Semiconductor Industry Outlook - Are We At The Bottom Yet - Steve Szirom, InsideChips.Ventures

InsideChips.Ventures ( October 2001)

Semiconductor Business Oultook

Are We at the Bottom Yet?

Business Cycle Position

In most of 1999 and 2000, chipmakers were selling virtually everything they could squeeze out of their factories. Because of the unending optimism on the dot-com front, the Nortels and Ciscos of the industry were increasing their capacity for what seemed like an infinitely expanding computer and telecom market. The Internet infrastructure market was surpassing the PC market's long-established position as the driver for the chip industry.

Semiconductor valuations went through the roof, especially for network/communications stocks (for example, Broadcom and AMCC) and IP firms (such as Rambus and ARM). But the sky-high valuations, driven in part by the Internet craze, reached levels that were unsustainable. Like a runaway freight train, the current downturn came suddenly and caught everyone in the chip industry off guard.

The dot-com bust came quickly and mercilessly, and those companies' lavish spending habits ground to a halt. Semiconductor producers, which had ramped their capacity to the max, had to step on the brakes hard. At first, there was a slight hesitation as year 2000 ended; by the end of the next quarter, however, it was clear this was not just a moderate correction. Many executives wishfully talked up a rebound, trying in vain to keep the slump relatively short and encourage a bounce-back in the second or third quarter this year.

Unfortunately, the industry is still in the waning phase of the business cycle, and visibility is poor.

The data for long-term monthly semiconductors shipments are shown in Figure 1 on page 3. The latest downward correction began in the fall of 2000; after reaching an $18-billion monthly shipment rate, the shipments have dropped to about $10 billion per month - with no evidence of a bottom forming as of July 2001.

Excess inventory is being whittled down, but a glut still encumbers the industry. Fabrication facilities are operating at substantially decreased utilization rates, estimated at 50% to 60% of total capacity. In addition, the general economy is slowing and, given the rising unemployment rate, its outlook is uncertain. As a result, consumer electronics will not be as robust as in past years. PCs, which are still a large discretionary purchase for consumers, are showing quarter-to-quarter weakness. One research firm, IDC, expects sales to be down about 10% worldwide this year.

The grim state of affairs brings to mind other downturns I've witnessed in the chip industry, the most severe being the 1975-76 bloodbath that reduced logic ICs to ridiculously low price levels. Texas Instruments dominated the logic IC market at the time and it went after market share; many logic providers, such as Fairchild Semiconductor, Motorola and Signetics, were bloodied. At the time, I worked for Motorola at its operations in Toulouse, France. I distinctly remember the gloom-and-doom communiqu鳠coming by telex from headquarters in Phoenix. My associates were telling stories of the company shutting down entire wings (will the last one to leave please turn out the lights...). Rumors circulated that the Motorola's chip operations would be sold.

Interestingly, I have heard the same rumors circulating today regarding Motorola selling its chip business, which is undergoing a retrenching just as severe as the one 25 years ago. Motorola has cut approximately 35,000 jobs since last December, leaving a workforce of about 110,000.

I do not believe we have reached the bottom yet. The current downturn, when viewed in the historical context of previous slumps, appears to be several quarters away from a rebound. Although there is some anecdotal evidence the downward spiral is stabilizing, there are no hard data indicating an immediate turnaround.

Industry Reaction to the Downturn

One characteristic of this downturn is that high-tech companies reacted more swiftly than in the past. This reflects better real-time inventory monitoring and sales-channel feedback.

Another interesting trend found in the current cycle is the tremendous amount of positive spin given to layoffs. I thought the term "downsizing" in the last slow period (1997/98) was a nice euphemism for laying off employees. This time, many firms' term of choice is "rightsizing". Other companies have called it "strategic refocusing" and one of my favorites - establishing a "performance improvement plan." Whatever it is called, U.S. chipmakers have reacted to the downturn by initiating wave after wave of slash-and-cut headcount reductions.

Rightsizing in Europe (Europeans call their layoffs "redundancies") is more difficult than in the U.S. In most European countries, the local employment laws make it very difficult to lay off workers. This is one of the factors causing higher unemployment rates in Europe, as companies take a very cautious approach to hiring new workers; they tend not to staff to the hilt during boom times because the same staff will be with them during the downturn.

