Editor's note: This article is part one of a two-part analysis on the state of the front-end capital equipment industry and its future prospects.
The semiconductor equipment industry has been battling a significant industry cyclical downturn since the end of 2007. Vapital spending by customers in the industry has declined significantly from the boom times in the 2000 period. In 2010, the industry is seeing signs of a cyclical rebound—albeit perhaps short-lived as the world copes with a sluggish recovery from the deep recession. I believe the industry has failed to cope with the last two cyclical downturns and is not well positioned to face uncertain economic conditions.
Lack of product innovation
Insignificant product innovation from all of the major equipment companies has led customers to restrain investment in R&D type of equipment and capital. Product development by the equipment companies in the past three to five years has only offered incremental improvement, which the customers refuse to pay premiums for, thereby reducing the profitability of the equipment companies. Unit volumes for new products have not grown due to the lack of innovation, demand interruption caused by the cyclical downturn and the customers' ability to reuse equipment.
Fundamental business model change
There has been a fundamental change in the business model of the semiconductor capital equipment company caused by the lack of product innovation. Product innovation is defined as products that are disruptive to the current installed product set that demonstrates a significant value through productivity improvement and process capability that enables customers to shorten their product development cycles.
In the 1990s, Applied Materials developed the physical vapor deposition system (Endura) which dramatically improved the capability of the customer and had an average selling price that was nearly 3X the price of its nearest competitor. The value proposition was so compelling that the customers willingly paid the prices since the tool improved the customers' capability significantly.
The current lack of innovation has the impact of commoditizing the tool set, which results in price erosion, consequently lower gross margins and therefore pressure on operating expenses which starts the cycle all over again. The equipment companies have had to reduce capacity and cost and spend less money on R&D and process development. Applied Materials' workforce is actually fewer today than it was in 2003. They have also shed employees and other valuable employees have left the industry completely moving to alternative energy or the biotech industries.
The major factors for this value migration is the impact of the lack of product innovation AND the impact of the 300-mm production implementation by the customers. There has been a resultant "brain drain" from the semiconductor equipment industry to other industries where process engineering skills are critical to growth. Venture-backed investment in equipment company startups has been virtually non-existent, with no single new company emerging as a major player in the industry.