Caught With Their Chips Down
Hewlett-Packard Co. knows what a close call feels like. Last December, the company came within days of having to shut down a critical line producing computer servers--high-margin products that sell for $2,000 and up. The reason: HP had nearly run out of capacitors--humble components that normally cost about 2 cents apiece. HP's buyers scrambled and found 100,000 of the parts on the Internet. They were selling at a hefty premium, "but it was worth it," says Don Schmickrath, Hewlett-Packard's vice-president for manufacturing. "This is not a 2 cents problem."
Plenty of other executives would second that thought. From Seoul to Silicon Valley, high-tech companies around the world are struggling with an unexpected problem: Surging global demand for all things electronic--especially cell phones, digital cameras, and networking gear--is outstripping the capacity of the world's semiconductor factories to produce enough parts. That is leading to an acute shortage of memory chips, LCD screens, and other key components. And it is driving up manufacturing costs. At the very least, some manufacturers will have to lower their revenue targets. If the drought persists, the effects will also show up in more retail shortages of popular gizmos and in lost earnings for more companies.
So far, big companies that have expressed the greatest concern--including Motorola Inc. and Cisco Systems Inc.--have resisted passing the increased costs along to their customers. But if the shortages don't ease up, prices on some industrial and consumer goods could start to reflect the strain.
How serious is the parts drought? Cisco Systems, the world's top supplier of Internet infrastructure, has been leaning on its suppliers to produce more hard-to-find parts, including a variety of semiconductors. But even with its immense clout, there are limits to how far Cisco can push its suppliers to build or reallocate parts. In the past year, memory-chip leader Samsung Electronics, for example, has boosted by 50% its allocation to Cisco of so-called flash memory chips, which retain data even when the power is switched off. "But that accounts for only about 70% of what Cisco wants," says Chung Eui Yong, Samsung's director for chip marketing.
The parts shortage springs from several star-crossed events. Over the past three years, as the chip industry suffered one of its worst slumps on record, manufacturers sharply curtailed spending on new plants. Companies that build personal computers and other products that use chips were partly to blame: They imposed relentless cost cuts on their chip suppliers, who in turn took that reduced income out of their own capital investment. Even giant Intel Corp. cut its spending--and is now facing a shortage of processors. "In retrospect, we probably underinvested in capital last year," concedes Intel Chief Executive Craig R. Barrett, "and we were caught by surprise by the strength of demand in the past six months." Last September, investments by chip companies started to climb again, but the damage was done. Adding capacity takes 12 to 18 months, so today's shortages will likely get worse for the balance of this year.
At some companies, the shortage is taking a toll on the bottom line--and the stock price. Higher prices on key components are eating into Motorola's profit margins, which have fallen to 3% on some cellular phones. And shrinking margins on its most prestigious consumer products have ruffled investors once again. The company's stock price has fallen below $100 a share from a high of $184 in early March.
Cisco, meanwhile, saw its stock swoon 7% after CEO John T. Chambers warned on May 9 that the parts problem could crimp future revenue growth. So far, few major companies have actually missed their growth projections and pinned the blame on missing parts. But that day may not be far off, warns Prudential Volpe Technology Group analyst Pete Peterson. When it happens, he says: "Expect big swings in the stock prices."
Although the parts shortage is just starting to bite into corporate operations, it is already shifting the balance of power between manufacturers and suppliers. As far back as the mid-1990s, product manufacturers shrewdly exploited a global glut in computer chips and other components to extract ever-lower prices from their suppliers. The global currency crisis also left Asian suppliers willing to sell at any price just to keep their factories running. No more. With demand racing ahead of supply, "the component makers are almighty," says Masami Fujino, an electronics analyst at Nikko Salomon Smith Barney Ltd. in Tokyo. "They can actually determine a manufacturer's market share."
For the long term, few manufacturers are panicking. That's because in many cases, the shortages can be ameliorated fairly quickly. In the case of printed circuit boards, used in almost all high-tech consumer gadgets, "capacity is nearly tapped out," says Philip E. Fok, a director at contract manufacturing giant Solectron Corp. But boards production is neither terribly complex nor capital-intensive, so their manufacturers have a relatively easy time ramping up.
Chip manufacturing is more difficult to accelerate. Ditto flat-panel displays, which are used in a growing array of consumer gadgets. Matsushita Communication Industrial, a leading Japanese producer of digital phones and car-navigation systems, says a shortage in small liquid-crystal displays for cell phones is now tearing through the communications sector and probably won't start to ease until the end of this year. And the crunch is starting to pit product makers against one another. Hewlett-Packard's Schmickrath, for one, blames "the damn cell-phone people" for gobbling up his once-steady supply of components.
The shortages in components are driving up some wholesale prices. Motorola and Ericsson say they are paying anywhere from 4 to 10 times normal prices for certain cell-phone parts, including ubiquitous capacitors and flash memory chips.
HOLDING THE LINE. So far, those wholesale prices aren't translating into sticker shock. Fearful of losing market share, most manufacturers aren't passing their rising costs along to consumers. Indeed, some wireless carriers--including AT&T--are still giving away cell phones to help persuade customers to sign long-term contracts. And when Sony Corp. introduces its long-awaited PlayStation2 in the U.S. next October, it plans to hold the price at $299--about $70 less than the game console's list price in Japan.
Even if consumers don't suffer price hits, rising component costs are changing the dynamics of the electronics industry, turning former winners into losers--and vice versa. After years of agony, Samsung saw its earnings quadruple, to $1.44 billion, in the first quarter, compared with the same period a year earlier. Almost all of those profits flowed from sales of memory devices.
Samsung's surging profits mark a turning point for electronic-parts makers. For the past five years, they have struggled with falling prices. And after the global currency crisis, some Asian producers simply stopped investing in new capacity. "The last downturn was so painful that chipmakers didn't want to build new plants," says Eric Rothdeutsch, a semiconductor analyst at Merrill Lynch & Co. "They didn't believe any uptick in demand would last."
Boy, were they wrong. Demand for electronic products, led by handheld and wireless products, has exploded in the past year. Sales of cell phones are expected to jump 60% this year, to 440 million, says Bill McClean, president of semiconductor consultant IC Insights. Says McClean: "There's no way the semiconductor industry today can meet that kind of demand."
SMART PLANNING. The parts drought has not hit all players equally hard. Credit smart strategies for part of that. Dell Computer Corp. announced earlier this year that it had staved off parts shortfalls through large, long-term contracts with Intel and IBM. Hewlett-Packard has avoided spot shortages by finding more sources for parts over the Internet. And at Nokia Corp., engineers arranged its manufacturing so that parts could be swapped easily from slower-selling cell-phone models to more popular ones.
These are clever moves. But companies such as Dell and Nokia also enjoy natural advantages. Overall, those with the fattest market share have been the best insulated. In times like these, "the top-tier players will get all the chips they need," says Will Strauss, president of Forward Concepts, a Tempe (Ariz.) market researcher.
Mercifully, times like these don't last forever. Intel, the world's largest chipmaker, is spending $6 billion this year to add new equipment and plants. In total, chipmakers worldwide have announced $50 billion in new capital spending so far this year. But much of that new capacity won't come on line for at least two years. In the meantime, manufacturers will have to beg and borrow--everything but steal--to keep those assembly lines moving.