In Semiconductors, China Is In

Commodity Hell (Part 4)

George Calhoun 08:24am EDT

Markets

Quantitative Finance Program Director, at Stevens Inst. of Technology

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The idea that there is – or will be, any time soon – a serious Chinese threat to
American technological leadership in semiconductors is an illusion.

Why then is there so much alarmism on this subject?

A lot of it is due to the fact that so many analyses don’t use the right
framework to understand competitive positioning.

The Market Share Fallacy

Comparisons of national strengths and weaknesses in a vital technology
industry like semiconductors often focus on “market share” as the primary
indicator of a country’s relative position. For example, the Semiconductor
Industry Association published the following figures in its 2021 Factbook:

Putative Market Share by Country in the [+]

Chart by author
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 But this chart is essentially meaningless, because the category – the
“Semiconductor Industry” – is incoherent (as described in a previous
column). The chip industry is divided into a number of qualitatively different
segments, with very different business models and cost structures – and very
different potential for creating and capturing economic value and
geopolitical power. Bundling them into a single market share calculation
obscures a great deal.

But it’s worse. The chart is in fact doubly meaningless. “Market share” itself is
a meaningless concept here, if used without qualification.

Raw share, unqualified, is a concept that applies properly only to commodity

products, like gasoline, or avocados. For highly differentiated industries like
semiconductors, a quantitative statement about a company’s (or a country’s)
market share must be supplemented by an assessment of the quality of the
company’s (or country’s) share.

How is quality of share to be assessed?

Value-Creation & Market Share

Segmenting helps. The quality, and value, of so-and-so-many percentage
points of market share depends first of all on which market we are talking
about.

Value-Added by Segment of the Semiconductor [+]

Chart by author

Design is clearly a stronger value-driver than, say, Packaging. In turn, value-

added for customers translates to value for shareholders (and other
stakeholders).

P/S Ratios for Different Semiconductor Industry [+]

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 Chart by author

Market share, then, is about sales dollars: How much of the industry’s total
sales does a company (or a country) capture? The best link to value is the
Price/Sales ratio, which translates revenue share into market capitalization.
Each additional market share-point in the Design segment creates almost $12
of market capitalization per share of common stock for companies in that
segment. Each share-point in the Packaging segment adds just $1 of market
value per share of common stock. Which market share points are higher
quality? Which business would you rather own?

But we have to peel down another layer to really see what is going on. If we
examine share as a function of product type, the picture becomes clearer. Let’s
look at a high-value product (processors), a commoditized product (memory
chips), and a mid-value service (contract manufacturing, or foundry
services).

Processors
The Design segment is made up of the fabless IC leaders like Qualcomm and
Nvidia, along with Integrated Device Manufacturers (IDM’s) like Intel, as well
as dozens of smaller less-well-known suppliers, many of them scattered
across East Asia. The top-level view of this segment is somewhat comforting,
but not decisively so. American firms have somewhat less than half the total
market share in the overall Design segment.

But in the most advanced processor categories – high-end CPUs (general

purpose processors), GPUs (graphic processing units), and FPGA’s (field
programmable gate arrays) – the U.S. share is nearly 100%.

China has less than a 1% share in these high-value product segments.

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 [The statistics here are drawn from an excellent report “The Semiconductor
Supply Chain: Assessing National Competitiveness,” published in January 2021 by
the Center for Security and Emerging Technology – CSET - at Georgetown
University.]

But for China, it’s really even worse. It is not just the small size of China’s
market share. The quality of China’s share is also low. In the CPU product
segment –

“Chinese CPUs have few civilian customers, reflecting their lack of

competitiveness on the open market. China’s large businesses depend
on imports for 95 percent of the CPUs they consume. The country
remains especially weak on CPUs with the x86 architecture.”

And in the GPU segment – seen as especially important for emerging

artificial intelligence and machine learning technologies – the picture is
bleak

“The United States monopolizes the design market for GPUs. Two U.S.
firms, Nvidia and AMD, dominate the market. Intel is also developing a
discrete GPU. China’s only significant GPU firm is Jingjia Micro, selling
largely to military customers. However, its sales totaled only $36 million
in 2019, and its GPUs are produced at the substandard 28 nm node.”

To put this in perspective, Jinjia’s $36 million in revenue from the PLA
compares to Nvidia’s $22 billion from the global market.

Memory
In the market for memory chips, a more commoditized product category,
with far fewer technological barriers to entry than the CPU and GPU
segments, the U.S share is much lower – 22% in DRAM and 37% in NAND
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 (flash) memory which comprise about 98% of the memory chip market. Asian
producers are generally more successful.

One might expect to find a stronger Chinese presence.

“Memory chips are more commoditized and easier to produce than logic
chips, and producers mostly compete on price—a strategy at which
Chinese firms excel.”

But China’s share in this low-barrier-to-entry market is minimal.

“South Korea, the United States, and Taiwan control the market for
DRAM design, while South Korea, the United States, and Japan do for
NAND flash memory. China is attempting to produce DRAM and
NAND chips [but] Chinese firms currently account for only a small
amount of memory chip production.”

