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Fixed Income

High Yield in View: An Update on Autos and Semiconductors

The intricacies and knock-on effects of the COVID-19 pandemic on the semiconductor and automotive industries continue to present interesting dynamics for investors to navigate. Franklin Templeton Fixed Income Research Analyst Aleck Beach offers his view of the space from a credit lens.  

By now we’re all well aware of the widespread supply chain challenges that have emerged as the world has come back from the COVID-19 economic lockdowns of 2020. Shortages in labor, materials, shipping and logistics have been a headwind to economic growth and have led to inflationary pricing pressures across the economy. Nowhere has this been more evident than in the auto industry, as shortages in semiconductors limited the rebound in global vehicle production over 2021 relative to the depressed production environment of 2020.

Following factory closures mandated by government shelter-in-place orders early in 2020 to address the emerging COVID-19 pandemic, consumer demand for personal transportation was strong as lockdowns were lifted. Vehicle sales rebounded and what was initially feared as a potentially long and deep downturn for the auto industry saw a relatively strong rebound as buyers returned to showrooms. The recovery in vehicle sales over the second half of 2020 soon hit a wall though as a shortage in semiconductors emerged in early 2021, thereby weighing on new vehicle production and limiting vehicle supply.

The auto industry was initially optimistic that semiconductor supply could catch up with demand, thus allowing lost vehicle sales during the first half of 2021 to be largely recouped over the second half of the year. However, the realities of long lead times to add semiconductor capacity as well as long production cycle times for chips meant improved supply would take time to benefit vehicle production. The disruption to industry output proved much more significant than initially hoped for.

Production Disruptions Meet Strong Demand

Over the course of 2021, semiconductor production was disrupted by unexpected events and further COVID-related challenges. Unusually strong winter weather conditions in Texas led to power outages at several semiconductor factories, which was followed in March by a fire at another chip plant in Japan. Over the summer of 2021, the spread of COVID-19 through Southeast Asia constrained operations at subcontractors involved in late-stage semiconductor assembly and final testing. This string of one-off impacts to semiconductor industry production in an already tight supply environment were added headwinds to the recovery in vehicle production. During this time period, demand for many technology-related end products that consume semiconductors remained strong, further adding to the supply demand imbalance. Strains from shipping and logistics challenges from port delays around the world have been an additional burden to supply chain continuity.

Given strong demand, semiconductor capacity utilization has been high, with vendors accepting orders on extended delivery lead times. The industry has responded to tight supply conditions through higher capital spending to grow capacity, but doing so in what is a complex and highly technical semiconductor manufacturing process takes time, denominated in quarters not weeks. Those vendors who have added capacity have seen demand more than absorb additional supply.

The global auto industry has now experienced two consecutive years of depressed production, first due to COVID-19 shutdowns in 2020 followed by semiconductor shortages in 2021 constraining a recovery in sales during a period of strong demand. In the US market, auto retailer inventories have been depleted to historically low levels which has resulted in reduced discounting and strong industry transaction prices. Auto manufacturers have also sacrificed production of vehicles that earn lower margins in favor of allocating available semiconductor supplies to more profitable vehicles such as trucks and SUVs. The combination of strong pricing and vehicle mix has been a significant benefit to profitability and has helped cushion the blow from lower unit volumes. For instance, on a year-to-date basis through the third quarter of 2021, Ford reported $8.9 billion of adjusted operating profit, including a benefit of $7.2 billion from favorable pricing.1 On a similar basis, General Motors reported a benefit of $5.6 billion from favorable pricing relative to year-to-date adjusted operating profit of $11.4 billion.2

As new vehicle supply has been constrained, car rental fleets have been lean, which has driven rental prices higher. As it relates to the used vehicle market, demand has likely benefited from tight new vehicle supply which pushes buyers into the used market. Furthermore, new vehicle sales that last peaked in 2018 declined slightly in 2019 and more dramatically in 2020-2021. This reduces supply of trade-in vehicles entering the used market, which constrains used vehicle supply. The combination of strong demand and tight supply has led to record used vehicle pricing.

