McKinsey: A review of global semiconductor economic profits over the past 20 years: the strong get stronger

On October 15, McKinsey conducted a macro analysis of the overall economic situation of global semiconductor companies and traced the performance of the semiconductor industry over the past two decades, examining 11 market segments and three key global regions.

The article believes that the global epidemic has greatly promoted the application and expansion of digital technology, and electronic devices have become essential for remote work and education during the epidemic. As demand from consumers and corporate customers soared last year, shareholders of semiconductor companies generally received high double-digit returns despite supply chain problems and increasing differentiation in global trade. As chip manufacturers rushed to gain scale advantages and demand surged, industry consolidation exacerbated the chip shortage crisis.

The article points out that the post-epidemic world may continue to accelerate digitalization, and semiconductor companies may benefit from developing strategies to cope with changes in the competitive landscape. In order to understand the value creation trends in the industry, the results show that semiconductor companies generally hope to focus on gaining leadership in profitable areas through mergers and acquisitions and partnerships, building supply chain resilience, and pursuing new technologies and innovations. Rapid investment in self-driving cars, the Internet of Things, and artificial intelligence, as well as the upcoming shift to 5G connectivity standards, provide opportunities for further growth and specialization.

The semiconductor industry has gone through two distinct phases since the 21st century. At the beginning of the century, the industry had low profit margins, with most companies earning returns below their cost of capital. However, profitability has improved over the past decade, driven by soaring demand for microchips across most industries, rapid growth in the technology sector, increased cloud usage, and continued consolidation in many sub-sectors.

One result is that the semiconductor industry’s profit pool (defined by overall economic profitability) has improved significantly relative to other industries (see chart below).

2000-2004 and 2016-2020 are two completely different time periods for the semiconductor industry

The industry economic profit margin curve, covering approximately 2,600 top companies in 24 industries worldwide, has changed significantly over the past 20 years, with semiconductors rising from 14th place between 2000 and 2004 to fourth place between 2016 and 2020.

The total annual economic output of chip manufacturers was $3.5 billion in total profit in the first phase, which increased significantly to $49.3 billion in the second phase. Average profitability peaked in 2017 and 2018, but pricing pressure on memory chips led to a sharp decline in 2019, and profitability rebounded in late 2020. In the long run, the semiconductor industry's relative ranking relative to other industries is expected to continue to improve and reach third place. (Note: McKinsey used current market capitalization to calculate the market-implied long-term economic profit of each industry.)

While economic profits in the semiconductor industry have grown substantially, they vary widely across companies and industry segments as the value pool has shifted over time and the most powerful players have increased their lead over competitors. Over the past five years, the industry power curve has steepened dramatically at the top: from 2015 to 2019, the top quintile of companies captured the majority of economic profits (see figure below).

The top fifth of semiconductor companies have captured the majority of economic profits over the past two decades.

The gap between leaders and laggards is widening as the most powerful players leverage their scale and diversified customer base to consolidate their dominance. The profit differential between the top 10% of companies and the remaining 90% was about 140% between 2000 and 2004, but widened to a staggering 400% between 2015 and 2019.

In terms of company performance, Intel captured almost all of the economic profits in the early 2000s. When looking at product categories, analysis shows that five segments produced the most value in the industry: memory, microprocessor units (MPUs), fabless, upstream equipment plants, and foundries. From 2015 to 2019, these five categories of companies accounted for more than 60% of the industry's cumulative economic profits of $335 billion (see the figure below).

Memory makers benefited from surging demand for electronic devices and rising prices, though oversupply and falling prices reduced returns in 2018. Fabless was second only to storage during the period, with Apple estimated to have earned about a quarter of total economic profits in the category.

