Semiconductor Outlook and Review - Apr. 2010 - Industry Outlook

The Semiconductor Industry serves as a driver, enabler and indicator of technological progress. Developments in the industry determine the way we work, transport ourselves, communicate, entertain ourselves and respond to our environment. The PCs we work on, the cars we drive, the phones we communicate with, the electronic gadgets on which we watch movies, listen to music and play games on, and the planes and weapons used to transport or protect us use semiconductor devices.

As environmental issues have become more of a concern today, semiconductor devices are being made to reduce power consumption, reduce heat dissipation, capture solar energy, create more efficient lighting solutions and so forth.

The industry has come a long way since the last downturn, when most of the players streamlined operations and transferred more routine production to low-cost locations. This led to the development of the Asian market, where most memory production and backend operations have shifted.

Lesson Learned in the Industry

Past experience has been put to good use this time around. When the recession hit in late 2008, semiconductor manufacturers cut production drastically instead of running the fabs at full capacity to maintain margins and hoping that the recession would blow over. As a result, there was no excess inventory that had to be burned off when demand started returning. There was instead a shortage in some cases, which led to stronger pricing.

As a result, the industry performed much better in 2009 than was originally anticipated. According to the Semiconductor Industry Association (SIA), worldwide sales of semiconductors were $226.3 billion in 2009, significantly better than the $219.7 billion forecasted for the year. This was a 9% decline from 2008.

The SIA estimates that around 52% of revenue came from the Asia/Pacific region (excluding Japan), followed by Japan and the Americas with a 17% share each, and the balance from Europe. The sales by geography were similar to 2008, indicating that the recession did not result in any major change in market dynamics.

The SIA attributed the better-than-expected performance to much superior inventory management than in the prior downturn, new product launches and strength in the consumer and PC markets toward the end of the year. These two end-markets together consume around 60% of total semiconductors sold.

Expanding Reach in Computing and Consumer Markets

The computing market is characterized by commoditization and corresponding pricing pressures that have made it a lower-margin business. As a result, a number of chip companies have shifted focus to other areas.

However, while it is true that the market is relatively mature and recession-impacted, there are some encouraging signs for 2010. The first is a revival in enterprise spending, which is being driven by new product cycles and some pent-up demand. The second is the server refresh cycle, growth of cloud computing and virtualization, and changes in data center operations. The third is the strength in mobile computing platforms (although some of the latest models of netbooks, tablets and MIDs are treated as consumer items).

The consumer electronics market is growing in importance, especially gadgets such as LCD TVs, Blu-ray players, smartphones and netbooks. The problem with this segment being a major driver of revenue is its inherently low margins. Competition is fierce and aggressive pricing is the rule of the day. Since semiconductors made for consumer goods are in the nature of components, there is ever-increasing pressure on their prices that correspondingly squeeze margins.

According to the Consumer Electronics Association (CEA), the 7.8% revenue decline in consumer electronic goods for 2009 was entirely on account of weaker pricing, as unit volumes of consumer goods increased around 10%.

However, the CEA is optimistic about slight growth in 2010 to $165 billion. The primary driver will be smartphones, which are expected to generate $17 billion in shipment revenue and 52 million in units. Notebooks will be the second largest driver, with shipment revenue of $14 billion and units of 30 million.

Blu-ray player units, which increased 155% in 2009, are expected to grow to more than 7 million units and generate $1.4 billion in shipment revenue. And finally TVs, which grew significantly in 2009, are expected to grow again in 2010 to 37 million units, driven by high definition, FPD and other advanced technologies. However, shipment revenue is expected to decline to $22 billion due to weaker pricing.

Other Markets

Communications infrastructure spending is currently being driven by China and India and the SIA expects infrastructure spending in these geographies to remain the major driver of semiconductor sales into the market. The domestic market will be driven by increasing data volumes. Medical Devices is an upcoming area and some chipmakers have started developing products targeted at this market as well.

The recovery in the automobile market is slow, with several of the large companies facing temporary issues and growing inventories. The longer-term prospects remain bright, since design activity is strengthening. Moreover, semiconductor manufacturers serving this market have a few advantages. The most important is the growing electronic content per vehicle, driven by the need for fuel efficiency, entertainment and automated navigation.

As a result, semiconductors serving this market should grow stronger than the industry over the next few years. The fact that an automobile model has a significantly longer life than a consumer device model is an added bonus, as once a semiconductor has been designed in, it continues to generate revenue for a number of years.

The aerospace and defense markets are dependent on government spending and policy making and current trends indicate that the strength in defense spending will continue. However, current spending continues to be targeted at terrorist activity, so spending on intelligence systems and basic weaponry is stronger.

Companies offering sophisticated weapons are not doing as well. Commercial aerospace remains affected by tight lending conditions, although the situation has started improving. So semiconductor manufacturers serving these markets are seeing mixed results, depending on the customers served.

Given the end-markets driving the current strength in the industry, we believe that manufacturers of DRAM and flash (both NAND and NOR) will continue to see strong demand. The transition from DDR2 to DDR3 will add to growth in this segment.

Ever Smaller & More Powerful

The demand for greater functionality in smaller and more power efficient gadgets is leading to greater integration within the semiconductor device. This is leading to increased demand for the system-on-a-chip (SoC), which is a single device incorporating a microprocessor, digital signal processor or graphics core, as well as memory and logic.

Within SoCs, both application-specific integrated circuits (ASICs) and application specific standard products are expected to do well. ASICs are usually customized for a single buyer, while ASSPs may have multiple buyers.

