Chip profitability jumps to decade high

Total industry sales may have fallen from the 2007 peak level but profits at semiconductor vendors have risen to their highest levels in more than a decade as manufacturers benefit from changes in manufacturing strategies, tighter cost management and continued product specialization, according to a research firm.

iSuppli Corp., El Segundo, Calif., said operating profitability in the industry surged to 21.4 percent in the final quarter of 2009, "the highest level since the fourth quarter of 2000 when it reached 24.7 percent," as a sales rebound helped companies offset losses piled up earlier in the year.

Operating profitability in the market had fallen to negative 5.3 percent in the first quarter of 2009 as capacity utilization fell sharply in the wake of the global economic downturn.

"Chipmakers in 2009 reacted quickly and aggressively to meet the downturn by cutting costs and improving cash flow," said Derek Lidow, president and CEO at iSuppli. "As the market began to turn back up, the industry showed great restraint against adding production in order to avoid any overcapacity situations. This allowed the companies to recapture their pricing power to boost profitability."

The improvement is not just a result of tighter inventory and production cost-cutting. Many semiconductor suppliers have tightened their industry focus with many exiting commodity sectors, including memory and wireless ICs, and directing resources to higher margin products. The resulting consolidation has helped the largest chip vendors raise their design wins at OEMs even as prices firmed despite pressures from the larger economy.

"The semiconductor industry has almost completely eschewed the broad-line model that once was the hallmark of the largest players in the business," Lidow said. "Instead, chipmakers now are concentrating on specific market segments, allowing them to focus on areas where they have pricing power and a competitive advantage. This has allowed them to improve profit margins and to cut overhead."

The trend is likely to continue. Companies like Infineon Technology A.G., STMicroelectronics N.V., NXP Semiconductor and Freescale Semiconductor have all sharply narrowed their product focus. Some dumped less profitable businesses and reduced overall expenditure as a result, further boosting operating margins. This move towards product specialization was in response to competitive pressures from smaller fabless semiconductor vendors, Lidow said.

"Broad-line suppliers constantly must fend off hordes of smaller competitors nipping at their heels," Lidow noted. "With a more narrow focus, semiconductor suppliers can gain greater efficiency and profitability. This allows them to become more competitive and to concentrate on profitability, rather than on market share."

Chipmakers are also benefiting from efforts earlier in the decade to reduce their total operating costs by transferring production to wafer foundries, a move that allowed companies to sharply scale back their capital expenditure as well as R&D focused on manufacturing efficiencies.

Many of the larger IDMs that used to spend billions of dollars on fabrication facilities have also embraced outsourcing and have experienced lower costs as a result although the semiconductor equipment market has shrunk as a result.

Spending on chip equipment, for example, fell three consecutive years starting in 2006 and although capex was forecast to rise in 2009 they would be "at less than half of what they were in 2007 and 2008," according to iSuppli.

"Furthermore, the planned spending by semiconductor manufacturers is primarily oriented at implementing advanced packaging to support new types of products, rather than at investments in expansion of overall wafer fabrication capacity," the researcher said. "This restraint has limited the growth in supply, keeping pricing under control."

Average selling prices throughout the industry stabilized in the second quarter of 2009, for instance, after sinking 5.4 percent in the preceding quarter, iSuppli said.