The Chips Are Down. Way Down

A severe shortage puts a squeeze on electronics makers

These should be the best of times for Silicon Integrated Systems Corp. The Taiwan company designs chips used in personal computers sold by the likes of IBM and Dell Corp. Yet while global demand for electronics products is soaring, SIS's stock price is off 60% since March. And in the first quarter, the company's profits fell by nearly half, to $46 million, from the same period last year. The culprit: a severe chip capacity shortage that is making it hard for SIS to get its semiconductors to market.

Taiwan chip designers like SIS have become victims of a business model that helped them prosper for much of the 1990s. Lacking their own silicon-wafer and chip-packaging facilities, most contract the work out. The most important suppliers are foundries Taiwan Semiconductor Manufacturing Corp. (TSMC) and United Microelectronics Corp. (UMC). The close-knit relationships between designers, manufacturers, and Taiwan's myriad materials and components suppliers--many of which are a taxi ride away from each other--is key to the island's edge over Japan and South Korea.

But now, with demand for chips used in cell phones and Internet appliances booming worldwide, Taiwan foundries are overbooked by up to 30%. And while they don't overlook their local partners' needs, they often are obliged to favor huge U.S. clients, leaving second-tier companies like SIS in the lurch.

HOT DEMAND. The capacity crunch may be a short-term hiccup. TSMC, UMC, and Singapore foundry Chartered Semiconductor all are spending billions on new wafer fabs. And South Korea's Hyundai Electronics and Samsung Electronics, among the world's biggest producers of memory chips, are devoting some of their capacity to fill outside orders for multimedia chips that are in hot demand. For at least the rest of this year, however, Taiwanese shops will have to find new ways to cope. Those that don't adapt, says Calvin Chang, a Jardine Fleming analyst in Taipei, "will have to go elsewhere--or go bankrupt."

One such survival strategy is to look for smaller foundries outside of Taiwan. This option is popular for companies like Sunplus Technologies, designer of chips used in the Furby doll. Major foundries now shun chips used for such low-tech products because they can make higher margins on devices used for more sophisticated gizmos, such as digital cameras or cell phones that access the Internet. So Sunplus hopes to get its chips from Korea.

Other chip designers are building their own silicon-wafer plants. In March, SIS opened a $340 million facility, and it is building two more. "We need to be in control of our own manufacturing capabilities," says product director Alex Wu. Macronix International Co. also is taking this approach. The Taiwanese chip company can only meet 30% of its orders for devices used in hot-selling MP3 players and Sega game consoles. So it is breaking ground on its third wafer fab, at a cost of $1.4 billion.

But building chip-fabrication plants is financially risky. For starters, if demand slows down for their products, the plants' owners can run up huge losses by being stuck with excess capacity. And if they can't recruit top-notch talent to run the plants efficiently, they risk being uncompetitive with their rivals. What's more, they could get cut off for good by a foundry like TSMC, which could devote its capacity to other design houses.

There also is a danger that smaller companies will simply misjudge the semiconductor demand cycle and capsize in the next industry shakeout. Overall chip capacity is expected to expand 30% annually for the next few years, but the Taiwan Semiconductor Industrial Assn. reckons that growth in annual demand for semiconductors produced on the island will slow from about 35% now to single digits after 2003.

So rather than take that plunge, most Taiwan electronics manufacturers will have to wait in frustration. In recent months, for instance, Universal Scientific Industrial Co. has been able to secure only about two-thirds of the chips it needs to build its computer circuit boards. USI's sales still are growing at a 22% clip. But its main customer, IBM, has seen sales of its notebook PCs nearly double this year. So it has had to buy more from USI competitors. Until the demand-supply equation equals out, it will be one of many Taiwanese companies that will have to watch opportunity pass it by.

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