Complicating Factors

In evaluating the prospects for when semiconductor supply improves sufficiently to satisfy auto industry demand, there are a couple of complicating factors to keep in mind. The auto industry relies on semiconductors that are relatively less complex than those used in the most advanced technology hardware. These less complex but still critical parts are manufactured on generally older and less expensive equipment in an effort to keep costs low. Outsourced semiconductor foundries that have come to make up a large share of the overall semiconductor manufacturing landscape are incentivized to focus their capital investments and capacity on providing leading edge capabilities. As we see large capital investment announcements from leading chip producers, not only are those projects several years away from volume production, but they will in many cases be focused on leading-edge capacity beyond the technical needs of most automotive applications. In addition, auto semiconductor-related vendors who also maintain internal capacity have increased investment spending but have done so at a pace which has not fully kept up with revenue growth and demand. Only in more recent quarters has spending increased more dramatically, and this spend will come with the necessary lead time of several quarters to result in improved semiconductor supply.

Another complicating factor to alleviating semiconductor shortages to the auto industry is the complexity of the auto supply chain and the use of multiple tiers of sub-suppliers to the auto companies. Semiconductors are typically shipped to tier 1 and tier 2 suppliers who then assemble them into subcomponents which then get shipped to the car manufacturers for final vehicle assembly. This has proven to be an added layer of supply chain complexity in coordinating the production and shipment of semiconductors which themselves require several months to produce, in relation to an auto supply chain structured on just-in-time inventory management principles. The result is zero room for error, and what has emerged from this period of semiconductor shortages is the realization by auto executives that closer coordination and tighter relationships with chip vendors is needed to help mitigate the risk of future disruptions. BMW, Stellantis, and Ford for instance have announced new partnerships with chip vendors in Asia for semiconductor design and manufacturing services.

Long Road to Recovery

While the industry saw improved vehicle production and a slight easing in supply constraints toward year end 2021 in relation to more acute shortages during the third quarter, we see a full normalization of auto industry production as taking perhaps longer than some market participants expect. This is due to a supply response which has begun but not as quickly as perhaps hoped for, in addition to long lead times to add and ramp capacity, and integration with an auto supply chain that is arguably more complex than previously realized when it comes to semiconductors. While supply conditions should gradually ease over the course of 2022, a full normalization of vehicle production may extend into 2023.

Cross Currents as Supply Normalizes

Vehicle supply constraints have resulted in record auto industry pricing power which has been a strong offset to depressed unit sales. Vehicle supply will take time to normalize which may continue to support strong pricing in the near term, but high prices and potentially rising interest rates will weigh on vehicle affordability. As semiconductor supply improves over time, vehicle supply constraints will ease, and what has historically been a very price competitive industry will be tested to see if production discipline is maintained, or if historically intense competition for market share returns thereby eroding recent pricing power. Auto manufacturer profitability will therefore have some interesting cross currents to navigate as supply and demand normalize.

Semiconductor vendors have, in many cases, quite astutely instituted non-cancellable purchase orders from customers potentially “double-ordering” as they scramble to get supply. The semiconductor industry is no stranger to prior bouts of supply and demand imbalances and the consequent risk of double ordering. The industry is taking steps to place the risk of any eventual overproduction in the hands of auto manufacturers, but any excess supply will ultimately need to be digested.

With regards to the traditional auto parts suppliers that have struggled along with their auto manufacturer customers from depressed vehicle production rates, they should benefit from a recovery in vehicle production as semiconductor shortages eventually ease, but with less risk from the lower vehicle prices that would result from any potential return of industry price competition amongst the auto manufacturers.

As the world continues to grapple with the fallout from the COVID-19 pandemic, the intricacies and knock-on effects on the semiconductor and automotive industries continue to present interesting dynamics for investors to navigate.

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1. Source: Ford third-quarter 2021 Earnings Review, October 27, 2021.

2. Source: General Motors corporate earnings reports: first-quarter, second-quarter and third-quarter 2021.

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