Next slump milder

OUTLOOK 2005

It hardly seemed like we got to the recovery, and here's the downturn again. Top analysts and electronics executives say we are in the middle of a three-quarter downturn, with flat markets, slack demand and falling prices dead ahead in 2005. The good news is that this slump is expected to be mild, and several drivers are in the pipeline to spur an uptick as early as 2006 for an increasingly diversified industry.

Plenty of macroeconomic factors are dampening the outlook. Gross domestic product in the United States is expected to slump in 2005 while interest rates edge up, and insecurity in the Middle East and high deficits at home remain constant. In addition, the average U.S. family will pay $650 more a year in energy costs, thanks to high oil prices.

"That doesn't account for the ripple effects on the system" of higher oil costs leading to higher transportation costs for food and other items, said Doug Andrey, principal analyst for the Semiconductor Industry Association (SIA). "That has some impact on consumer electronics," a category that now makes up more than half the electronics market.

Roll it all together and the SIA forecasts a flat year worldwide and a decline of about 4.5 percent in the United States, where semiconductor consumption continues to migrate offshore. Semico Research (Phoenix) is more pessimistic about, predicting that worldwide chip unit shipments will rise by 2.8 percent, but revenues will dip slightly less than 5 percent, thanks to falling prices. Both SIA and Semico see an upturn in 2006.

Market watcher iSuppli Corp. is slightly more upbeat about 2005, but less so about the turnaround. In December, the company revised its 2005 forecast of worldwide semiconductor growth down from 9.6 percent growth to 4.7 percent. However, the El Segundo, Calif., firm believes a downturn in DRAM revenue will limit semiconductor growth to only 2.2 percent in 2006, pushing out a double-digit recovery to 2007.

The SIA's Andrey cushions the blow of the bad news, noting that the 2005 downturn follows two years of solid growth (at 18.3 and 28 percent). The industry should grow at a compound rate of 10 percent over the next few years, he said.

In addition, "there are factors reducing the amplitude of this [down] cycle," Andrey said. Chip makers have much less inventory on hand and have spent significantly less building up capacity than in the dark days of the dot-com bust. Specifically, overall capital expenditures for chip makers is about two-thirds what it was in the last cycle, he said.

Brian Halla, chief executive of National Semiconductor Corp., puts an even brighter face on the forecast. "We are back to the level of shipments at the top of the dot-com boom, so there's been some kind of recovery in total revenues," he said.

What's more, he noted, some core geographies and markets — such as Asia, analog, DSPs and optoelectronics — will continue to see growth in the coming year.

System slowdown
Unfortunately, some key end markets including cell phones and digital cameras are hitting the brakes. The SIA and Semico agree that cell phone growth will drop from about 30 percent in 2004 to about 5 to 8 percent in 2005.

In the wake of the camera phone, which hit the market in 2004, there are few new, compelling features in cell phones next year. "So the upgrade cycle is coming to an end, but it's not as bad as 2001 when handset growth went negative," said Jim Feldhan, president of Semico.

Halla, whose business is closely tied to the cell phone, said the theory is "plausible" but held out hopes his own company would grow by taking market share in its key analog businesses.

Digital cameras are expected to take a similar plunge, dropping from about 24 percent down to 6 percent growth in 2005 compared with 2004, according to the SIA. Now that more than half of all cameras sold are digital, the industry has less opportunity to cannibalize analog film cameras. And with digital models sporting 5-plus-megapixel resolution and 3x optical zoom becoming common, finding new, compelling features is increasingly difficult here, too.

The SIA projects PC growth will also fall in 2005 to 10 percent from 14 percent in 2004. However, International Data Corp. (Framingham, Mass.) expects global IT spending to rise by 6.1 percent in 2005. That assumes a modest rise in IT spending in the United States.

As systems markets slow, chip inventories are on the rise.

Chip inventory in the supply chain swelled to $1.6 billion in the third quarter of 2004, compared with $800 million in the second quarter and practically zero in the first quarter, according to iSuppli.

