The Chips Are Falling IBM's Way

Its huge bet on a new leading-edge fab is looking smart

It was a bold bet, and it kept IBM (IBM ) Technology Group in the doghouse for a year. Smack in the middle of the semiconductor industry's worst recession in decades, IBM poured $3 billion into a state-of-the-art factory in East Fishkill, N.Y. It was the company's biggest capital project ever.

And it crushed the bottom line. Last year, the group lost $254 million, in addition to $803 million in one-time charges. Some questioned whether IBM should keep slugging it out in chips.

Now, Big Blue appears poised for a silicon recovery. In custom chips made for individual customers, IBM is already No. 1 and is extending its lead over rivals such as Texas Instruments (TXN ) Inc. and Japan's NEC (NIPNY ) Corp. And in its foundry business, where it transfers complex designs from other companies onto silicon, IBM is wresting contracts away from the Taiwanese leaders. Indeed, BusinessWeek has learned that IBM is close to securing additional major foundry work with Broadcom (BRCM ) Corp., which sells networking chips, say sources close to the deal.

A turnaround at the chip division is key to IBM's bottom line. While the $2.9 billion division represents only 4% of total revenue, Toni Sacconaghi Jr., an analyst with Sanford C. Bernstein & Co., estimates that resurgent chips, which accounted for so much red ink last year, will contribute $139 million in pretax profits this year, making up 12% of IBM's estimated $1.2 billion in pretax profit growth. As IBM ramps up the Fishkill fab from the current 35% of capacity, he expects a small loss in the second quarter. Still, for the year he's predicting that sales for the chip group will grow to $3.7 billion, up 28% from last year, excluding gains from businesses sold a year ago. At full capacity, Sacconaghi estimates, the Fishkill facility could bring in an extra $2 billion in revenues.

A chip turnaround would vindicate IBM's ambition to be the Sultan of Silicon. Big Blue derives the majority of its sales and profits from services and software. But Chief Executives Louis V. Gerstner Jr. and, currently, Samuel J. Palmisano have stuck with chips despite the high capital costs and increased volatility they bring. Why? Microprocessors give IBM's own computers an edge. IBM's new mainframe, released on May 13, features IBM-built processors that are 40% quicker than their predecessors. And high-powered chips with the zippiest graphics capabilities push IBM into hot new products, such as Sony (SNE )'s upcoming PlayStation. "We have a vision that we're sticking to," says Sumit Sadana, strategy director for IBM microelectronics.

IBM's high-end strategy plays to its tech knowhow. In the latest chips, transistors are measured in microscopic nanometers and can no longer be easily shrunk -- they have to be redesigned to take into account the physics of silicon. And IBM is one of the few that can offer customers patented design, new materials, and advanced production. "IBM's strong research capability puts them in a class by themselves in this new Nano Age," says G. Dan Hutcheson, president of market-watcher VLSI Research Inc.

But to cash in on chips, Big Blue must stay at the leading edge -- without falling over it. Top foundry players Taiwan Semiconductor Manufacturing (TSM ) Co. and United Microelectronics (UMC ) Corp. also are building new megafabs. This pushes IBM toward newer processes and materials, where the smallest glitch can gum up production. Last year, say competitors, complications with a new insulator called SiLK forced IBM to move customers back to an older insulator. "IBM really hurt a lot of customers and did me a lot of good," says Steve Sutton, vice-president in charge of Texas Instruments' custom chips. Sadana declines to comment on SiLK.

Despite missteps, IBM shows no signs of losing its position as the No. 1 maker of custom-made chips, called application-specific integrated circuits, or ASICs. With $1.7 billion in sales, IBM claims an 18% share of the $9.6 billion ASICs market, up from 17.7% in 2001, says Semico Research Corp. A new contract engineering arm now offers to put customers in touch with hundreds of IBM engineers and provide them with its design tools. In the first quarter, sales of the unit leaped from $6 million to $34 million.

IBM's advance is even more dramatic in the foundry business. Although IBM, with only $700 million in foundry revenue, is a small fry, it grew 109% in 2002 and has been nabbing high-profile customers, such as Nvidia (NVDA ) Corp. and Xilinx (XLNX ) Inc., from the Taiwanese giants. Nvidia, a leading maker of graphics processors, tapped IBM this March to produce its next chip after glitches at TSMC led to delays. "It's getting harder and harder to get the traditional foundries to come out with the technologies we need," says Di Ma, Nvidia's operations vice-president.

The Taiwanese say that for every customer that bolts, hundreds remain satisfied with their service. And TSMC is busy adding the latest chipmaking equipment to maintain its leadership. "I don't feel squeezed," declares TSMC Chairman Morris Chang.

But the most lucrative relationships for the Taiwanese are sure to be tested as the tech race heats up in chips. And IBM will be a big part of their problem.

By Spencer E. Ante, with Otis Port in New York, Bruce Einhorn in Hong Kong, and Andrew Park in Dallas

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