San Jose, Calif. -- There's no doubt LSI Logic Corp. CEO Abhijit Y. Talwalkar understands the new realities of the ASIC market as he prepares to head the company's reformulation. But there's plenty of skepticism about Talwalkar's $3.5 billion deal to blend in the remnants of AT&T's former chip division, Agere Systems.
The combination lacks focus and heft, analysts and observers said, but it still could work. Indeed, it may be the best option for the two faltering giants, as they struggle through the transition from yesterday's ASIC market to today's demands for a cost-sensitive mix of standard and custom chips.
In the go-go days of the semiconductor industry, companies needed their own fabs with the latest technology and an ability to make any kind of chip for any customer who might come along. LSI Logic and AT&T Microelectronics were two of the hot items in the roaring ASIC market of those days. In today's slow-go climate, you don't need your own fab or even the latest process technology. You just have to get focused on some good customers, then get as big as you can get.
The rising costs and declining demand for ASICs have left LSI and Agere smarting. Revenues have proved wobbly and profits elusive for both companies since the dot-com crash of 2000. LSI has sliced R&D 20 percent and Agere a whopping 40 percent during the past five years.
Talwalkar, a former Intel division manager who took the reins at LSI 18 months ago, said the two companies will be able to slash $125 million in costs starting in 2008 as they develop common platforms for standard and custom chips. And they won't need to exit any businesses or change manufacturing strategies to find the savings, he said.
Craig Berger, an analyst with Wedbush Morgan Securities, said the merger could be part of a trend toward consolidation by companies that need to provide customers with more silicon intellectual property. "The big are getting bigger," Berger said. "As the technology advances, you need more and more IP blocks to offer customers. If you aren't big, you don't have a lot of IP blocks to offer."
Subsuming the small
That strategy of "integrating the little guys out of existence" has been successfully carried out by companies such as Marvell Semiconductor Inc. and Broadcom Corp., which have acquired technology and "baked it in" to more-integrated products, Berger said. Consumer chip makers ripe for takeover in this environment, he said, include Silicon Laboratories, Genesis Microchip and Zoran Corp.
Jim Feldhan, president of Semico Research (Phoenix), cited Marvell's acquisition of Intel's Xscale as a recent example of a deal between a big company seeking focus and a midsize player looking for volume. "Weeding out the weaker players and seeking strong combinations are part of being in a mature semiconductor market," Feldhan said.
The networking sector also has its share of midsized companies that may have adequate focus but could all use a shot of heft, including Applied Micro Circuits Corp., Conexant Systems Inc. and Vitesse Semiconductor Corp. Talwalkar held talks with an undisclosed number of chip companies when he went looking for a partner, and presumably all of them are pondering whether to undertake their own strategic combinations. "The LSI-Agere merger is another example of consolidation for scale. We're seeing a lot of this and expect to see more," said Gartner Dataquest ASIC analyst Bryan Lewis.
Every deal has its drawbacks. With the sole exception of a strong position in the market for hard drive controllers, LSI and Agere are not clear leaders in any of their core markets.
The $2 billion LSI worked hard over the past 18 months to scale back from a broad-based ASIC company with its own fab to a fabless entity focused on two markets: storage and consumer. With the merger, LSI adds the $1.5 billion Agere's joint venture fab with Chartered Semiconductor, its three assembly and test plants and its focus on cellular and wired networking.
"That's four of the top six application areas, covering 80 to 90 percent of the ASIC business today," said Jordan Selburn, a principal chip analyst at iSuppli who once worked at LSI. "Now it looks like their focus markets are everything except burger-flipping machines."
But in today's slow-growth market, "it's a question of being tightly application-focused or being big--and it's not clear this makes them big or focused enough," Selburn said.
Will Strauss of market watcher Forward Concepts (Tempe, Ariz.) put it more bluntly: "This sounds like two old ladies trying to help each other across the street. That may be unkind, but neither company has been a polished performer lately."
With the exception of Agere's hard drive controller business, the companies have little in common, Strauss added. "I don't know where they are going to get this synergy they talk about, because they are in completely different markets."
Wall Street was skeptical as well. The deal, initially valued at $4 billion, slipped to $3.5 billion when Agere's share price slumped from $22.81 to $19.82 on Dec. 4, the day the merger was announced. The market shaved a dollar, or about 10 percent, off LSI Logic's stock price the same day.
But Wedbush Morgan's Berger called the merger a good strategic combination that bolsters the companies' combined storage chip offering and engineering resources, providing a stronger platform with which to compete against Marvell.
Agere ranks first in units and second in revenue to Marvell in the 300 million-unit annual market for hard drive controllers, according to Forward Concepts' Strauss.
