherlands has not allowed the export of EUV tools to Chinese entities at the behest of the US government, while still allowing export of DUV tools that are able to produce at larger nodes.  EDA software vendors face a more complex challenge as the new rules are still broad enough that EDA companies might find that their internal thoughts on the application of certain modules might differ with those of the government, triggering a conflict as to whether they can be sold to those entities that fall under EAR guidelines, which is likely what much of the public commentary concerning the new rules will encompass.  Depending on the government’s ultimate decisions, the rule on EDA restrictions can be narrow or broad, with key EDA design firms such as Synopsys (SNPS) and Cadence (CDNS) generating 16.8% and 13.2% of revenue from sales to China in the most recent quarter, the most focused on the change, although the specifics as to GAA design revenue regional sales are not specified.

We are very used to cyclicality as a way of life for products in the CE space and watch that cyclicality to indicate when product or component pricing begins to change momentum or direction to better understand the coming months, quarters, or years.  Semiconductors however seem to be less cyclical, with grow across the industry driving sales and device growth rather consistently over the last few years, and while consumers have been in an unusual environment since 2020 regarding the lifestyle changes that COVID-19 has forced on us, despite the continued spread of the virus, the world seems to be getting back to what might be considered a more ‘normal’ mode, albeit with a few leftover lifestyle anomalies. 
 
We have seen demand, artificially induced or otherwise, rise and fall for many CE product categories, over the last 2 1/2 years, with much of that reflected in pricing, but given the very specific capacity issues facing semiconductors, plus the expense and time it takes to add capacity, semiconductor sales have been growing steadily through much of the pandemic, as seen in Figure 1 and Figure 2, although in the most recent quarters, unit volumes have been decreasing from their peak last year as sales and ASP have flattened.  Based on expectations developed by WSTS (World Semiconductor Trade Statistics), a non-profit forecasting agency for the industry, 2H ‘2022 will grow another 15.1% y/y, pushing full year growth to 16.7%, down from last year’s 25.7%, but still a very strong year.
 
What might cause some concern is that the WSTS prediction for 2023 calls for y/y growth of 5.1%, the slowest growth since the pandemic began, and while this is still substantial growth for an industry that has grown rapidly during the last two years, we would assume that pricing will be more difficult to maintain in an environment where sales and unit growth have leveled off and will likely be more influenced by seasonal patterns than during the last two years, with ASPs a bit more volatile.  Our concern now is that expectations for the 2nd half of this year are a bit more optimistic than the overall global economy might be able to support, and if 2H results are weaker than expected, forecasts for 2023 will be lowered with the potential to slow capacity expansion projects.  Under such a scenario fab capacity estimate for 2024 – 2025 would likely be reduced, but we see such changes as positives for the semi space, given the potential for over-capacity in 2024 and beyond.  In the CE space it is a bit easier to see the trends as the industry is rarely capacity constrained for extended periods but the semi market seems to have become bifurcated once again, with certain products remaining in short supply while others see weakening demand, making it more difficult to spot macro trends, but we take what we can from the data thus far and look toward 3Q to better understand how weak CE demand will affect the semiconductor supply chain.
 

​As the US passes the CHIPS Act, the former head of the country’s “Big Fund” which funded a number of China’[s major semiconductor companies,  has been remanded to authorities and is under investigation.  This follows a similar investigation of a former executive of Sino-lc Capital, the manager of the “Big Fund” on July 15.  The big fund’s first investment round, which closed in 2018 was valued at RMB 138.7b ($20.57b US in today’s dollars) with 84% of funds going toward chip design and manufacturing, which included funding SMIC (688981.CH), YMTC (state), and UNISOC (state), and continues to sup[port China’s semiconductor industry today.
The Big Fund, aka The National Integrated Circuit Industry Investment Fund was created by the Chinese Ministry of Finance and China Development Bank Capital (state) in 2014, with major shareholders including China National Tobacco Corp (state), China Mobile (941.HK), and China Electronics Technology Group (state), also known as CEC, with both being on the US entities list due to connections to the Chinese military.  The fund has over 74 direct holdings and over 2,700 indirect holdings, with over 200 being outside of China, and uses its resources to make investments that furthers the goals of the Chinese government.  The funds from the first round were used by the end of 2018 and a 2nd round raising RMB 200b ($29.7b US) was completed in 2019.
In both investigations there was no mention of the reason for the inquiry, although mention of ‘serious violations of laws’ was referenced in statements made by the Central Commission for Discipline Inspection, and since the 2nd round there have been a number of visible and large failures in the Chinese semiconductor space, with HSMC (Wuhan Hongxin Semiconductor Manufacturing) being the most obvious.  The company was valued at $18.5b as a start-up and was to build out a 14nm line followed by a 7nm line but closed last year before producing any silicon.  The company ran out of money due to poor planning and was unable to raise capital after being accused of promoting technology it could not produce.  Whether the investigations are related to the HSMC debacle or some other issue remains to be seen.

