The Semiconductor Shortage is Delaying Automotive Sector Recovery – Here’s Why.

The global economy has faced numerous COVID-induced supply shocks over the past year, leading to strained supply chains across the world. This phenomenon is most prevalent in the semiconductor industry, which is currently contending with chip shortages induced by historically high levels of demand. Since semiconductors are heavily used in electronic circuits, they’re required in the manufacturing of a wide variety of final products. As a result, the current chip shortage is negatively impacting various industries, causing production cuts and reducing the availability of goods for consumers. Although the shortage is cutting into margins for many industries, the automotive sector is among the hardest hit, plunging its post-COVID recovery into peril. 

Similar to the rest of the corporate world, semiconductor manufacturing facilities shut down in March 2020 due to the emergence of COVID-19. Society came to a standstill, and global demand for products plummeted. These facilities started coming back to life over the next few months, just as work from home (WFH) and learn from home (LFH) became the norm. This fueled a tremendous spike in demand for personal electronics, with smartphone and PC sales skyrocketing. However, supply constraints in the semiconductor industry were already creeping in. The large scale of semiconductor manufacturing facilities results in high costs to start and stop production, and a substantial amount of time required to ramp up production capabilities from a halt to full capacity. Consequently, the industry struggled to fully meet the high demand for personal electronics; this trend has continued over the past year as governments have poured money into consumers’ bank accounts and economies have slowly reopened, leading to demand rising at historic rates, and outpacing capacity. This shortage was exacerbated by the US Midwest freeze in February 2021 and the recent Suez Canal blockage, which brought global supply chains to a screeching halt. Cumulatively, average semiconductor lead times have risen to all-time highs of 15 weeks, with the largest semiconductor manufacturer in the world, the Taiwan Semiconductor Manufacturing Company (TSMC), reporting lead times of 6 months.

The automotive industry failed to anticipate the economy’s V-shaped recovery and had cut its semiconductor orders at the beginning of the pandemic. Thus, as demand bounced back, automotive firms were forced to place new orders, putting them at the back of the line. Furthermore, since personal electronics demand is still extremely high, semiconductor producers are disincentivized from prioritizing automotive chips. This is because automobiles use legacy chips with low margins for semiconductor producers in contrast to the newer, high-margin chips that personal electronics use. In addition, the process of shifting production lines to accommodate auto chips is an expensive and lengthy process that further disincentivizes semiconductor firms from doing so. These factors have severely strained the automotive supply chain, causing car producers to cut production once again, and dealerships to raise prices on the extremely limited supply of vehicles they have on hand.

 These shortages have wide-reaching implications. They're welcomed by players in the semiconductor industry as they help increase their pricing power, with firms from varying industries bidding up chip prices to gain preferential access to supply. This helps increase chipmakers' operating leverage and profitability and has led to equity analysts expecting extremely strong results for the first quarter of this year. However, although this situation is expected to persist for the majority of 2021, thus helping to create and maintain record profits, chip stocks may not be the best place to be. The semiconductor industry is cyclical, with profits rising at a strong pace when demand outpaces capacity; however, this cycle reverses as chipmakers increase capacity to meet demand. Since it takes a substantial amount of time to onboard new capacity, semiconductor firms' ability to service higher demand typically arrives as demand wanes, with profits struggling thereafter. The industry is currently at its peak and this is accurately reflected in chipmakers' all-time high stock prices, as the Philadelphia Semiconductor Index is up double digits for the year. Firms’ efforts to increase capacity will start to materialize soon and with it pricing power will decline, posing risks for semiconductor stock prices. On the other hand, automakers’ and auto suppliers’ recovery will be severely delayed. Automakers across the globe have cut production guidance for 2021 while shutting down manufacturing plants, and are expected to miss out on USD $61 billion in sales in the first quarter of 2021 alone. With chipmakers leveraging their strong position to hike prices and automakers’ volume being limited, automotive companies’ margins are set to take a hit. As a result, automakers’ sales will outpace production this year and their recovery will have to wait until 2022 when new capacity materializes. However, this recovery may not be strong enough. After bleeding inventories for the majority of 2020 and 2021, automotive firms will have to invest heavily in their working capital as they are forced to build back their inventories, as well as their dealerships’ inventories. This will result in a significant cash burn and limit the upside on their stocks. 

In addition to the industry-specific financial impacts of the current chip shortage, the recovery of the automotive industry also influences the future of the global economy. With automakers being such important contributors to national economies, state governors, President Biden, and the leaders of many European countries have attempted to rectify chip shortages to no avail. Such efforts are placing additional focus on domestic reliance on foreign production. The American share of global semiconductor fabrication is down to about 12% from 37% in 1990, with the majority of current semiconductor manufacturing occurring within a few concentrated players in Asia. In fact, this industry is largely oligopolistic, with TSMC accounting for ~70% of global auto microcontroller production. With COVID-19 showing Western countries the pitfalls of relying on Asian production for critical supplies, Western manufacturers now realize that outsourcing chip production can be a dangerous strategy. Resultantly, American and European governments are pushing to backsource production domestically and are set to offer substantial subsidies to semiconductor firms to do so. This is in line with Western governments’ current efforts to concentrate supply chains within domestic confines, and it threatens to slow the economic growth and development of Asian countries.

Chip demand is currently near all-time highs across a variety of sectors and is outpacing semiconductor manufacturing capacity, thus creating chip shortages. The automotive industry is worst hit by this phenomenon due to their decision to cut orders at the beginning of the pandemic, and the relatively low-margin chips they use when compared to semiconductor firms’ other customers. This situation has led to skyrocketing chipmaker stocks as they near the peak of the semiconductor cycle, posing risks for further gains. It is also set to lower automakers’ margins and sets them up for a cash burn in 2022, limiting the upside in their stocks as well. The effects of this situation are not limited to the financial world, as the Western world is waking up to the pitfalls of offshoring, and is looking to bring manufacturing back home, creating real risks for the future of the Asian economy.