Fabrication
In the foundry segment, the picture is the same. China is said to have a 7-9%
market share, which might be seen as a foothold. In fact, it is a case study in
low-quality market share.

“Although China’s shares look strong, much of that capacity is

aspirational (suffering from low yields and utilization) and at older
nodes. Many of these fabs stay online with the help of state support,
receiving subsidies far greater as a percentage of revenue than any
leading fabs.”

The Chronic Low-Quality of China’s Market Share

In Semiconductors
:
 These vignettes demonstrate the importance of market share Quantity vs
Quality. The indicia of China’s low market-share-quality mentioned in the
CSET report include:

dependence on government subsidies

inability to win commercial customers in open competition
out-dated technology
poor operational metrics, low yields, and low capacity utilization, which
undermine profitability

Profitability vs Market Share

Simple profitability – is another lens through which to scrutinize the relative
competitiveness of different segments and different countries.

In practice, market share is often a misleading indicator, even when

categories are correctly configured. What really matters in business – the
source of value, the source of market power, the basis of technological
leadership – is profitability.

Market share and profit are often only loosely correlated. Sometimes not at
all.

A great example: Apple AAPL -1.8% has a 13% market share (of unit shipped)
in the smartphone market – but they make 75% of the industry profits. This
is the most recent profit-share figure, which is down slightly. In the past,
Apple has typically captured 80-90% of the industry profit-share, and even, at
least once, in Q3 2016, “Apple actually grabbed 103.6% of operating profits
for the smartphone industry.” Everyone else lost money. Apple’s market
share in that particular quarter actually fell – to 12%.

For Apple, the profit-share/market-share ratio ranges from 5 to 9. For

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 everyone else in the smartphone business, it may be nearer to 1, or less.

Profit-share figures are hard to calculate for an industry as complex as

semiconductors. Many of the companies are private and do not report
according to a consistent format, if at all. But here’s one small indication: in
the smartphone chipset business, Mediatek (Taiwanese) and Qualcomm are
the leaders. In 2020, they each had about the same market share (26% and
28% respectively). But Qualcomm made three times as much profit as
Mediatek.

Another reasonable proxy for quality of profit share is the gross profit
margin. Companies with high gross margins have more strategic latitude,
more freedom - more “market power” – and are generally more highly
valued.

In semiconductors, there is a big difference in average gross margins across

the industry segments.

Gross Profit Margins By Semiconductor Industry [+]

Chart by Author

The profit-per-market-share-point of the Packaging segment (where China

has its strongest – albeit not that strong – foothold today) is just half that of
the Foundry segment, and only one third of the profit-per-market-share-point
of the Design segment.

In the chart, I added the so-called “leading Chinese semiconductor company”

– SMIC is principally , which is a foundry, and perhaps an aspirational
IDM. SMIC’s gross margin is about 20%, terrible for a high-tech company,
and close to that of the highly commoditized chip-packaging segment.
(Foundry-leader TSMC has a gross margin of nearly 50%. IDM leader Intel’s
gross margin is 58%.)
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 All indications are that Chinese firms achieve much lower profitability than
international rivals, so that even the meager market share positions they
enjoy are of lower quality.

Commodity Hell
Some segments of the chip business seem to chronically skate along the edge
of “Commodity Hell” (as GE’s former CEO Jack Welch called it). This is the
desolate economic zone in the market where profits are low, competition is all
about price, and “strategy” is all about cost. Technology is no longer
important as a competitive asset. Products are undifferentiated. Customers
gain the upper hand over suppliers. Stock values tumble. Whole industry
sectors become unattractive. A company that falls into Commodity Hell faces
a grim prospect. Management should do everything it can to stay out of the
pit.

Intel provides a classic story about this challenge. The company started out in
the memory business. They invented DRAM technology, and for a while it
was cutting-edge tech, “new” and exciting and highly profitable. But it was
not a market they could hang onto as low-cost competition from the Far East
developed. Japanese and Korean producers were happy to “buy” market share
points at any price, even if they lost money (sometimes called “dumping”),
and to stay with it even as the business became fully commoditized, and
profitability more or less evaporated. At some point, Intel had to confront the
“memory business crisis,” as recounted by former CEO Andy Grove in his
classic business memoir Only The Paranoid Survive. Grove called it a strategic
inflection point. It prompted the company’s turn to the non-commoditized
product category of microprocessors. Intel became Intel, as we know them
today. They escaped Commodity Hell.

The story of Intel’s retreat from the memory chip business makes clear the
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 extremity of China’s backwardness in the chip industry today. Memory chips
are the most commoditized product segment in semiconductors – the easiest
segment of the business to enter – yet China can’t manage to get a meaningful
foothold, even there. The memory-chip market (DRAM and NAND) is
dominated by others.

So China really doesn’t have to think about how to get out of Commodity Hell
in semiconductors. They can’t even get into it.

Follow me on Twitter or LinkedIn.

My first career: I spent 25 years in the high-tech segment of the wireless

technology industry, involved in the early development and
commercialization of digital

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