​Samsung Electronics’ (005930.KS) S2 semiconductor fab in Austin, Texas and its sister fab in Taylor (under construction) could have other siblings as Samsung has submitted paperwork for 11 potential semiconductor fabs that it could build in Texas over the next two decades.  The paperwork, which is required when applying for tax subsidies, noted the potential for a total of $192b in spending  for the 11 fabs, which would cost between $12b and $23b and provide ~900 jobs each, although the Austin fab employs ~10,000 total.  Samsung indicated that it had no specific construction plans for these potential fabs and is spending $17b on the Taylor project, but indicated a target of 2034 and extending out until 2042 for the last two projects. 
The tax breaks on the real estate are estimated to be as high as $4.8b and usually last for 10 years.  As the US Chips Act winds its way through Congress it would seem an appropriate time to allude to a desire to build semiconductor capacity in the US, although these plans do not commit Samsung to anything more than the Taylor project, but it certainly won’t hurt to see if it stirs up some excitement from other potential fab locations in and outside of the US.  Samsung has two fabs in China and three in South Korea but none in Europe.

​The US Senate will begin voting on legislation that is expected to boost the country’s semiconductor efforts in light of the global silicon shortages that have been causing supply disruptions and price increases over the last year or so.  The original bill, the “CHIPS for America Act (S.3933) contains a number of incentives to expand the country’s standing in the world semiconductor market, particularly in semiconductor production and metrology.  While the final form of the bill might differ after last minute negotiations and partisan politics, we summarize the bill below:

• Credits of 40% of the value of equipment placed in service before 2025 with the credit decreasing by 10% each year until the end of 2025 after which it disappears.  This includes any equipment, new construction, acquisition of equipment or upgrades that would incur depreciation or amortization including leases and lease extensions or renewals.
• Any property approved will receive a reduction in basis although new construction must be completed within 5 years.
• No credits or basis change will be issued for any equipment or items used outside of the US or in any way connected with the governments of China, Russia, Iran or North Korea.
• $10m/year will be allocated to advanced metrology for 3nm or above
• $10m/year will be allocated to metrology for security and supply chain verification (assumedly verifying imports and fakes)
• $30m/year will be allocated to developing a ‘manufacturing institute’ that will focus on research in virtualization and automation, advanced test, assembly, and packaging, and educational skills
• Various other ‘institutes’ will be developed and funded to foster ‘leadership’ in semiconductor R&D and packaging
• $50m/year will be allocated out of the DOD budget for R&D and development specifically for the semiconductor sector
• Innumerable studies, reports, and addresses to Congress, and the usual political ballyhoo will become part of the program’s oversight

Hopefully the $52b bill does not get watered down much further and if passed, does not get mired down in red tape when it comes to actual cash allocations, but at least it is a step in the right direction and one of the few that seems to have bi-partisan support, although with only 21 days left before the Senate summer holiday, much still needs to be done to make this a reality and considerable lobbying from special interests is still in play.  While the bill is certainly not perfect and we can already see dollars being spent for reports that only serve to justify the politics behind the bill, passing it before September would certainly be a plus and would give the US semiconductor space a longer-term boost toward regaining both manufacturing prowess and keeping semiconductor development ahead of the global competition.  Our focus is less on China and the like and more on Taiwan, South Korea and Japan where well established players can exert considerable semiconductor supply chain pressure and can maintain sometimes singular control over materials and equipment.  Perhaps by spending highly directed capital on the industry we can develop processes and technology that the US can utilize and/or lease to others under more favorable arrangements, but before any of that can happen, Congress has to actually pass the bill and allocate the funds.  They do work for us, right?
 

​On July 8 bad weather in Hiroshima, Japan caused a power outage at Micron’s (MU)  Fab 15 DRAM plant that lasted between 5 and 10 minutes, and while backup generators were triggered, a portion of the production tools had to be restarted and recalibrated.  Fab 15 accounts for ~30% of Micron’s monthly wafer starts and ~7% of the global total and is focused on smartphone DRAM and R&D.  This happened roughly a week after Renasas (6723.JP) was forced to shut down its Kawasaki fab for a week after a lightning strike that hit a power line outside of the plant.
Micron cautioned that the shutdown will have some effect on quarterly results but was still assessing the damage to wafers that were on the line during the outage, but the impact on the overall DRAM market is expected to be minimal as inventory levels are high and the industry is facing continued oversupply.  Given that Micron will be working at low production levels and will likely have to scrap partially produced wafers, the resulting production losses will likely work toward bringing down inventory levels, but not enough to make an impact on pricing, other than in the spot market, with expectations for a ~10% price reduction for DRAM in 3Q remaining intact..