The trends driving these profit models for semiconductor companies around the world are likely to continue. The industry continues to move toward a fabless production model as companies seek to take advantage of leading-edge technology while amortizing the necessary investments. Apple's M1 chip (used in laptops, low-end desktops, Mac Minis, and tablets) embodies this shift toward in-house chip design, which leverages foundries to manufacture products. Even companies with well-established in-house manufacturing facilities, such as Intel, are considering outsourcing some to chip foundries to benefit from greater production flexibility and cost reductions.

The distribution of economic profits in the semiconductor industry also varies by region (see figure below).

North America, home to some of the largest fabless players (such as Apple, Nvidia, and Qualcomm), accounted for about 60% of the global value pool during 2015-19. Europe accounted for 4% of the industry's total economic profits, mainly captured by upstream equipment companies. Asia remains the center of chip manufacturing, accounting for the remaining 36% of the value created in the industry.

From the end of 2015 to the end of 2019, the total return (TRS) to shareholders of semiconductor companies averaged 25% per year (see the figure below). Last year, as consumers and businesses increased demand for various digital devices, shareholders of semiconductor companies received higher returns, averaging 50% per year, and this trend is expected to continue.

To meet investors' expectations of continued high growth amid a changing industry landscape, chipmakers can draw inspiration from leading companies in the industry and the strategies they follow to generate the majority of the industry's economic profits. Ensuring leadership in profitable areas has always been a key measure of their success. Leading companies have further expanded their leadership through continued capital investment or research and development. It is worth noting that recent history has shown that it is difficult for semiconductor companies to catch up with their leading competitors in technology fields with clear boundaries. In summary, there are three ways semiconductor companies can expand in the "post-epidemic era."

Collaborate across the value chain to expand customer base

The industry is increasingly demanding solutions for specific applications, such as those embedded in ADAS by automakers. Many of these requests have expanded to companies that previously had no experience designing their own integrated circuits. While semiconductor companies must secure their order volumes to justify the rising R&D costs of leading-edge custom chip designs, efforts to tap into the customized needs of customers downstream in the value chain are a way to enter high-growth industry niches.

Develop a programmatic M&A strategy

Amid ongoing industry consolidation, semiconductor companies need to consider developing programmatic M&A strategies, such as small acquisitions targeting specific markets, aimed at expanding into adjacent areas or adding capabilities that are critical to future growth. Chipmakers may also consider major deals that open up markets. For example, Nvidia's acquisition of Arm, if approved, would enable Nvidia to enter a wider market.

Keeping markets alert for a more volatile world

The semiconductor supply chain is undergoing major changes. As global trade diversifies, especially for cutting-edge technologies, semiconductor companies can gain advantages by increasing the resilience of their supply chains. Several large chipmakers are already exploring diversifying production so that they can rely on multiple suppliers. These moves are motivated in part by new government subsidies designed to support the ability to manufacture advanced chips.

Strengthen pricing and allocation strategies to address supply shortages

Especially in the automotive and industrial sectors, chip shortages may become the new normal, so semiconductor companies will benefit from carefully considering strategies for allocating inventory and fair pricing. These companies can also explore the potential of inviting customers to co-invest in the development of customized chips, which will help buyers reduce the risk of supply shortages while ensuring manufacturers have real demand for new designs. Chipmakers can also work with the broader industry to explore ways to address ongoing shortages. Chipmakers can work with equipment manufacturers to apply advanced analytics to accelerate the yield improvement process. For example, modeling enabled by advanced combinatorial learning can replace physical testing of chips, thereby reducing the cost and time to market of introducing them.

Pushing the limits of Moore's Law

Innovations in line with Moore’s Law will certainly continue, and further advances in system-on-chip architectures using chiplets are likely. Manufacturers can also explore innovations beyond Moore’s Law, such as new substrate materials such as silicon carbide and gallium nitride.

After a period of rapid growth, semiconductor leaders should prepare for a new world of increasingly challenging supply-demand matching, geopolitical issues, and new requirements for specialized products. To meet shareholder expectations for continued high returns, semiconductor companies can expand partnerships and look for industry-wide solutions to product shortages.