A Jumping off Point: China and U.S. market conditions for the semiconductor industry


This article is the first in a year-long series focusing on the economic climate for the semiconductor industry. Each article in this year's series will focus on a particular
coupling of regions or countries to explore how immediate economic indicators are affecting the manufacturing and the consumer end-market subsectors in our industry. The goal of these articles is to provide a meta-analysis and synthesis of evolving economic and market conditions to guide planning and procurement.

A global moment
As the saying goes, "all good things must come to an end." In its earlier days, the semiconductor sector enjoyed the benefits of new industry - rapid growth and near -immunity from economic turmoil. But, as pointed out in MarketWatch Quarterly Summer 2007, "Open Market Review: Volatility and Opportunities," the semiconductor market has matured and now closely correlates with global gross domestic product (GDP) growth. This proved to be true for 2007. According to the Semiconductor Industry Association (SIA) briefing of February 1, 2008, the global, total year-to-year sales as a percent of change was 2.5% not far off of the 3 to 4 % global GDP growth for 2007, especially considering the memory market volatility in 2H07 (www.sia-online.org/pre_release.cfm?ID=464). An outlook for the semiconductor market in China and the U.S., thus, needs to start with the global outlook.

Given the murky global economic waters, this year's global GDP is likely to be around 3%, with individual OECD countries barely hitting 1.5-2% (www.industryweek.com/ReadArticle.aspx?ArticleID=15655). The biggest contributor to the somber outlook for global growth is the current performance of the U.S. economy. Economists and regional analysts at the International Monetary Fund (IMF), World Bank (WB), Asian Development Bank (ADB), and country specific agencies are working overtime to collaborate on everything from stimulus strategies to monetary tightening. Advice is being handed out to all, from the U.S. Federal Reserve System ('the Fed') to the most nascent of emerging economies. All the while there is only partial agreement as to the possibility or extent of cascading effects of global economic downdraft onto any subset of economies. The question is the extent to which individual economies are coupled or not and the resiliency to withstand the current volatility.

The 2008 growth forecast for the semiconductor industry is more optimistic, projected at 7.7% by SIA (www.sia-online.org/pre_release.cfm?ID=464), and 7.5% by iSuppli and 6.2% by Gartner Dataquest. The question being raised, though, is whether this will be a "profitless prosperity," as offered by Steve Newberry, CEO at Lam Research Corporation (www.semiconductor.net/article/CA6523410.html). While demand for chips increases due to the continued decrease in cost combined with the "faster, smaller, cheaper" phenomenon (source: SIA, ibid.), "industry revenue figures tend to mask the growing pervasiveness and economic contributions of semiconductors, according to SIA President George Scalise (source: SIA, ibid.) As Wall Street analysts present, the current "book-to-bill ratio of 0.89 according to the January 2008 Book-to-Bill Report published by [Semiconductor Equipment and Manufacturers International] SEMI" translates to a solid and growing demand for chips (http://seekingalpha.com/article/65965-outlook-for-semis-continues-to-improve?source=d_email). "With equipment installations going down, the oversupply that currently exists will soon be absorbed, [U.S.] recession or not." (source: ibid.)

While the global economic moments are critical to gauge the health and trajectory of the semiconductor industry, relating the macro-economic picture to the specifics of our industry presents an interesting and, with regard to developments in China, a curiously hopeful picture.

Two to Tango: The (de-)coupling of industrialized and emerging economies
The subprime debacle and ensuing credit problems in the U.S. along with record setting oil prices, unemployment increases, and financial uncertainty are pointing to the elephant in the room - recession and "stagflation." In China, another global market heavyweight, there are equal pressures as a result of its recent position as a first time net importer of coal, and ensuing energy price surges. Considered with new labor laws, environmental and banking policies, China is experiencing an inflationary period combined with continued double-digit economic growth - 11% in 2007. These two countries are significant players in the semiconductor industry, and their economic health is critical to the health of the industry.

Economists and analysts alike are debating the extent to which economic slowdowns in the major industrialized countries may affect the rest of the world. The question is one of economic coupling - are today's emerging markets maturing enough so as to be decoupled from the industrialized economies and thereby better withstand downdrafts? As reported in the Wall Street Journal (WSJ),"'[n]o country can decouple from the U.S.,' said Kamal Nath, India's trade minister. 'The question is the impact.'" Echoing this sentiment in the WSJ article is James Wolfensohn, former head of the World Bank, "to talk of decoupling, at this stage of economic development, is premature."(WSJ Online 1/24/08 "Developing Economies Can't Shake Global Risk" - http://online.wsj.com/article_print/SB120112269478210999.html)

For the semiconductor industry, the question of the maturity, hence decoupling, of the emerging markets is an important variable in assessing the health of the newly emerging consumer end-market sector. The consumer electronics sector is seen as a critical stabilizer for the semiconductor industry, especially as chip penetration continues (http://www.evertiq.com/news/print-body.do?news=9641&cat=2):

As EMS providers attain higher and higher levels of penetration in the communications infrastructure and computing segments, the EMS business in these sectors becomes more and more dependent on end-market demand. Together, these segments represent nearly half of the EMS market ([MMI] April 2007, p.1). Manufacturing Market Insider (MMI) Vol. 18, No. 1:1

If we accept that emerging markets are still coupled to industrialized markets, and we recognize that the semiconductor market has reached significant level of penetration because of the proliferation of components in myriad consumer end-market goods, then we recognize that the present economic slowdown is sobering but not without some important optimistic moments. The increasing levels of market penetration brings with it increased sales. However, the reasons for the increases are, to an important extent, related to the declining ASPs, hence the possibility of a "profitless prosperity" forecast as mentioned above. There is a more positive side to this economic moment. The consumer end-market is expanding rapidly with a solid, sequential, positive trajectory. There are millions of new middle class consumers entering the marketplace over the next two decades from emerging economies.