​Against rising raw material prices and a weak yen, Japanese semiconductor material companies have already been raising prices this year, but it looks as if that trend will continue as Showa Denko (4004.JP) has indicated that it will have to raise prices for a number of materials used in the semiconductor process (etchants) as the company, along with others, struggles to find a way to convince customers to carry more of the burden of higher raw material and transportation costs.   While convincing customers such as Taiwan Semiconductor (TSM) that it will benefit them in the long run to pay the higher prices is a difficult task, the inability to pass through those increases will cause Showa and others to abandon a number of less profitable materials and cancel contracts with smaller customers, further extending the inflationary spiral the CE space finds itself in currently.
Wafer supplier Sumco (3436.JP) will raise prices on long-term contracts while it increases capacity over the next two years, and Sumitomo Bakelite (4203.JP), a major producer of packaging encapsulants and Shin-Etsu Polymer (7970.JP), a producer of wafer transport containers have also raised prices, and we have noted that the war in Ukraine has limited the supply of neon gas a necessary component of photolithography tools and caused significant price increases.  At this point, it seems that semiconductor foundries are still willing to accept higher prices in order to ensure they have the necessary materials, but we expect as global electronics demand slows there will be a point where there will be some resistance to continued price hikes.  With weak demand continuing through the 2nd half, we expect Japanese material suppliers to institute those price hikes in the near-term or miss their opportunity if foundry demand slows in 2H as we expect it will be increasingly difficult to convince semiconductor manufacturers that such price hikes are appropriate and will benefit customer over the long term, as Showa employees have been instructed to do. 

​This week Samsung’s (005930.KS) Vice-Chairman and empire heir Lee Jae-yong visited with Peter Wennink, the CEO of ASML (ASML) in the Netherlands to discuss the future of semiconductor technology, market prospects, and the supply of EUV equipment, according to tech press, but it is also said that the trip had another purpose and that was to secure the purchase of an extra EUV tool, above the orders originally set for this year.  With ASML as the only supplier of the EUV tools needed for semiconductor production at or below 7nm, Samsung’s ability to grow its chip business in order to catch up to leader Taiwan Semiconductor (TSM), is dependent on ASML, who has scheduled 51 such tools to be built this year. 
Currently Samsung has been scheduled to receive 18 such tools while TSM is to receive 22, leaving 11 for other customers, so the trip from Korea to the Netherlands is said to also have been made to secure another EUV tool from ASML to help Samsung grow a bit more than originally planned.  Samsung purchased a 3% stake in ASML in 2012 for $280.8m, which is worth ~$3.4b today, but Intel (INTC) and TSM also own stakes in the company (15% and 5% respectively), so being a stakeholder in ASML likely had little influence.  That said, a visit from the heir to the Samsung fortune and the company’s 2nd largest customer does hold some sway.  Whether it was enough to grab another $150m tool remains to be seen, but we expect it was more whether ASML can up the total number of units it produces this year, as we expect all of the other 11 units to be produced were already on order from other customers.

Semiconductor prices have been rising as capacity constrained fabs are forced to allocate resources to high volume profitable customers, but as inflation dampens demand, the question is whether the industry will continue to have the bargaining power to continue to increase chip prices for the remainder of the year and into 2023.  Throughout the development of the global semiconductor industry, the majority of material suppliers have been able to maintain a stable supply chain and reasonable profitability, but the global macro-economic situation in which we currently live continues to spread higher cost and disruptions in areas that rarely see market perturbations, and those ‘pockets of problems’ are and will likely continue to be a thorn in the side of the semiconductor industry.
Semiconductor material suppliers seem to all be in agreement that the industry has become so interrelated that almost no one is immune to being affected by bottlenecks or escalating costs. A simple illustration (Figure 3)  given by a chemical company executive illustrates how the price of crude oil, which has risen by more than 70% since last June, affects the production of EIPA (Electronic-grade Isopropyl Alcohol), which is used to clean wafers and tools during the semiconductor production process.  Aside from the increased cost of crude, the increased cost of processes that require heat (gas), and the cost of transportation, is the cost of building a new plant to add purification processing, which is now at least 20% to 30% than it was one or two years ago, according to the company representative.
Considering that there are hundreds of gases, liquids, and metals used in the manufacture of semiconductors, the cost of refining these materials, many of whom have only a few sources, continues to rise with energy prices and have increased far beyond what might be considered ‘normal’, and all of those costs make it more expensive to produce semiconductors, in addition to the cost of more expensive single digit node tools, and while semiconductor manufacturers have been enjoying the ability to run fabs at full or near full capacity, even with the price increases seen thus far, the tentacles of material cost price increases continue to take hold of almost every aspect of semiconductor production, which will impact fab margins unless they are able to pass on those increases, which will become increasingly difficult as demand slows.
All in, it is logical to expect semiconductor producers to see lower margins going forward as the vast chain of materials necessary for chip production continue to see higher prices, but we expect that demand will weaken enough by the beginning of 2023 that material prices will stabilize, which will begin to depressurize semiconductor pricing in 1Q ’23.  While COVID-19 and China’s strict policies toward the virus are still a factor to a degree, we see the war in Ukraine as the biggest risk factor to a more stabilized semiconductor material market in 1Q ’23.  If that conflict continues or escalates, any price stability could be pushed out and 1H 2023 will see more of what we have seen in recent months or an even greater reduction in demand, a prospect that will make it even harder for semiconductor fabs to raise prices to meet higher costs, a prospect we would see as quite disastrous to the industry.  More likely the scenario will far somewhere in between, but even that prospect still carries considerable risk.