The semiconductor industry
Under new management
Chipmakers were suffering even before the global economic downturn. Recession is heightening the pain and highlighting changes in structure and ownership
Apr 2nd 2009 | DRESDEN | From The Economist print edition
MOST tourists come to Dresden to view the city’s architectural wonders. Beautifully rebuilt, the Frauenkirche (Church of Our Lady), for instance, reveals no hint that its huge cupola once crumbled after a rain of British bombs. But the capital of the German state of Saxony also has more contemporary attractions—at least for technically inclined travellers. It is the hub of one of Europe’s biggest technology clusters. Silicon Saxony, as the region has come to be called, boasts 1,500 high-tech firms employing 43,000 people, most of them in the semiconductor industry.
Yet industrial tourists had better hurry. Recently Silicon Saxony has taken some hits that have weakened its foundations. On April 1st Qimonda, a maker of memory chips and the cluster’s largest employer, mothballed its factory, having been forced into insolvency earlier this year. Its last hope is to be bought by an outside investor lured by money from the Saxon government. Inspur, a Chinese computer-maker, is among those expressing interest in Qimonda, which has developed some cutting-edge technology.
At Dresden’s other big “fab”, as chip-fabrication plants are called, is an indicator of another change that may prove just as damaging. There is a new logo at the entrance: visitors are no longer welcomed to AMD but to Globalfoundries. AMD, a maker of microprocessors for personal computers (PCs), decided last year to spin off its fabs into a separate company and to sell a majority stake to investment funds controlled by the government of Abu Dhabi. A good deal of production, some fret, may eventually move from Dresden to the Gulf.
The likely death of Qimonda and the birth of Globalfoundries have turned Silicon Saxony into an industrial showcase of a very different kind. It is a visible token of how hard recession around the world has hit the semiconductor industry, which had already been weakened by one of its periodic downturns. Just as important, it demonstrates the longer-term upheavals in the industry. The semiconductor business is becoming less vertically integrated and more concentrated. And its centre of gravity is shifting eastwards.
Despite a few signs that the worst may be over—Asian chipmakers’ share prices soared recently after shortages were predicted—the industry is still in the midst of the longest slump in its 50-year history. If market researchers are right, it will shrink again in 2009 before resuming growth in 2010. iSuppli, one such forecaster, thinks that revenues will fall by more than 20% this year, to $205 billion (see chart 1). Other observers have been making similarly gloomy predictions.
To understand why the semiconductor industry has been so pummelled, think of integrated circuits (ie, chips) not as tiny pieces of silicon engraved with millions of transistors, but as an essential resource. Before long every man-made object will come with at least one embedded microchip (see chart 2). Jerry Sanders, AMD’s founder, once called chips “the crude oil of industry”. This seems apt: integrated circuits have become the grease of the information economy. The flip side is that chipmakers have come to depend increasingly on the health of the rest of the economy.
The chip cycle
However, the industry’s own economics are also to blame. Even without the world’s wider troubles, these would have caused problems. In explaining how, Dan Hutcheson, chief executive of VLSI Research, a consultancy, likens semiconductor manufacturing to a different industry: farming. Investment decisions have to be made long before products can be sold. Chip farmers have to spend billions and wait years before they can start etching circuits onto “wafers”, those thin disks of semiconductor material, the size of pizzas, which are sliced into hundreds of chips at the end of the production process.
This goes a long way towards explaining why chipmakers, like farmers, have a tendency to oversupply the market, particularly if they sell memory chips, an undifferentiated product (like winter wheat). Even if prices fall below costs, they have an interest in keeping their fabs humming, in order not to lose their heavy upfront investment and to recover the variable costs. What is more, they are caught on a “technology treadmill”, in the words of Mr Hutcheson. Competition forces them always to employ the latest technology, which both increases output and puts pressure on prices.
Finally, just as in agriculture, governments further fuel this innate tendency to oversupply. In prestige, national security, industrial policy or just a desire to create jobs, politicians have always found a reason to support their semiconductor industries, mostly with cash. Silicon Saxony, for instance, has received more than €1.5 billion (nearly $2 billion at today’s exchange rate) from the state of Saxony alone, much of it to coax AMD into investing.
Asian governments have been the most active. Thanks to Taiwan’s industrial policy, more than half of the world’s chips are now made there. Support from the South Korean government made Samsung and Hynix the world’s biggest makers of memory chips; they supply about 50% of this segment. China seems intent on turning its semiconductor companies into market leaders at almost any price, above all Semiconductor Manufacturing International Corporation, or SMIC. All this explains why of the 40 fabs under construction in 2007, 35 were in Asia, three in America and only two in Europe.
Not surprisingly, at times supply far outstrips demand. From 2002 until last year Asian makers of memory chips, especially, invested as if capital were free—which explains why everybody is now bleeding money. In July 2007 the price of a DRAM (dynamic random access memory) chip with a capacity of 512 megabits was more than $2. In early April it was about 50 cents. Smaller makers cannot cope. Qimonda, for instance, piled up losses of about €1.5 billion between October 2007 and June 2008. Its revenues were only €1.3 billion.
