By Richard Tortoriello With semiconductor sales up 16.4% for the first 10 months of 2003 from the same period a year ago, we believe that the long-awaited recovery in the chip industry is finally under way. Unlike previous recoveries, however, the driving force isn't corporate upgrades of technology gear, nor revolutionary new applications such as the cell phone or the Internet. Instead, rising consumer-electronics demand and wider geographic penetration are fueling sales. In particular, we at S&P see a booming economy in China and the ripple effects that are extending from it throughout the Asia-Pacific region driving recent semiconductor growth.
What's happening is a startling shift in semiconductor demand from the West (primarily from the U.S. and to a lesser extent Europe) to the East, driven by China (see chart below). According to the Semiconductor Industry Assn., China has rapidly become the third-largest market for semiconductors, with $19 billion in sales in 2002, or about 14% of total demand.
One primary reason for this is a major shift in electronics manufacturing to Asia. For example, in its fiscal year ended March, Singapore-based Flextronics International (FLEX), the world's largest electronics-products maker for the PC, telecom, consumer, and other industries, made 36% of its goods in Asia and 22% in the Americas. In fiscal 2001, those figures were 21% and 42%, respectively.
Source: Semiconductor Industry Association, S&P Forecasts
CHINESE CONSUMPTION. A recent report by International Finance Group, a member of World Bank Group, suggests that 8% of all electronics manufacturing now takes place in China, and that's expected to more than double by yearend 2005. A combination of low labor costs and a highly educated workforce is luring manufacturers to China, as well as to other regions of the Far East.
As a result, China's major cities have experienced a boom in employment, construction, and personal income. In turn, Chinese consumption of electronics goods has jumped. Over the past decade, it has become the world's largest market for cell phones, adding more than 300 million subscribers. Still, the penetration rate is only 11%. For PCs, China now accounts for over 40% of shipments from the Asia-Pacific region (excluding Japan).
As more chips are made in China to meet the rising demand for electronics products worldwide, we believe the economic balance of power is shifting from the West to the East. The manufacturing strength in it and other developing countries is resulting in a modernization boom in China, the Pacific Rim, India, and even Eastern Europe. The result, in our opinion, will be increasing demand for semiconductors to power both high-tech infrastructure and electronics products purchased by a rising middle class.
WHERE AMERICA LEADS. Indeed, chipmakers have been getting more of their sales from the East. Intel's (INTC) revenues from Asia-Pacific (excluding Japan) have risen from about 20% of total revenues in 1998 to 38% in 2002. Analog Device's (ADI) sales to Asia have risen from 14% in 1999 to 32% in 2002. Vishay Intertechnology's (VSH) Asian revenues have risen from 12% in 1998 to 29% in 2002.
Though chipmaking has been on rise in the East, we believe that the U.S. still holds the leading position in semiconductor design. China has been rapidly building chip plants, but much of that capacity is for trailing-edge, or older, technology, rather than for today's most sophisticated chips. At the same time, chip-design capabilities in China have lagged behind its production capacity.
Among other Asia-Pacific areas, the Taiwanese market is highly focused on chip-contract manufacturers, or foundries. Korea is focused primarily on the volatile memory-chip market. And Japan, while strong in both memory and consumer-related chips, is still recovering from a period of underinvestment in new manufacturing technologies.
CYCLE DRIVER. A quick glance at market-share rankings for different types of semiconductor products shows U.S. companies are leading all categories except dynamic random access memory (DRAM), where Korea's Samsung is No. 1, and analog integrated circuits, where Texas Instruments (TXN) is second to Swiss-based STMicroelectronics (STM). However, U.S. companies continue to hold the lead in the lucrative high-end analog integrated-circuit market.
We believe that the current semiconductor up-cycle will continue to be driven by Asia and be aided by the continued penetration of semiconductors into consumer goods and the return of corporate information-technology spending in the U.S., as profits and employment rise. Semiconductor up-cycles typically last about three years (some are slightly shorter). Given continued economic strength in Asia, we believe this one could easily last through 2005, and we forecast 16% semiconductor sales growth this year and 22% in both 2004 and 2005.
Although we believe Asia will be an area of significant growth in the world economy over the next several years, investing directly in the stocks of foreign countries involves a number of risks, including political uncertainties, currency fluctuations, and regulatory risks (despite recent corporate debacles, U.S. public companies remain the best regulated in the world).
HOT PICKS. We think that investing in U.S. chipmakers with a strong competitive position and a significant presence in Asia is a good way for investors to participate in the region's growth, without the additional risks of investing in foreign securities.
Our favorite stocks include Intel (INTC), Texas Instruments (TXN), Analog Devices (ADI), Microchip Technologies (MCHP), Cree (CREE), and Vishay Intertechnology (VSH), all of which carry our highest ranking of 5 STARS, or buy. Analyst Tortoriello follows semiconductor equipment stocks for Standard & Poor's