Major Players

The major players in the industry may be categorized into chipmakers (OEMs -- whether fabless or otherwise), equipment and material suppliers, and foundries.

According to Gartner Dataquest and iSuppli Corp, Intel Corp (INTC), Samsung and Toshiba Corp were the top three semiconductor suppliers in 2009. Texas Instruments (TXN) remained in the fourth position, as the company continued to phase off its wireless baseband business. STMicroelectronics (STM) was in fifth position, followed by Qualcomm (QCOM), which rose from the eighth position in 2008. Hynix also gained, moving from the ninth position in 2008 to the seventh position in 2009. Japan’s Renesas slipped a couple of places to number eight. Applied Micro Devices (AMD) re-entered the top ten at number nine, followed by Sony (SNE), which slipped a few places to end at number ten.

VLSI Research estimates that semiconductor equipment sales by the top ten suppliers declined 38.2% in 2009, following a 26% decline in 2008. Therefore, the segment has shrunk by over 50% over the past two years. North American suppliers declined 36.9%, Japanese suppliers declined 35.6%, while European suppliers declined 44.5%.

However, despite the difficulties related to the recession and the new trend of equipping fabs with used materials, Applied Materials (AMAT) easily maintained its number one position in 2009. Tokyo Electron Ltd moved from the third to the second position, exchanging places with ASML Holdings N.V. (ASML). Nikon Corporation was at number four, followed by KLA-Tencor (KLAC) and Lam Research Corp (LRCX). The other players in the top ten included Dainippon, ASM International N.V. (ASMI), Novellus Systems, Inc. (NVLS) and Teradyne, Inc. (TER), in that order.

The Foundry segment has undergone a major change in 2009, according to recently-announced research from IC Insights. Although Taiwan Semiconductor Manufacturing Company (TSM) remains the leader by far, followed by Taiwan-based United Microelectronics Corp (UMC) and Singapore-based Chartered Semiconductor Manufacturing (CHRT), the fourth position has gone to GlobalFoundries, which commenced business in March last year. Semiconductor Manufacturing International Corp (SMI) of China was pushed to the fifth position.

OPPORTUNITIES

Manufacturing digital ICs is expensive, as it requires state-of-the-art technology and processes. On the other hand, digital products are cheaper, so cost recovery is more difficult. This has led to specialization in the industry and a greater contribution from Asian manufacturers. However, a large portion of the intellectual property remains with the domestic companies.

We believe equipment suppliers will be big beneficiaries of the ongoing recovery and we are bullish on the sector. All the companies here had been severely impacted by the recession, as foundries, memory and logic makers decided to cut capex. However, both Gartner and IC Insights have projected a 45-55% increase in semiconductor capex spending in 2010.

We are, however likely to see increased use of old and refurbished equipment. Among the equipment suppliers, we particularly like Applied Materials (AMAT), not just because it is one of the largest equipment makers, but also because of its position in the solar device equipment market, as well as its existing refurbished tools business. We are also optimistic about KLA-Tencor (KLAC) and Novellus Systems (NVLS) and believe they will do well both in terms of revenue and profit growth in 2010.

The analog and mixed-signal market is dependent on innovation. Consequently, these products generate higher margins than digital products. They are also more customized and have longer life cycles. These advantages are not lost on U.S. players, so the number of companies entering the market is on the rise.

Our favorites in this area include Texas Instruments (TXN), Linear Technology (LLTC), Analog Devices (ADI), Semtech Corp (SMTC), Intersil Corp (ISIL) and Maxim Integrated Products (MXIM), which are seeing very strong demand. Although some of these companies could see a faster recovery than others, they are, for the most part, highly diversified, high-margin businesses. Hence, the sector should do very well in 2010.

Microprocessors are a big market dominated by a few players. We are positive about Intel Corp. (INTC) because of its market position, superior innovation, effective strategies and strong cash generating ability. We remain a little concerned about the legal tussles with NVIDIA Corp. (NVDA), which could come to a head in September.

Advanced Micro Devices (AMD), on the other hand, is low on cash and market position, although the company’s new product roadmap, aggressive pricing, recent market share gains, the foundry spin-off and promise of positive cash flow in 2010 indicate upside for the stock.

It is hard to ignore ARM Holdings (ARMH) in this space, whose power-efficient low-performance chips dominate the growing cell phone market, or NVIDIA, which continues to make waves in graphics processing chips.

WEAKNESSES

The Asian foundries will operate at full capacity this year, but order fulfillment could still be a challenge due to low investment in capex during the recessionary environment. Consequently, we believe that foundries, such as Taiwan Semiconductor (TSM), United Microelectronics Corp (UMC) and Semiconductor Manufacturing Int'l (SMI), will see limited upside this year despite very strong demand. Similar will be the position at memory manufacturers, such as Micron Technology (MU) and Hynix.

We remain extremely positive on the semiconductor sector in 2010 and do not really see any great weaknesses. However, we would caution investors about companies with relatively weak financials, such as Exar Corp (EXAR) and FormFactor (FORM). For instance, FORM continues to burn cash despite strong demand for its specialized probe cards. It also has significant customer and market concentration that increase execution risks.

SIA Forecast 2010

The Semiconductor Industry Association expects semiconductor sales to increase 10.2% in 2010 and 8.4% in 2011. January and February sales data as published by the SIA shows very strong double-digit growth from the corresponding year-ago periods.Zacks Investment Research