While it is unlikely that the semiconductor industry will see double digit growth or profits in 2008, analysts seem to agree on a 6-7% sales growth for 2008 (sources: iSuppli, Gartner, Lehman Brothers, MMI, Consumer Electronics Association (CEA), SIA). Not a bullish year, but given the global economic slowdown, these are respectable numbers.

The good news from China for the semiconductor industry
There is more good news. While consumer spending is likely to be dampened in industrialized economies, such as the U.S., many economists and analysts argue that these negative market conditions will be off-set by increases in consumer spending by the growing middle classes in emerging economies, most notably China, India and Russia (cf. http://go.worldbank.org/TC26UFESJ0). According to The Economist, the data from 2007 reveal that the general economic picture in China has been changing significantly (www.economist.com/finance/displaystory.cfm?story_id=10688833). There was a near-6% drop from 1Q07 to 4Q07 in China's export growth due to "[...] weaker American demand and the impact of a stronger yuan" (ibid.)"Meanwhile import growth surged from 18% to 26% on the back of strong industrial and consumer demand. In other words, Chinese imports are now growing faster than exports." (ibid.)

As the new middle class emerges in China, among other Asian and South Asian countries, important consumer end markets are unfolding. "By the year 2030, 361 million Chinese - more than the entire current population of the U.S. - will meet the World Bank's classification for middle class [...]" (WSJ Online 2/20/2008 "A Rising in the East" - http://online.wsj.com/article_print/SB120346486010978371.html). Additionally, these new consumer electronics markets are increasingly important because, according to analysts and senior executives such as "David Sheu, chairman and CEO of Taiwan-based equipment supplier Spirox, [...] '[...] in contrast to the US market, China's consumption of high-price products should not be underestimated.'" (DigiTimes 12/12/2007).

On the manufacturing side, there are equally important positive data coming from China amidst the grim global news. While China's Pearl River Delta is experiencing an exodus, these are the troubles of light manufacturers, not high-tech or automotive manufacturers.

Similarly, while there is considerable press regarding new Chinese labor laws that are leading to increased costs associated with employees, notably wage and benefit increases, the high-tech manufacturers have already been paying higher wages to secure skilled workers. "[...] over the long run, the [labor] rules could prove a 'blessing in disguise' for big manufacturers by pushing out smaller rivals that try to undercut them on price, says Steven Tseng, an analyst for ABN Amro in Taipei who covers Hon Hai [...] and other[s]." (http://online.wsj.com/article_print/SB120120382737914255.html)

Other governmental policies are positive for the semiconductor industry. As China invests significantly in infrastructure improvements, manufacturers stand to gain. Railways, roads, airports and sea ports all are included in the Chinese government's improvement plans. Improved logistics in a country where logistics is already considerably ahead of neighboring Asian and South Asian countries will strengthen local manufacturer's positions. Additionally, improvements to the power grid are set to come and will have similar positive effects.

The currency exchange impacts are notable, and as the Chinese yuan continues to rise and the U.S. dollar continues to weaken, pressures will mount along supply chains (www.industryweek.com/ReadArticle.aspx?ArticleID=15560). For many in the semiconductor industry, currency impacts will be a factor, but not likely as dramatic as in other industries. As discussed in MarketWatch Quarterly Summer 2007, "New Value Chain Strategies Defining Today's Electronics Industry," the electronics industry is made up of highly modularized and globalized value chains. During volatile economic periods, this modularity can be leveraged by organizations to support their diversified portfolios and value chain partners' agility and global reach. By engaging with value chain partners who also have global assets, the exposure to unfavorable currency fluctuations can be lessened (cf. IndustryWeek article for additional cost-savings approaches).

Finally, iSuppli forecasts double-digit chip market expansion for 2008 at a rate of 12%. This number represents a 3% loss over 2007, but a rebound is forecasted to begin by 2010. Among the reasons offered are increased price-based competition as a result of the continued rise of the Chinese yuan, the Chinese government's economic restructuring plans, and the general state of the domestic electronics industry. "In response, chip makers are accelerating new product development efforts.[...] suppliers are strengthening partnerships [...]. Improved service is becoming another important competitive differentiator within China's electronics market." (http://www.isuppli.com/news/default.asp?id=8698&m=12&y=2007).

New consumers, cyclicity and industry maturity lead to opportunity
The global economic arena is extremely volatile and presents increased risk for everyone, from consumers to multinational organizations. However, as electronic components continue to permeate consumer end-market goods, growth opportunities arise for the semiconductor industry. There are important market expansions to engage as new middle classes arise in the emerging economies and the savvy corporation has initiated their local market expansions.

Cyclicity is important to keeping one's perspective in tense markets. For example, despite the continued disappointing news regarding NAND flash memory prices which are expected to fall "by as much as 55 percent this year" and global NAND revenue set to drop from the original projection of 27% to 7-9% for the year, the major NAND flash manufacturers are preparing for significant revenue growth expected to come in 2009 and 2010. This exemplifies the fact that "[p]ricing [...] is cyclical." (www.washingtonpost.com/wp-dyn/content/article/2008/02/22/AR2008022200044.html).

The semiconductor industry is well poised at both the macro- and micro-economic levels to ride out 2008 and even implement forward-thinking strategies that can return competitive advantages. As witnessed, the good investments and business practices engaged by the high-tech manufacturers in China are presently buffering them from the number and degree of economic changes being implemented by the Chinese government. The ability to weather economic and market cyclicity is based, in part, on the maturity, hence diversification and modularity, of the industry.
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