SWKS - SOXX ETF: China's Ban On Critical Metals Could Backfire

2023-07-11 17:30:07 ET

Summary

• Gallium Nitride compound is used in a subset of the chip industry due to its superior energy efficiency and heat resistance, making it ideal for mobile phone chargers and RF chips.
• China is a leading producer of gallium, and the U.S. relies heavily on the country for imports.
• If a ban on Chinese GaN to the US is imposed, companies like Qorvo and Skyworks could be significantly impacted. Both form part of the iShares Semiconductor ETF's holdings.
• While GaN is difficult to replace in the short term, Silicon Carbide is a potential alternative with companies maintaining large inventories of GaN due to China's earlier Covid restrictions.
• Expect a lot of volatility as this eventful episode in the U.S-China relationship unfolds.

The semiconductor sector does not lack ingredients that can induce volatility in its stocks, with the latest salvo fired by the Chinese authorities by announcing a ban on exports of Gallium and Germanium, two metals used in the production of chips and fiber optics.

Now, since China was the world's largest metal exporter in 2022, the objective of this thesis is to assess the potential impact of such a measure on the U.S. companies that design and manufacture chips. For this purpose, I use the iShares Semiconductor ETF ( SOXX ) which provides a sector view of the chips ecosystem and will specifically focus on Gallium.

GaN's Importance and the Impact of a Ban on SOXX

Most people are aware that semiconductors are made up of silicon, a more readily available material used by most chipmakers today. However, a subset of the chip industry uses Gallium in the form of the Gallium Nitride compound as it has better energy efficiency than silicon by 25% to 30% . There are other advantages as tabled below, which make it possible to produce mobile phone chargers that are more compact while storing more power than their silicon-based equivalents. Other applications include RF (radio frequency) chips for mobile phones, cellular base stations, and satellite communication.

However, unlike industrial applications dedicated to silicon which have a higher installed base and may also be more profitable, those related to GaN require adjustments in the manufacturing process, and one country which has specialized in this field is China. The country is currently responsible for above 80% of gallium production, with other producers located in Japan and South Korea. Other countries include Ukraine, Russia, and Germany.

Now, the U.S. depended on China for 53% of its Gallium imports, as domestic production remains limited. Other figures reveal imports of $5 million of the metal and $220 million of the gallium arsenide compound for 2022.

Consequently, in case the ban goes through in the sense that no Chinese companies obtain licenses to ship the metal to the U.S. after August this year, the companies most likely to take a direct hit include Qorvo (QRVO) and Skyworks (SWKS), according to Piper Sandler's Managing Director Harsh Kumar speaking on CNBC. Now, these two companies form part of SOXX's holdings as pictured below, constituting 2.03% and 1.14% of the ETF's overall weight respectively, as shaded in red.

Looking for confirmation, these two are indeed among the few which dominate the Gallium compound semiconductor market with the list also featuring Wolfspeed ( WOLF ). However, deeper investigation reveals that the latter uses both GaN and SiC (Silicon Carbide) for power-switching and RF semiconductor devices signifying that the impact of the ban may be more mitigated.

Furthermore, according to Mr. Kumar, there should be a partial impact on Marvell Technology ( MVRL ), Analog Devices ( ADI ), Broadcom ( AVGO ), and ON Semiconductor ( ON ) as shaded in orange above.

Adding together those impacted, it amounts to 23.84% of SOXX's overall weight, likely to be impacted in one way or another as a result of a potential ban. Investors will also note that I have added Micron ( MU ) to the list as its memory chips have been branded as security risks by Chinese regulators.

Looking At Inventories and Alternatives

Now, to be realistic, these companies will not see sudden stoppage in their production lines as since the highly restrictive China's Covid policy of 2020-2021, they have kept relatively large stocks of the compound, as evidenced by their quarterly inventory progression over a period of five years as charted below. Thus, according to Reuters, out-of-China stocks could last up to six months.

Singling out Qorvo and Skyworks, their inventories have gone up by 68% and 156% respectively, but, this may not last long in case their customers opt for advanced orders in order to avoid being supply-constrained in the later part of the year.

Now, looking at alternatives, Gallium comes mostly as a byproduct of Zinc and bauxite, and the fact that Chinese companies have supplied it at relatively low prices has discouraged production by developed markets like the U.S.

Furthermore, the CHIPS and Science Act which was signed into law in August 2022 and seeks to incentivize U.S. production of semiconductors does not seem to address vulnerabilities concerning critical metals. This omission could indicate a serious shortcoming for a high degree of reliance on foreign sources for certain raw materials.