The European market typically slows after a downturn in the U.S. is already well entrenched. Europeans are returning from their summer vacations to a weakened chip industry.

Japan's companies, which have traditionally provided lifetime employment for their workers, are moving away from that long-established employment strategy and beginning to focus more on results-oriented management styles. One trend in alignment with that new mode of operating is large Japanese corporate conglomerates breaking out their semiconductor divisions. Still, change is more evolutionary than revolutionary in Japan, and employment reduction is accomplished today using various "early retirement" schemes.

Japan has been undergoing a severe industry slowdown and is on the verge of a recession. The Nikkei stock average is now hovering around 10,000 - representing a 17-year low. The country's turmoil is seeping across its borders and affecting Taiwanese chipmakers, many of which are in various stages of implementing co-development and outsourcing deals with Japanese chipmakers.

Looking Forward

No one can predict the future of the chip industry and definitively answer the two questions posed at the beginning of this piece: "Are we at the bottom yet?" and "If not, when?"

However, I make the following assertions with great confidence:

1) The chip industry is real and is very unlike the dot-coms, which sprang up rapidly and bombed with equal intensity. Chips are the crude oil that fuel the electronics industry and the Internet age. They have had, and will continue to have, a profound impact on the world. My comments also apply to equipment and materials suppliers, as well as those in the EDA business. The semiconductor industry is not a fad and will not go away. While that sounds obvious, I point it out because high-tech has been closely associated with the Internet dot-com boom, which was little more than an investment craze built largely on smoke and mirrors. Consumers went for it lock, stock and barrel because they could easily understand the benefits. The average consumer does not have the same understanding of the semiconductor industry, even with Intel's widely recognized marketing campaigns.

2) The semiconductor business cycle is not dead. Back in 1999 and early 2000, some very smart industry spokespersons proclaimed that the business cycle is no longer as relevant to the industry as it was in the past. However, as long as there is overbuilding of capacity; as long as there are technologies that explode on the market like the Internet; as long as commodity chips are priced like airplane seats - there will be a business cycle.

To summarize, not only did the dot-com craze experience a spectacular wipeout, but our own chip industry became impacted by four industry-specific factors:

1) A decline in IT spending that has caused the network sector (which was increasingly becoming the driving force in the chip industry) to quickly deflate.

2) A slowdown in wireless deployment and cell-phone sales, which has caused wireless-oriented companies to retrench.

3) A slowdown in the PC industry, which still plays a significant role in determining the chip industry's total revenues.

4) An oversupply of wafer capacity, due in large part to fabs established in the late 1990s coming on line and putting downward pressure on prices.

At InsideChips, we watch the semiconductor indexes closely. One of the more popular indexes, The Philadelphia Semiconductor Stock Index (SOX.X), depicts the action of stock prices between 1994 and the present. During this time period, investors have experienced three intermediate upward-moving peaks: fall 1995, fall 1997, and spring 2000. The dotted lines in Figure 2 (page 3) trace the index's upper and lower ranges and clearly show the long-term upward trajectory of the industry. Our own analysis was pointing to the industry bottoming out at the 400 level in the index for sometime around January 2002. That would have been a 3:1 contraction in the index - consistent with other recessions.

Then, the tragic events of Sept. 11 sent a shock wave throughout the world. The financial world came to a standstill as the nation mourned the needless loss of human life. As a consequence, we are revising our outlook to reflect the dynamics of the new economic situation: We believe the industry, which we earlier forecast would be down 25% this year, will now be down 30% to 35%. Since Sept. 11, the SOX.X index has broken through the 400 support level. The next support level is at 200 - the level at which the index stood in 1998.

In our view, the upturn will not be quick, given the slowing economy in the U.S. and weakness in Japan and Asia. InsideChips sees 2002 as a long, arduous turn-around year and 2003 as a return to normal growth rates.

(Note: This review is based on historical trends and a review of fundamental semiconductor market conditions. Actual industry performance may differ from the analysis presented.)

Figure 2 - Philadelphia Semiconductor Stock Index