We’re living in a time of immense structural change. For investors, the internet-led waning of established brand names and bricks-and-mortar distribution networks and the loss in value of existing manufacturing plant and equipment as new factories spring up in developing countries are among the most important.
One exception to this trend has been in semiconductor production. There the engineering knowhow required to run the factories is very high and the pace of change has been very swift. In addition, the cost of building a new fab is prohibitive for most: a current-generation plant costs about $3 billion. If a firm wants to fill the plant exclusively with its own chips, that requires annual sales of $7 billion or so. In other words, only INTC and Samsung are big enough and rich enough to afford their own plants and the technological edge that brings. Everyone else has to use third-party contract foundries like TSMC.
INTC currently has maybe a two-year lead over other semiconductor manufacturers in process technology. It can make smaller, faster, less power-hungry chips than anyone else. To preserve this advantage, the company has been making preparations–including funding research by equipment manufacturer ASML–to be the first out of the blocks with plants running new “extreme ultraviolet” technology and processing much larger silicon wafers to boot.
What has come to light very recently, however, is that these new factories are going to be mega-expensive, at $10 billion apiece or more. As things stand now, that makes building one of them a bet-the-company move for anybody, even an industry giant like INTC.
Where to from here?
It’s not 100% clear, to me anyway, but:
–extreme ultraviolet lithography is probably at least a half-decade away, not a 2017 event as previously thought. This means R&D and capital spending will be spread over a much longer period of time. All other things being equal, this will mean higher cash generation by INTC.
–absent a significant cost-reducing breakthrough in EUL, INTC will likely partner with at least one other party to fund a next-generation fab. Partnering could either be with other chipmakers or with one or two large deep-pocketed users of chips. …AAPL? …MSFT?
–it’s conceivable that INTC will itself end up with a substantial foundry business manufacturing chips designed–at least in part–by third parties. One might argue that this would be a come-down for the premiere manufacturer of proprietary microprocessors. However, the best foundry, TSMC, trades at a substantial PE premium to INTC even though its technology is inferior. So morphing into a foundry could easily add a quarter or a third to INTC’s stock price.
To the extent INTC maintains its lead in process technology, they may be able to price their foundry service on a value basis (they may be the only game in town). As you suggest, it is unclear if they will maintain this lead and how this industry evolves, but at INTC’s current valuation, it looks like the possibility of them maintaining their process lead and realizing value-based foundry pricing is free optionality.