The company predicted that excess inventories would decline marginally to $1.5 billion by the end of the fourth quarter, leaving a significant overage for the supply chain to deal with in 2005.

"I think inventory is peaking right now. By the second quarter of next year the excess should be gone and things should start to recover," said Feldhan of Semico.

Bad as the problem may be, it's much less worse than 2000, when excess inventory totaled $15 billion, and companies are more quickly adjusting for the excess this time around, said both Andrey and Feldhan.

"Unlike the last downturn, where there was denial about excess inventory, this time around it appears companies are being more proactive about recognizing the problem and doing something about it," Feldhan said.

For its part, Altera Corp. claims that it is now at the top end of its allowed inventory backlog, said chief executive John Daane. So far, the FPGA maker has been able to stay inside its planned three- to four-month inventory backlogs since 2001.

Merrill Lynch analyst Joe Osha said he believes real chip demand can be fairly well-predicted by multiplying global GDP by a factor of about three. But that's a metric few chip makers use, he said.

"This business is always over- or under-shipping on demand. We will be in inventory correction mode until the end of the second quarter of 2005," said Osha.

With demand slack, inventories rising and more capacity coming online, prices are on the decline, especially in commodity passives and memory.

The SIA projects revenue for flash memory will slip 1.8 percent in 2005 while DRAM sales tumble 14.7 percent. It's an old story for many commodity players.

"The trend has been one of price erosion for the last twenty quarters," said John Denslinger, vice president of sales and marketing in North America for Japan's Murata Manufacturing Co. Ltd., a $4.3 billion supplier of passives. He expects average selling prices to fall as much as 2.5 percent a month or 10 percent total in 2005.

"That's better than as much as 4.5 to 5 percent in some past quarters," he said.

Merrill Lynch is predicting that ASPs could decline industrywide by about 1.7 percent in 2005. However, Osha has developed a new model that predicts prices could fall 4.4 percent. If unit shipments slump, ASPs could fall as much as 7.6 percent and industry revenue could shrink as much as 12 percent, he said in a recent research note.

Daane said ASPs for programmable logic tend to be stable. Although the costs of an individual logic element fall by 30 to 35 percent/year, average prices stay level, thanks to increasing volumes and new high-end products in the mix.

Investment impact
So far, answers to the question of whether the down year will cool spending plans at chip makers are mixed.

"We have a longer-term view," said Daane of Altera. "This industry has always been cyclic. We are continuing to hire," he said. Daane expects the company will grow as much as 25 percent on a compound basis over the next few years, driven by opportunities to take business from ASIC and application-specific standard-product suppliers. But predicting the near-term future is not a business he wants to be in.

"There's just not much visibility so we think it's better to take things one quarter at a time," he said.

In one reaction to the expected cooler global business climate in 2005, ARM Ltd. will hold off on setting up a new design center in China. Jerry Ardizzone, president of ARM's U.S. operations, said the company is exploring what sort of R&D it wants to do where in China, but will put the evaluation on the back burner until the industry picks up again.

Process technology development is clearly marching forward. At the end of 2004, Intel Corp. showed progress in fabricating 65-nanometer logic. Intel's schedule calls for its first microprocessors in a 65-nm process to move to early commercial production in the second half of 2005.

For many other chip makers, 2005 may be more a year to lay the groundwork for their 90-nm products.

"2005 is the design-in year for our 90-nm products. The big growth will come in 2006," said Daane of Altera.

The company netted $1 million in revenue for its 90-nm FPGAs in the third quarter when they first started shipping.

Among other sunny spots for the industry, 2004 saw a small surge of manufacturing business back to Mexico and Brazil, according to Denslinger of Murata. Mexico "was one of our fastest-growing areas last year," growing by 35 percent, he said.

The growth came from several sources. Nokia and Sony Ericsson Mobile Communications AB both moved some cell phone production to the area.

In addition, Dell Inc. and Hewlett-Packard pulled back some manufacturing programs from Asia to Mexico to simplify their supply lines and save on transportation costs for end systems shipped to the Americas, Denslinger said.

