Chips: Going From Thrills To Chills

Suddenly, the chip biz is plunging. How bad will it get?

Microchip makers can't fool themselves any longer. Their notoriously cyclical $144 billion industry has plunged into the sort of worldwide slowdown that was supposed to be obsolete. In recent weeks, the bad news has been pouring in from chipmakers around the globe: Lower profits. Production cutbacks. Layoffs. In the end, 1996 could be the industry's worst year this decade.

Nearly every major semiconductor maker is feeling the heat: On June 20, California's National Semiconductor Corp. said it will take a charge of some $300 million in the quarter ending Aug. 25 to cover restructuring. Advanced Micro Devices Inc., Cypress Semiconductor Corp., and others say their earnings are being pounded, too. In Europe, shares of giant Philips are in a swoon over chip fears. In Japan, Fujitsu Ltd., Hitachi Ltd., and others are scaling back huge planned expansions in production. From South Korea to Taiwan to Idaho, other chipmakers are also being rocked.

The critical questions for the chip industry and the investors who have bet heavily on its fortunes: Just how bad is it going to get? And how long can this devilish downturn last? One of the more pessimistic market watchers, Pathfinder Research Inc. in San Jose, Calif., forecasts a 9% drop in total semiconductor revenues in 1996--a gut-wrenching decline after last year's 42% gain. And Pathfinder's outlook for dynamic random-access memory (DRAM) chips is much gloomier: a plunge of 36%. Faced with a possible glut, DRAM producers are scrambling to trim output. "We can't get around the fact that the DRAM business is a commodity market," says Thomas J. Engibous, president of Texas Instruments Inc.

Many market watchers aren't as pessimistic as Pathfinder. But any slowdown at all makes a mockery of what market gurus and chipmakers had been proclaiming: the end of their industry's cyclicity. Eternal double-digit growth was almost assured, they said, because chips have become so pervasive--vital components in everything from cars to computers to consumer electronics.

Bushwa. Richard L. Whittington, an analyst with SoundView Financial Group, proclaims that "1996 is a washout." Already, investors are feeling the pain. Hammered since late last year, chip stocks are now really getting whacked. Cyrix Corp. dropped 26% after warning on June 20 of a likely loss this quarter. The Philadelphia Stock Exchange's Semiconductor Index has lost 41% since its high-water mark, posted last September. "The downturn seems to be affecting just about everybody," says Robert K. Beachler, strategic marketing director at chipmaker Altera Corp.

More bad news may be in the offing. The Semiconductor Industry Assn.'s book-to-bill ratio, which tracks the backlog of customer orders for chips against U.S. factory shipments, reached its lowest point ever in April, when it hit 0.79 (chart). It had been at an all-time high of 1.19 just eight months earlier.

SELF-INFLICTED. Still, none of this means the high-tech sector is heading for the tank. Unlike previous chip crises, this one wasn't triggered by a huge drop in demand. Rather, chipmakers inflicted the pain on themselves. After five years of increasing new capacity cautiously, they added new factories en masse last year. By the fourth quarter, 48 new plants were spewing out chips for a holiday boom that fell short of expectations.

Continued growth in demand will spare some companies. PC sales are projected to climb 19% worldwide this year, according to market researcher Dataquest Inc., down a bit from last year's 25.6%. PCs remain the gravy train for chip suppliers, accounting for about 40% of sales. That means makers of microprocessors, complex logic chips, and other proprietary products should ride through the downturn.

One of the unscathed--so far--is giant Intel Corp. It expects to notch a June quarter that equals its first quarter, when it earned $894 million on sales of $4.6 billion. And Intel says its gross margins should hold strong, at around 50%. Other makers of high-margin, specialized chips--such as S3, Xilinx, Analog Devices, and Microchip Technology--will be on the upswing by the end of the third quarter, predicts Prudential Securities analyst Mark Edelstone.

The real squeeze is being felt by the Big Three makers of DRAMs--Korea's Samsung and Japan's NEC and Hitachi. Prices on the spot market are in free fall, declining 75% since November. As a result, earnings of Asian chipmakers could plummet 40% to 50% this year. America's DRAM specialist, Micron Technology Inc., might fare even worse. Its second-quarter earnings were off 74% from a year ago, falling to just $58 million on sales of $771 million.

PIPE DREAMS. There are ominous signs that the price crunch is spreading. DRAM suppliers are switching production to more profitable designs, such as logic chips. Now, some of these markets are getting overcrowded, pinching more U.S. companies, including Cypress and Lattice Semiconductor Corp. Even Motorola Inc. has delayed two plant expansions.

Hard to believe, but this downward spiral was touched off by a minor shortfall in holiday PC sales. The industry was looking for a 40% surge, not the 25% one it got. That left PC makers and chip suppliers holding bags of DRAMs. But chipmakers kept on pumping out silicon, betting on a pickup in 1996. "Semiconductor manufacturers had very unrealistic expectations for growth in PCs," says Vladi Catto, Texas Instrument's chief economist.

The roots of the delusion trace back to Asia, circa 1989. Reacting to soft sales and a weak domestic economy, Japanese memory makers put the brakes on new plants. Instead, they ran existing factories at full tilt to squeeze out juicy profits. It worked: Memory chips stayed tight, prices held firm, and profits were enormous. But the strategy also enabled Korean rivals to grab more market share, since they were less adverse to plowing DRAM profits into new plants. Samsung Group climbed to the top of the heap--and earned billions from DRAM chips.

Japan's restraint produced the longest period of sustained prosperity in semiconductor history. But with no end in sight, the Japanese joined the latest round of plant-building. Technology improvements added to the glut. The resulting surplus of memory capacity may last through much of 1997, warns Edelstone. A continuing worry: Chipmakers are slated to add another 49 fabrication plants in 1997, figures analyst George Burns of Strategic Marketing Associates in Santa Cruz, Calif.

The wild card now is whether Asian producers really will pare back planned production hikes. Some analysts suspect empty promises made as a ploy to boost the spot-market price of DRAMs. If so, a glut could recur at any time. "It's like white-water rafting. All you can do is try not to hit the next rock," says Gary McDonald, a vice-president with memory supplier Kingston Technology Corp. Easy to say. But not easy to do when business is in a downward spiral.

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