Short circuits, blown fuses and the chips they are a changing

It's been a disastrous 12 months for semiconductor sales, yet things are looking up

Still reeling from the biggest slump in its volatile history, the semiconductor industry finally gave the stock market something to cheer about last week. With optimism fuelled by a favourable report from a trade body and a price hike by a leading memory chip maker, investors are beginning to believe that the worst may finally be over. The question now is how long will it be before the industry returns to healthy growth rates – and how many suppliers will still be around to enjoy them?

The scale of the problems that beset chip suppliers was evident just before Christmas, when industry analyst Gartner Dataquest released a preliminary review for 2001. According to its figures, worldwide semiconductor revenue plummeted 33 per cent to $152bn (£106bn) as the global economy nosedived, with market leader Intel suffering an estimated 22 per cent drop and fourth-placed Samsung seeing a decline of some 40 per cent. As Mary Olsson, chief analyst for Gartner Dataquest's semiconductor group, noted at the time: "A downturn of this magnitude will be difficult for many companies to recover from in 2002."

Although the 2001 figures were disastrous for a sector that has previously enjoyed annual growth rates of some 17 to 18 per cent, there were signs in the fourth quarter that the market was at least bottoming out. Last week the Semiconductor Industry Association (SIA), a California-based trade body, reported the second consecutive month-on-month increase in global sales for November, enough to convince it to stick by its prediction that sales in the traditionally buoyant fourth quarter would climb 4.7 per cent on the previous quarter.

Although the Americas remained flat in November and the Japanese market slipped, Europe led the recovery with a 5.3 per cent sales increase, with the Asia Pacific market reporting just under half that level of growth. Coupled with news that South Korea's Hynix Semiconductor had increased its memory chip prices for the third time in a month, this was enough to rally semiconductor shares around the world.

The good news, however, is only relative, and despite the temporary optimism, the outlook for 2002 remains sluggish. While Gartner Dataquest predicts 3 per cent revenue growth for the semiconductor industry over the year, Ms Olsson cautions that a weak first quarter could delay recovery, and neither the SIA nor industry analysts expect annual revenue growth to make a real recovery until 2003.

With the telecoms sector still in a slump, the speed of the recovery now rests on several core markets, including personal computers, wireless communications, consumer electronics and, to a lesser extent, the automotive sector. Vinay Asgekar, semiconductor research director at AMR Research, believes that the wireless sector will probably lead the recovery, driven by new demand in Asia this year and fuelled by take-up of next-generation technologies in Europe in 2003. PC sales, he argues, will remain fairly flat this year with a recovery towards the end, climbing further in 2003 when the home networking market may also begin to take off. Hand-held devices, which generate modest revenue for the semiconductor industry, may also grow as organisations look to achieve corporate productivity gains on top of the personal productivity improve- ments that have characterised growth in that sector so far.

Ms Olsson at Gartner Dataquest, meanwhile, argues that the consumer market will once again play a prominent role in leading the industry out of its slump, not so much through "legacy" products, such as TVs and electronic appliances, as through new digital products. Many believe the DVD market, for example, is set for a strong year.

While these different pulls may take the industry back into positive growth, the laboured nature of the recovery means that further consolidation is inevitable. Some Japanese suppliers, as well as a number of long-established US companies that have dropped out of the top tier, are expected to pull out of the market, and takeover talk is set to rise. But the shake-up could be more far-reaching than a simple wave of mergers and acquisitions, as economic pressures accelerate two important changes in the way that the entire sector is structured.

To begin with, vendors will be forced to take a more collaborative approach to their design and production processes. As in several other hi-tech sectors, the semiconductor industry is becoming vertically integrated, with suppliers joining forces rather than attempting to own the entire production process. That trend was reinforced last week by Japanese media reports that 11 semiconductor makers are looking to team up to produce the next generation of chips – an approach that could lead to significant factory cost reductions. The cultural challenges inherent in collaboration, however, mean that building these kinds of relationships won't necessarily be easy, particularly since some major suppliers will be negotiating a role for themselves from a position of relative weakness.

Just as significantly, the industry will need to focus on improving the efficiency of its supply chains in the face of continuing pricing pressure. Rapid advances in technology are driving down production cycle times, changing the dynamics of the supply chain and forcing suppliers to re-evaluate their manufacturing and logistics strategies.

"Chief executives have talked in the past about engineering and new designs," says Mr Asgekar at AMR Research. "Today, the supply chain is becoming a topic for chief executives as well. This year will be a year of execution – people want focus, execution capability and flexibility."