Given the scale of the losses and the screaming from other industries, governments look less inclined to help this time. Even Taiwan is having second thoughts about an ambitious plan to save its memory-chip industry, announced only last month. The idea is to merge and bail out the country’s six makers of memory chips, which have lost $12.5 billion in the past two years and accumulated $11 billion in debts.
Even if Taiwan were to let these firms fail, which is highly unlikely, supply would still exceed demand, according to iSuppli. Global sales of memory chips will not start growing again before next year. And growth will not reattain its 2006 rate before 2015.
Whatever happens to Qimonda and its Taiwanese rivals, the current crisis is sure to speed up two seemingly contradictory long-term trends in the industry. It is consolidating, in that the manufacture of chips is becoming concentrated among fewer companies. At the same time, it is splitting up, in that more companies are specialising in design, and contracting out or quitting the making of chips. Both developments are mainly the consequence of what has come to be called “Moore’s Second Law”, an economic counterpart to a better known observation by Gordon Moore, one of the founders of Intel, the world’s biggest chipmaker by revenue.
The original Moore’s Law is usually summarised thus: the number of transistors on a chip doubles every 18 months. In fact Mr Moore first predicted this would happen every year and later changed his forecast to every two years; the average has become his law. Mr Hutcheson points out that Mr Moore made more than a purely technical prediction. He also stated that the cost of an integrated circuit would stay the same, a halving of the cost per transistor with every doubling of the number.
This has turned out to be essentially correct, but progress has come at a high price. The ever more sophisticated equipment required to make semiconductors has been getting dearer with every iteration of Moore’s Law. The most advanced chips are built using 32-nanometre technology, meaning that transistors are now so tiny that more than 4m can fit on this full stop. Lithographic tools for transferring Lilliputian circuitry onto a wafer cost up to $50m a pop. To reach the economies of scale needed to make such investments pay, chipmakers must build bigger fabs.
Rising fixed costs give rise to Moore’s Second Law: as the cost of transistors comes down, the cost of fabs goes up, albeit not at quite the same rate. In 1966 a new fab cost $14m. By 1995 the price had risen to $1.5 billion. Today, says Intel, the cost of a leading-edge fab exceeds $6 billion, including all the preparatory work. And the Taiwanese Semiconductor Manufacturing Company (TSMC) has built two “GigaFabs” for between $8 billion and $10 billion each, which would buy you four nuclear power stations. The output of such monsters depends on the mix of products, but they each could easily churn out 3 billion chips a year.
These ever-increasing costs and the need for specialisation have caused the industry to splinter, says Derek Lidow, iSuppli’s chief executive. Originally, all chipmakers were vertically integrated, meaning they designed the chip, built the tools to make them, ran the fabs and added the necessary connectors. As costs went up and certain activities became more and more complex, they were spun out to spread expenses and know-how. Semiconductor equipment, design software and packaging have long been done by separate companies. But the past ten years have seen the rise of “fabless” firms, which merely design integrated circuits.
Now established chipmakers can no longer afford to develop their own manufacturing processes or even to run their own fabs. To share the pain, IBM, Samsung and others have teamed up to use chipmaking technology jointly. Some firms, such as Texas Instruments, have chosen to go “fab-lite”, meaning that they have their own fabs only for certain chips. Others, such as AMD, have spun off manufacturing completely (although AMD’s decision had much to do with a lack of cash after it bought ATI, a maker of graphics chips, for $5.4 billion in 2006).
Hence the rise of “foundries”, the smelters of the information age. These are essentially contract manufacturers. Although far from household names, they are huge companies, churning out about one quarter of the world’s semiconductors. The biggest, TSMC, has a manufacturing capacity greater even than Intel’s. Its revenues grew at an annual average rate of 13% for several years, topping $10.6 billion, before falling by almost a third in the last quarter of 2008.
TSMC also illustrates a corollary of Moore’s Second Law: even the biggest chipmakers must keep expanding. Intel today accounts for 82% of global microprocessor revenue and has annual revenues of $37.6 billion because it understood this long ago. In the early 1980s, when Intel was a $700m company—pretty big for the time—Andy Grove, once Intel’s boss, notorious for his paranoia, was not satisfied. “He would run around and tell everybody that we have to get to $1 billion,” recalls Andy Bryant, the firm’s chief administrative officer. “He knew that you had to have a certain size to stay in business.”
Grow, grow, grow
Intel still appears to stick to this mantra, and is using the crisis to outgrow its competitors. In February Paul Otellini, its chief executive, said it would speed up plans to move many of its fabs to a new, 32-nanometre process at a cost of $7 billion over the next two years. This, he said, would preserve about 7,000 high-wage jobs in America. The investment (as well as Nehalem, Intel’s new superfast chip for servers, which was released on March 30th) will also make life even harder for AMD, Intel’s biggest remaining rival in the market for PC-type processors.