Therefore, the metal may be difficult to replace in the short term, but, there is an alternative for GaN in the form of Silicon Carbide whose supply chain is relatively more diversified . However, the use of these two compounds for high-voltage power transistors ultimately depends on the voltage with SiC preferred for above 800 volts applications while it is GaN for those consuming less than 400 volts.

In this respect, Wolfspeed is currently constructing the world's largest SiC crystal growth facility in North Carolina with the first phase to be completed in 2024. This may be the reason why its stock has in fact gained in contrast to Qorvo and Skyworks since the news of the ban hit markets on July 5.

Therefore, given China's overwhelming control of the Gallium supply chain, a full ban on exports to the U.S. would certainly hurt, but beneficiaries that favor domestic production could also emerge. Still, weaponizing critical metals in such a way may be detrimental to China's economy as its post-Covid recovery is sputtering .

Assessing the "Do Nothing" Posture and Some Worst-Case Scenarios

In this context, China exported $23 billion worth of chip-making and industrial metals to the U.S. in 2020. Now, together with Germany, Japan, Australia, and South Korea, the world's largest economy accounted for 28.5% of Chinese exports of the commodity. This means that China's move could backfire in case the U.S. and its allies in turn put embargoes on the import from China and instead source them from other countries.

To further complicate matters, China imports a lot of raw Zinc from countries like Australia, Japan, and others. It also imports bauxite . Now, these two serve as the raw materials for producing Gallium as I mentioned earlier and, given that related supply chains are interlinked and complex, it is difficult to assess who could actually win in case there are tit-for-tats reactions from either side.

Furthermore, this potentially restrictive action by China could also backfire in case the export control measures which are in force and currently cover only GPUs (graphic processing units) produced by Nvidia ( NVDA ) and Advanced Micro Devices ( AMD ) are extended to also include Intel's ( INTC ) CPUs (computing processing units). The same analogy could be applied to restrictions covering advanced chip-manufacturing machines from companies like KLA Corp ( KLAC ), Applied Materials ( AMAT ), and Lam Research ( LRCX ) being extended to other companies like ACM Research ( ACMR ) which specializes in cleaning products, also essential in the semiconductor manufacturing process. Consequently, any broader U.S. restriction could not only reduce revenues for SOXX's holdings but also impact China's semiconductor and tech industries significantly.

Therefore, the above analysis of possible actions involving a U.S. retaliation through the metals or chips ecosystem reveals that it is difficult to identify a clear winner. In the same vein, the "Do Nothing" action as detailed in the above table, could work over the short term, and even over the longer term but provided that the smartphone and communications equipment industries are prepared to use less efficient and bulkier power devices. From this viewpoint, while Gallium is an essential metal, it is not an absolute necessity for tech companies. As for the U.S. military, it has the option of buying current stockpiles of Gallium compounds on national security grounds.

At the same time, the above table shows that China stands to lose economically in case it presses on with a ban on chips-making metals, which opens the door for the "Negotiation" option.

The Ban Could Backfire, But Negotiations are Possible

Now, the timing for the announcement on July 5 came one day after the arrival of Treasury Secretary Janet Yellen in China for high-level discussions over trade including the chip industry. The announcement also comes in the aftermath of news about U.S. authorities possibly enacting legislation to limit Chinese corporations' access to the intelligent cloud services provided by the likes of Microsoft's ( MSFT ) Azure or Amazon's ( AMZN ) AWS.

Therefore, instead of throwing a spanner into the CHIPS Act, the Chinese authorities could be raising the stakes for a negotiated settlement. In this respect, the restrictions on Micron's memory chips came on June 15, or less than one month ago, and may be aimed at showing that China is not completely dependent on foreign technology.

Thus, with both sides probably aware of the pains to be inflicted on each other's industrial growth in case of an escalation, there are reasons to think that they would opt for a negotiated settlement. However, this does not mean that it is now time to invest in SOXX especially given its meteoric upside of more than 40% during the last year, which is 27% higher than the broader market represented here by the SPDR S&P 500 ETF Trust ( SPY ). As such, the iShares ETF comes with a Price to Earnings of 23.73x , or 19% higher than SPY's 19.9x .

Now, with higher returns also come more risks , in the form of a higher degree of share price fluctuations as pictured below in blue for SOXX.

In conclusion, this thesis has shown that as much as 23.84% of SOXX's overall weight could be directly impacted (but at varying degrees) by being denied chip-making metals. Therefore, expect a lot of volatility as this episode in the long history of U.S.-China relationships unfolds which also signifies that it is better to take a pause and wait for tangible signs of any progress in resolving the issue before investing.

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