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As the COVID-era buying spree of PCs and smartphones enters the first phase of their replacement cycles, are we in the midst of a new demand cycle for tech hardware? Will AI-enabled devices help? If so, how do investors benefit?
These were questions we tried to answer earlier this year, when five of our global equity portfolio managers and analysts visited Taiwan, which from an efficiency perspective is hard to beat: dozens of technology companies clustered in a handful of technology parks.
We met with 25 companies across different technology industries and market capitalizations, and came up with the following key insights.
Replacement cycle comes into focus
Our investable areas in Taiwan actually consist of technology hardware (33.5%) and semiconductors (66.1%), with only a few software or IT services companies.
In technology hardware and semi-finished products, smartphones and Although areas such as automobiles and industry are growing rapidly, personal computers are still the largest end market. Smartphones and PCs are also two of the hottest topics during our travels.
Shipments in both end markets will see double-digit declines in 2022 and 2023, but the outlook is improving. The destocking process has resulted in lower inventories, but demand is turning positive, so we may see more production in 2024. As the supply-demand imbalance begins to shift in favor of companies, they have greater pricing power.
For example, the smartphone industry had unusually high inventory levels in the first and second quarters of 2023, but fell sharply in the fourth quarter of 2023. This resulted in a surge in emergency orders for tech hardware and semi-finished products, followed by component restocking and major inventory adjustments. These adjustments show improved growth across the industry. In addition, we expect smartphone sales growth to rebound, possibly growing 5% in 2024-2025 after falling 10% in 2022-2023.
In the PC field, the market share of our investment targets continues to increase. Every time a new PC model is launched, industry standards change, often resulting in an increase in average selling prices and subsequent growth in these companies’ products.
It should be emphasized that we believe that the current trend is not just a short-term cyclical rise or a temporary restocking phase, as was the case in similar industries in Taiwan a decade ago. Instead, we believe we are observing sustainable long-term tailwinds that will likely benefit the companies in our portfolio.
One of our largest holdings is a Taiwanese multinational semiconductor foundry manufacturing and design company whose core business focuses on personal computers and smartphones. But smaller companies also benefit from this replacement cycle.
For example, one design services company in our portfolio uses advanced packaging capabilities at foundries (semiconductor manufacturing and design companies mentioned above) on behalf of end customers such as Intel (INTC) and Amazon (AMZN). The design services company is a broad AI enabler across the hardware supply chain.
Another, smaller company makes hybrid bonding equipment critical to advanced packaging. It is not based in Taiwan but has shown its supply chain is larger than the island.
When we start discussing artificial intelligence (AI), it’s worth noting that we are in the traditional replacement cycle of smartphones and PCs. But what if these devices became AI-oriented?
When you add artificial intelligence to the traditional hardware upgrade cycle, you may see an increase in demand. Whether this means we’ll get a massive content upgrade on existing smartphones, or we’ll all have two devices, remains to be seen. But either way, this is spending we care about, and people are definitely going to spend more money on new devices or killer apps to increase productivity. There was an excitement there.
Another free ride: artificial intelligence
Artificial intelligence provides a second path to growth for many Taiwanese companies, especially those related to artificial intelligence servers.
For example, 6% of the 2023 revenue of the aforementioned Taiwanese multinational semiconductor company will be related to artificial intelligence. Of course, this is only a small portion, but we believe it has the potential to double or triple in the next few years.
For this company and others like it, the key AI products will be semiconductors designed specifically to support the technology stack in the AI cloud – think Google (GOOG) (GOOGL), OpenAI, Meta (META) and All other companies are building their own proprietary AI operations. These companies need more advanced semiconductors; they need hardware (servers); they need memory for those servers.
In the long term, we believe this software model is poised to reap significant AI-related profits, as a significant portion of each sale is converted into additional revenue and profit.
Microsoft (MSFT) is perhaps the best example. Outlook 365 costs users $10 per month. But Outlook with Copilot (the AI-enabled version) costs $30 per month. Adding AI adds $20 to the cost per user.
Think about how many people use Microsoft and how much more efficient they can be using artificial intelligence. As a result, we believe adoption rates among these software companies will be high, leading to significant revenue and margin growth.
Of course, this won’t happen before acceptance, and we’re still in the early stages – our team calls this the foundation upon which to build. But the company is now building the hardware to enable that growth, which is why we’re so bullish on the hardware supply chain.
Consider artificial intelligence servers. Designed for artificial intelligence workloads, including machine learning and deep learning tasks, these servers are optimized to handle complex operations, large data sets and complex algorithms that require intensive processing power and fast data throughput. This requires specialized hardware. Among those we spoke to during our visit, there is continued optimism about unit growth for AI servers, with everyone expecting unit growth for non-AI servers to be close to flat this year.
Also expected to grow is advanced packaging, which refers to a complex set of semiconductor packaging technologies that go beyond traditional methods to improve the performance, shrink size and enhance functionality of semiconductor wafers. Unlike traditional packaging, which is primarily used to protect a single die and provide connectivity, advanced packaging integrates multiple die into a single package, enabling higher performance and functionality while reducing space and power consumption.
There are significant constraints on the availability of advanced packaging capacity necessary to produce AI chips. This scarcity affects the company’s ability to effectively package AI chips.
In other words, demand for advanced packaging services critical to assembling and finalizing AI wafers exceeds available supply, leading to challenges in meeting the production needs of these high-tech components. This set of necks may impact the timely delivery and expansion of AI technologies in the market.
In the short term, sales are likely to be limited, so the revenue opportunity is unlikely to start in 2024; this is more of a longer-term opportunity.
Impact on investment portfolio
Looking back at our investment strategy that emphasizes understanding market cycles, the gains in Taiwanese technology stocks over the past year have been primarily driven by increases in stock valuations. In 2024, we expect the focus to shift to profitability. Essentially, we focus our investments on advanced drivers, namely technologies and companies that are at the forefront of their fields and that are showing signs of fundamental improvement and anticipated demand recovery in their respective markets.
Editor’s note: Summary highlights for this article were selected by Seeking Alpha editors.