Two other long-term developments also point towards further concentration of chipmaking. The first is technological change beyond that ordained by Moore’s Law. Fully automated “lights-out” fabs are in operation. Within a few years fabs will be producing wafers with a diameter of 450mm, up from 300mm now, making them even more productive. “When the industry goes to 450mm and this happens at 22 or even 11 nanometres, it is conceivable to have one factory handle all our needs as a company,” says Mr Otellini. He adds, however, that Intel would never put all its eggs in one basket.
The other development is the maturing of the industry. Its annual growth has slid from double digits in the mid-1990s to an average of around 5% since then. And since 2004 the profitability of chip firms has dropped steadily as many chipmakers have lowered prices to expand their markets. In the future, only three types of semiconductor firm will make a decent return, predicts Mr Lidow: those with unique intellectual property; those happy to make commodity chips; and those with enough cash to achieve unprecedented scale.
How far will consolidation go? High-ranking executives at leading firms, who prefer not to be quoted, give similar answers. In the long run, they say, there will be only three viable entities, at least at the leading edge of chipmaking: Samsung in memory chips, Intel in microprocessors and TSMC in foundries. The rest will be “nationalistic” ventures in need of regular government bail-outs.
Yet such predictions may be a little off the mark. Largely because of that nationalism, the semiconductor industry is unlikely to end up as a bunch of near-monopolies. The Taiwanese are unlikely to let the South Koreans rule the memory roost. The newly founded Taiwan Memory Company (TMC), which is to take over the six local firms, could become the core of a global memory giant. It will hook up with Elpida Memory, Japan’s sole maker of memory chips. TMC is also said to be interested in Qimonda.
Precious pizzaAs for microprocessors, in the fast-growing market for netbooks and other mobile devices, Intel has to do battle with many “fabless” firms, most of which build chips based on designs by ARM, a British company. What is more, after spinning off manufacturing, “our customers no longer have to ask: is AMD able to invest in the next generation of manufacturing?” says Dirk Meyer, the firm’s chief executive. And Abu Dhabi’s investment in Globalfoundries is part not just of its preparations for the post-oil age, but also of a long-term plan to create a “global” alternative to foundries in Taiwan and mainland China. The company will build a fab in New York state and perhaps one day in the Gulf state.
Whatever the precise number of firms, the semiconductor industry will be highly concentrated and much of it will be dominated by Asian companies. Does this matter? From a purely economic standpoint, probably not much. The industry’s extreme capital-intensity is certainly a barrier to entry, and in theory a market with only a few suppliers is ripe for rigging. But chipmakers are unlikely to be able to extract a disproportionate rent or restrict supply—or even to try. For one thing, the industry has a history of intense competition. This is especially fierce among Asian national champions, for which prestige plays a big role. More important, the global production network of the information-technology industry is much too interdependent. If foundries, for instance, took a much larger piece of the pie, others in the value chain, such as chip designers, would find it hard to survive.
From a political perspective, the shift towards Asia could matter much more—especially for Europe. Although America has lost much of the “back end” of chipmaking—the packing and testing—to Asia, it still is the home of many leading-edge fabs, notably those run by Intel. Intel’s finances, thanks to its dominance, are still healthy, but the big European chip firms such as STMicroelectronics (revenues of $9.8 billion in 2008), Infineon Technologies ($6 billion) and NXP Semiconductors ($5.4 billion) are struggling. NXP has just announced a financial restructuring to lighten its debt burden of nearly $6 billion.
Worse, over the past ten years Europe’s market share in semiconductors has dropped from more than 23% to about 15%, according to Future Horizons, a consultancy. A recent report by the European Semiconductor Industry Association (ESIA), a lobbying group, listed some of the reasons for this erosion: the appreciation of the euro, much more generous subsidies in other regions and lagging R&D spending. If governments do not act soon, the report concludes, chipmakers will continue to migrate elsewhere and put Europe’s competitiveness at risk.
Although sophisticated chips are an essential ingredient of many European exports, from cars to medical equipment, the answer is unlikely to be a splurge of taxpayers’ money. A lot has already been spent on manufacturing, to create jobs. But this approach will work even less well in the future. Trying to draw level with Asia in chipmaking would be futile.
What is more, although there has been a lack of spending on research, the real problem has been a lack of successful commercialisation. What Europe’s semiconductor industry—and its technology sector as a whole, for that matter—badly needs is a better environment for entrepreneurs, says Dan Breznitz of the Georgia Institute of Technology, a specialist in the global IT industry. Because Europe’s semiconductor industry has been dominated by big, hierarchical companies, fabless firms are still rare. In Israel, by contrast, with its newly entrepreneurial culture, they have multiplied. Europe, argues Mr Breznitz, is still too focused on manufacturing.
Europe could stage a comeback, some say, should an old idea finally take off: “mini-fabs”—small, flexible and agile production units. Such a revolution has happened before, in steel: giantism once seemed insuperable, yet today plenty of steel is made in “mini-mills”, which use scrap as raw material. Might the foundries of the information age one day be under a similar threat? Maybe. But experts are right to be sceptical: transistors may get ever smaller, but in chipmaking scale rules.
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