Agere focuses on desktop and notebook controllers, while LSI has controllers for server hard drives, said Jeff Richardson, who worked under Talwalkar when they were both at Intel and who now heads LSI's custom solutions group. Richardson said the disk controller sector could form the pattern for the partnership. The two companies will create common silicon platforms for standard and custom parts to serve existing customers with a broader and deeper palate of offerings.
Most of Agere's roughly $625 million in annual storage business last year came from integrating its read channels, pre-amps, motor controllers and other building blocks into control ASICs for hard drives. Seagate is its largest customer, representing nearly 40 percent of its overall business if one factors in the business Agere had with recent Seagate acquisition Maxtor.
Seagate accounts for as much as 80 percent of Agere's storage revenue and roughly 45 percent of LSI's storage revenue, estimates Shebly Seyrafi, a financial analyst with Caris & Co. "We view this merger as a negative for Marvell," Seyrafi wrote.
"The merger makes LSI almost the same size as Marvell, their chief competitor in storage, but LSI will have a wider product offering," said Lewis of Dataquest. "The challenge is in what they do with the communications business."
LSI and Agere hope they can apply the hard drive template to networking, Richardson said. LSI did a $312 million business over the last four quarters in standard and custom devices for Ethernet switching in the data center. Agere had a $551 million networking business during the same period, focused mainly on public networks, with Ethernet and Sonet flavors.
But Agere has just started to see profits in the last two quarters for its $300 million cell phone baseband business. LSI got in and out of wireless in the 1990s.
Semico's Feldhan said Agere's cellular processors could be a boon for the new LSI, which needs high-volume markets. LSI's MPEG capabilities could be merged with Agere's basebands for future video-ready phones, he added.
Consumer has been a big focus at LSI since it bought C-Cube Microsystems in 2001. The company has a leading position in DVD recorders and is trying to expand into MPEG sockets in set-tops. But at $251 million a year, consumer now becomes the smallest of the new company's four market sectors and could have trouble contending for corporate resources.
Even in storage, the two companies diverge. A minority of LSI's $1.4 billion storage business is in disk controllers. Much of it is in other server chips, RAID adapter cards and OEM storage arrays.
"It will be a struggle to make this work," Selburn said of the market mixed bag.
Many analysts were left wondering where the new LSI will find its $125 million in proposed annual savings beyond the usual elimination of redundant operations staff. No layoff plans were announced with the merger. The companies have a combined workforce of roughly 9,100 employees, including nearly 4,300 engineers.
Although LSI has gone fabless, Talwalkar praised the financial soundness of Agere's joint-venture fab with Chartered in Singapore and the company's three wholly owned assembly and test plants in Singapore and Thailand. About 2,400 of Agere's 5,100 employees work in manufacturing.
Agere uses the joint-venture fab for older process technologies; it sources parts made in new geometries from Chartered and TSMC. LSI has not disclosed its foundries. Its annual report says it uses "wafer foundries in Taiwan, Japan, China and Malaysia . . . and assembly and test operations in South Korea, Taiwan, the Philippines, Malaysia, Thailand and China," suggesting the company has yet to consolidate on core vendors.
Talwalkar said at a news conference announcing the merger that there are no immediate plans for "changes in our manufacturing strategy."
Agere presumably is already running lean. When its current CEO, Richard Clemmer, came in about a year ago, he reorganized the company and laid off 650 people, or more than 10 percent of the staff.
"We regard the deal as ambitious given the limited product overlap and manufacturing synergies," of the two mainly fabless companies, Joe Osha, an analyst with Merrill Lynch, wrote in a report on the merger. Nevertheless, Osha retained a "buy" recommendation on LSI.
The combination puts LSI back on the map as an ASIC supplier. After its last reorganization, it fell off the list of top 10 ASIC companies tracked by iSuppli. Agere ranks between sixth and seventh on that list. With the merger, the combo could rise to fourth place in ASICs, behind Texas Instruments, IBM and STMicroelectronics, said Selburn.
"There are certain markets that continue to use custom silicon to support differentiation, but neither company is focusing on being a broad-based merchant ASIC supplier," said Talwalkar.
The all-stock deal is expected to close, subject to stockholder and regulatory approval, in the first quarter. LSI and Agere shareholders will own approximately 52 percent and 48 percent, respectively, of the combined company.
The company will operate under the LSI name, headquartered in Milpitas, Calif., with Talwalkar as CEO. LSI nonexecutive chairman James Keyes will continue as nonexecutive chairman of the new company's board.
LSI's board has also authorized a stock repurchase program of up to $500 million, expected to be funded from available cash and short-term investments. -- Dylan McGrath contributed to this report.