Chips feel the crunch

The chip industry has taken a few knocks from the economy, but bigger issues lurk underneath.

Mike Fister, president and CEO of electronic design automation (EDA) company Cadence Design Systems, was in bullish mood when he told investors that he had launched
a bid for third-placed supplier Mentor Graphics. Fister's aim was to create an EDA powerhouse that could dominate the market and regain ground lost to Synopsys in recent years.

Mentor's board rejected the advances from Cadence, but Fister and the Cadence board were keen to press ahead, going direct to Mentor's shareholders in a hostile bid in the hope that their target's management would come to the table. But, even if that did not happen, Fister claimed the bid was generous enough to convince Mentor's shareholders to sell up.

Just two months later, Cadence withdrew the bid.

What went wrong? Cadence became a victim of the credit crunch that has steadily tightened its grip on, among others, the electronics sector. Cadence expected to pay $1.6bn for Mentor, offering $16 in cash for each of Mentor's shares. Last year, the offer would have been derisory. But turmoil in the markets saw Mentor's share price tumble with the result that Cadence's offer represented a 30 per cent premium.

To finance the offer, Cadence needed to borrow more than $1bn. This proved to be the stumbling block. After revealing a slide in sales in its second quarter results at the end of July, the company found it was unable to negotiate a loan at a price that would let the deal make sense.

The company was finding itself caught in a squeeze between deteriorating economic conditions and the rising cost of borrowing.

Fister admitted in July: "I have been around the world almost everywhere in the last month, and even if you look at the spate of announcements from a variety of sources, not necessarily concentrated in the semiconductor industry, the environment has gotten worse. I am struggling to find anybody who thinks that the second half is going to be strong, let alone hold up to where it was, and that's continuing to reach out into not just the start of 2009, but the second half of 2009."

Downsizing

Now, the company is looking at job cuts - instead of getting bigger, Cadence sees itself adjusting to a smaller market. Kevin Palatnik, the company's CFO told analysts in September: "We will resize the company to the lower [sales] base plus the lower growth that we see in the next three to four years."

Cadence is not alone in cutting costs as economic conditions turn down. NXP blamed a combination of factors for its decision to close its older fabs and transfer production to just two: one in Hamburg; the other in Singapore.

The move came on the day that Texas Instruments celebrated the 50th anniversary of the first demonstration by Jack Kilby of a prototype integrated circuit (IC).

In a conference call, NXP CEO Frans van Houten claimed that the changes came in response to a variety of external factors. "The semiconductor market remains flat against the background of a weakening macroeconomic environment. Our factories are underloaded and we want to deal with that. We have also had to deal with a challenging currency environment. The US dollar has been weak but a substantial amount of our cost base is in Euros."

A further factor is the reduction in size of the company after moving its wireless business into a joint venture with STMicroelectronics. NXP says the layoffs programme will affect up to 5,000 people globally - 3,000 of them in manufacturing - and will save $500bn annually, but cost $800m to implement.

The programme means NXP will migrate products to more advanced production processes. The company will reduce its own, mature-process production capacity. NXP plans to consolidate the majority of its production to two of its more advanced European fabs: Nijmegen, Netherlands and Hamburg, Germany. Production will also be moved to SSMC in Singapore.

As a result, four factories are planned to be sold or closed. The fab in Fishkill, New York, US will be closed in 2009.

Additionally, two other factories are planned to be closed by 2010: the 'ICN5' part of the NXP facility in Nijmegen, and part of the 'ICH' fab of the Hamburg facility.

NXP's fab in Caen, France, which has a pilot line for system-in-package (SiP) parts aimed at the communications sector, will be put up for sale. In the event that a buyer is not found, the facility could be closed as well during 2009.

The plan aims to increase the loading in the remaining fabs to more than 90 per cent, as well as result in expected savings of $300m per year by the end of 2010. After the restructuring, NXP reckons it will invest 16 to 17 per cent of sales in R&D, which the company says is in line with other semiconductor companies.

Van Houten claims shedding its communications IC operation means it has lost the biggest draw on R&D cash: "The system chips for wireless require very high investments. Without those we can adjust the central R&D programme significantly."

Blame from some quarters fell on NXP's investors, a consortium of private-equity companies that financed the acquisition with a high level of debt. The borrowing effectively weakened NXP's position.

However, Freescale Semiconductor, which makes heavy losses because of its similar borrowings has seen sales increase in the last quarter, in the face of a weakening market.

Some analysts believe that economic problems in the West should not affect the semiconductor business, although an increasing number of companies have forecast a slow second half to the year.

Frost & Sullivan claims problems caused by the credit crunch will be offset by a growing consumer electronics market, still the principal end-user of semiconductors.

Optimism surrounding the upcoming US presidential election and an anticipated rebound of the economy are expected to have favourable implications for the semiconductor industry, the firm claims. More importantly, with the majority of US semiconductor sales taking place outside the country, international trade takes a bigger role.

