With very few exceptions chip makers do not earn enough to fund the huge payout needed to buy the latest equipment, so some have begun to co operate to cut costs, writes Lucas van Grinsven.
A New York fund manager recently considered buying semiconductor stocks because valuations seemed so low. Then she crunched the numbers and found none of the firms she visited had ever generated cash.
To make sure, she asked the opinion of the sell-side analyst who had joined her on the visits.
When told that all of the companies needed regular cash injections, she decided to stick to other, more mundane industries like retail and banking.
Within the high-tech chip industry, people like to joke it is a $150 billion-a-year business for very bright people who do not know how to make money.
"For investors there is no long-term value in the chip industry. If you buy these stocks today, it's for a few hours or days, not months or years," said another analyst, at a major investment bank in London, who declined to be named.
The Philadelphia semiconductor index has lost 57 per cent this year as hopes for a recovery have been pushed out, and it is now back at levels last seen in 1998.
With the exception of a handful of chip makers, including market behemoth Intel and Texas Instruments of the United States, none of them earn enough money to pay for the massive investments in factories, equipment and research that are needed to buy the latest chip manufacturing equipment.
Do not be fooled by profits. A successful company like Franco-Italian STMicroelectronics, which in a few years time has managed to climb six slots in the top 10 to become the world's third-largest chip maker, is still bleeding cash. The company ended with net debt of more than €450 million (€458 million) in both the bumper year 2000 and the weak year of 2001.
The reason the company was still in debt after posting record 2001 net earnings of $1.45 billion is because it invested $3.3 billion in new factories, $2.2 billion more than the depreciations and amortisations in the profit and loss account.
"And STMicroelectronics is one of the better performing companies in the business. It's a fair assessment that the semiconductor industry as a whole requires cash injections," said analyst Mr Steve Woolf at Commerzbank in London.
Investment bank UBS Warburg recently calculated that four of the top six European chip firms destroyed cash from 1996 to 2001, which explains why, between them, they raised $18.2 billion of external funding, equivalent to 6 per cent of aggregate sales.
The actual value destruction would be even higher if factory-free chip designer ARM had been left out and internal subsidies from cash-generating divisions in Philips had been deducted. Government grants and tax relief that run into billions of euros also need to be deducted.
Investments in cutting-edge technology are the chief culprit. Ten years ago it cost an average $1 billion to build a new chip factory, in recent years it ran to $2 billion and the latest "fabs" cost between $2.5 and $3 billion. "Moore's Law is driving the investments higher," said JP Morgan's semiconductor analyst Mr Uche Orji in London, referring to the 1965 observation of Intel co-founder Mr Gordon Moore that computing power for every dollar doubles about every 18 months as a result of thinner circuits etched on to silicon wafers.
Lithography machines to make thinner circuits for faster and smaller chips have become exponentially more expensive.
The pain comes in downturns, which occur every four or five years when sudden bursts of fresh supply coincide with a lull in demand and prices for commodity chips can fall up to 80 per cent. At the same time, chip buyers like PC and mobile phone makers such as Dell and Nokia are becoming more powerful, squeezing selling prices even further in non-commodity areas.
Philips Semiconductors spooked financial markets last week by reporting heavy price pressure. While revenues fall, fixed costs due to investments and research remain high - at around 40 to 45 per cent of sales.
Only by tapping the capital markets can companies continue the arms race. Germany's Infineon issued a €1 billion convertible bond in early 2002, South-Korea's Hynix is currently trying to avoid bankruptcy with refinancing.
Singapore's Chartered Semiconductor left investors gasping for breath after a recent move to sell additional stock in an eight-for-10 rights issue aimed to raise $633 million.
"For investors the attraction is to be there when the market rebounds. You can be a very happy man for a few months," said JP Morgan's Mr Orji.
But over the full cycle the chip business is like a casino where betters, on average, win less than the ante they put in.
"If you presented the chip industry as an anonymous case study to business and finance students, they would dismiss it. They'd say it would never work," said Commerzbank's Mr Woolf.
It only works because chip makers keep receiving cash from parties with a vested interest, like creditors and governments who hope additional money will help a firm through the downturn.
Inspired by the Silicon Valley hotbed, governments hope chip companies can create incubators in their country. Many nations offer investment subsidies and tax relief. These are often cited by chip firms as reasons to select a site.
Moving to a sustainable business model by investing less is therefore rarely an option because there will always be a rival with the latest technology, or one dumping its products despite heavy losses, as long as incremental material costs are covered. This has forced consolidation and co-operation.
Chip makers such as Philips, Motorola, ST and Taiwan Semiconductor Manufacturing Co have all started co-operating in basic manufacturing and research activities.
And it looks like this trend will have to continue if the sector is to attract long term investment. - (Reuters)