"At $45 a barrel, transportation costs can become a significant item," said Feldhan of Semico. "If the consumption of the boxes is expected to be in the Americas, it makes sense to do the production there, especially for people like Dell who live on very slim margins," he said.

Maturing markets
Another piece of good news is that the electronics markets continue to diversify. More than 50 percent of the semiconductors sold in 2004 will go into products purchased by consumers rather than corporate IT departments, and this proportion will continue to grow, said the SIA.

From that perspective, 2005 may be the year Intel's growth flattens out and the company loses its position as the bellwether of electronics.

"People will begin to ask hard questions about their long-term growth,"said Osha of Merrill Lynch. "It's becoming apparent how much slower microprocessors are growing than the industry in aggregate," he said.

"That's not a bad thing. It means broad-based companies like Analog Devices and Linear Technology will be able to continue on their trajectories for some time to come," added Osha, who sees more long-term growth in analog and programmable logic than in CPUs and baseband chips.

Ultimately, all boats are expected to rise in the next upturn, which Feldhan and Andrey see coming in 2006.

PERSON TO WATCH
Crack Wall Street analyst Joe Osha of Merrill Lynch & Co. Inc. singles out two executives as the hot chipmeisters to watch in 2005: John Daane of Altera Corp. and Dave Orton of ATI Technologies Inc.

The men are viewed as archrivals in a business makeover race that's seen as nearly dead even. Daane has executed a turnaround for Altera, which goes head-to-head with Xilinx in the highly competitive FPGA sector.

Orton has reshaped ATI from an also-ran into a leader in graphics controllers that rivals Nvidia Corp. Today ATI is better-positioned than Nvidia in such emerging markets as cell phone and digital TV graphics and is executing at least on par with its rival in core PC markets. While Nvidia grabbed a design win in next-generation Sony videogame consoles, ATI has won sockets in both Microsoft Corp.'s Xbox Nex and Nintendo's follow-on to the GameCube.

Osha also said that Hector Ruiz at Advanced Micro Devices Inc. has put that company on a strong footing, helping it to gain share in the slowing market for PC microprocessors. He further gives kudos to the managers at SigmaTel Inc., who are hanging on to the rocket that is the MP3 player market, despite heated competition from low-cost components emerging from China.

Brian Halla, chief executive officer of National Semiconductor Corp., sees a strong contender for the title of 2005 turnaround artist in Ed Zander, the former Sun Microsystems Inc. executive who's now driving Motorola Inc. forward.

Halla is also keeping a close watch on Clemens Joos of the handset division at Siemens as an innovator to watch in the coming year.

COMPANY TO WATCH
When you ask Brian Halla, chief executive officer of National Semiconductor Corp., which companies he considers the ones to watch, he doesn't hesitate.

"Samsung," Halla said. "They are doing all the right things in all the right markets. I have never seen a company be so aggressive."

Indeed, the broad-based Korean system and component maker skyrocketed into the top tier of cell phone makers this year, showing global leadership in a market where Motorola has faltered, Nokia has wavered and Ericsson has slipped.

Sony gave the Samsung group a huge vote of confidence recently when the two struck a 50-50 joint-venture partnership to make LCDs for flat-panel TVs.

Jim Feldhan, president of Semico Research (Phoenix), picked Chinese PC maker Lenovo, which just acquired the IBM PC division as the company to watch in 2005.

"They are kind of the Dell of China," said Feldhan.

AT A GLANCE
Population (2002): 288.3 million
GDP: $11,303 billion (2004, est.)
GDP growth in 2004: "4.2 percent
Unemployment: 5.4 percent (November 2004)
Average hourly earnings: $15.83 (November 2004)
Value of total exports of goods: $1,190.1 billion
Share of world semiconductor market: 19.4 percent in 2003
Leading technology: 65-nm logic process in development at Intel
Top companies: Intel, IBM, TI
Favorite pastime: watching reality TV shows
Best local dish: pizza and beer
Sources: 2004 U.S. Budget, Bureau of Labor Statistics, U.S. Department of Commerce, Merrill Lynch, WSTS, EE Times