"The unpredictable economic climate has made technological sophistication and lower cost structures imperative for semiconductor companies in the US to sustain their leadership," says Frost & Sullivan research associate, Prerna Mohan.

"Forecasts of a looming recession, offset by optimism for the end-user consumer electronics industry, and opportunities to capitalise on the booming Asian market, are expected to help buoy the semiconductor industry."

Nobody's safe

Gartner is less bullish. Analyst Richard Gordon says: "We do not believe that the semiconductor industry can remain completely immune to the macroeconomic environment. We expect business and consumer spending on electronics to slow in coming quarters, and semiconductor market growth to remain muted."

Gartner believes that tougher conditions for consumers, making it harder for them to borrow, will ultimately put a brake on spending on gadgets and PCs. Even emerging markets, such as China, India, Russia and South America, will slow, Gordon claimed in an earlier research note.

In contrast, iSuppli sees long-term factors forcing bigger changes in the semiconductor business, of which NXP's drastic action may just be the first. Problems with credit and a weakening economy are simply obscuring systemic problems.

According to iSuppli, the semiconductor industry has entered a period of lowered expectations and diminishing options, forcing chip suppliers to rethink their basic strategies for success.

"Semiconductor profitability has eroded steadily since mid-2004, with quarterly net profits having fallen into the single-digit range in 2008, down from the 17 to 19 per cent range in 2004," says Derek Lidow, president and CEO of iSuppli. "The semiconductor industry now is less profitable as a percentage of revenue than the notoriously low-margin PC business, something that hasn't occurred before, except during E F a short period of the severe market downturn in 2001.

"To a degree, conditions in the semiconductor industry have been impacted by short-term events, such as the market volatility in 2006 due to inventory write-offs and price wars in major product segments like DRAMs and microprocessors," Lidow observes. "However, the long-term trend indicates that the semiconductor industry - which historically has been good at capturing profits in the electronics value chain - seems to have lost its money-making touch."

As profit has diminished, the semiconductor industry has re-segmented itself into new groups, according to Lidow. During the period of 2001 to 2004, semiconductor companies seemed to fall into three categories: a small group of firms whose growth outperformed the market; a middle-performing group consisting of most suppliers; and a set of low performers at the bottom. The top caste of suppliers typically employed predatory business strategies that enabled them to take market share from weaker competitors. The lowest performers often served as the market-share prey for the predators and the middle-range of suppliers.

However, during the semiconductor business cycle from 2004 to 2007, the prey in the lowest caste of suppliers went extinct - and so did the success of predatory strategies, creating a larger group of middle-performing players.

"The number of low- performing companies decreased by so much that there now are only two major distributions in the industry: a few outstanding performers and the rest," Lidow claims. "The number of competitors achieving growth of more than 100 per cent during the period of 2004 to 2007 declined to nine, down from 19 during the period of 2001 to 2004."

Lidow claims one strategy that semiconductor suppliers can use is to go out and capture value from their customers by designing more of the total system with system-level chips built around proprietary intellectual property (IP). He namechecks Qualcomm, MediaTek and Linear Technology as examples of this strategy.

Another strategy is to milk established cash-cow products in the industry. Such cash-cow products are typically trailing-edge devices that have passed through their commodity stage, have fairly steady pricing and have a dwindling number of suppliers that are willing to devote their best people to designing and managing products that most semiconductor cowboys would find boring. Sellers of such devices include Microchip, Diodes Inc, Microsemi and Rohm.

Or well-heeled semiconductor suppliers can use their resources to massively outspend their rivals in the areas of products and manufacturing and thus maintain technical and scale dominances in competitive market segments. Companies employing such strategies include Samsung Electronics.

New reality

Lidow says that, as semicon-ductor companies attempt to pursue such strategies, they will have to face the reality that the electronics industry has become increasingly unforgiving of mediocrity in any area because such underperformance drains profits as well as device and operational performance.

Furthermore, semiconductor buyers expect their suppliers to be first rate in all pursuits, ranging from process technology to marketing, a standard that many companies can meet.

"In this day and age, semiconductor suppliers have the opportunity to outsource any or all of their operations to third party sources that offer world-class work," Lidow observea.

"Those semiconductor companies that are unable to achieve top-quality and performance in all processes, either through outsourcing or by using internal resources, will be punished in the marketplace."

A further consequence of the change in conditions may bring about the long-delayed process of consolidation in the industry.

Lidow reckons daring semiconductor managers have another option: build a scalable acquisition process that would allow a semiconductor company to grow by buying other companies or selected parts of companies.

"Developing such a process would allow a company to achieve unprecedented scale and vast wealth," Lidow claims. "With semiconductor processing becoming increasingly commoditised, such an endeavour is becoming practical."

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