Here Comes China, the Chipmaker

Its foundries are churning out lower-priced chips and threatening to take market share from the world's semiconductor giants

Three years ago, semiconductor giant Texas Instruments (TXN ) seemed to have run out of options. As chip technology took another leap, it needed to spend $300 million to $400 million to upgrade its factories. An alternative: Look for a contract chip manufacturer willing to spend on a new production line to finish TI's semiconductors.

But it found no takers. Established manufacturers such as Taiwan Semiconductor (TSM ), United Micro Electronics (UMC ), and Chartered (CHRT ) turned up their noses because TI had an unusual request. It wanted to half-finish the chips in its Dallas plant, then complete them at another company's foundry, says Tom Thorpe, TI's vice-president for external manufacturing. Foundries typically do only whole-chip production because it means fatter profits.

But a Chinese newcomer, Shanghai-based Semiconductor Manufacturing International (SMI ), was willing to take the risk. Like most Chinese chipmakers, it was "young and hungry," says Thorpe. Now, the two companies are inseparable. In future years, SMIC is likely to reap a bigger slice of TI's business.


  It's also likely to cut into the business of other big-name chipmakers. The Chinese are flexing their youthful muscles due to many factors, both global and local. For one, domestic demand is skyrocketing. This year, China is expected to use $34.3 billion worth of semiconductors, making it the world's largest chip market, according to chip consultancy IC Insights in Scottsdale, Ariz.

Today, most of those chips are imported. But it's financial common sense for companies catering to China to produce semiconductors locally. Since TI's aggressive effort paid off, expect other companies to be a lot more willing to couple with a Chinese manufacturing partner.

China's chip industry has come of age very fast. Its first semiconductor-only foundries went online four to five years ago. Local makers seemed doomed from the start because various international laws prohibit companies from sending their advanced chip-manufacturing technologies to China. The new industry appeared destined to produce nearly obsolete chips, essentially, to pick up low-end crumbs falling from the table of chipmaking heavyweights like Taiwan Semiconductor.


  Four years later, Chinese chipmakers are at the back of no one's line. Their prices are cheaper, typically 10% to 20% below competitors. Often subsidized by the Chinese government and able to take massive losses, these "foundries are willing to sell stuff just as long as they cover their variable costs," says Len Jelinek, an analyst with the electronics industry consulting firm iSuppli in El Segundo, Calif.

That's allowing Chinese foundries such as SMIC, Shanghai SIM-BCD, Jilin Sino-Microelectronics, and CSMC Techologies to gain prominence and market share. Already, SMIC "is emerging as a mainstream choice," says Jelinek. "In the past, customers went to UMC and Taiwan Semiconductor."

China produced about $2.4 billion worth of chips last year. In 2003, it accounted for 4% of world production. But by 2007, it should more than double that, to 9%, Jelinek estimates. And this could be conservative. China's market-share gains are expected to increase this year, with global demand for chipmaking capacity growing a lot more slowly than in 2004. As that happens, foundries will compete even more on price, where the Chinese, with lower labor costs and government subsidies, have an advantage.


  Already, many major semiconductor manufacturers are building plants in China as well as placing orders with local foundries. Taiwan Semiconductor opened a Chinese plant in October. STMicroelectronics (STM ), together with joint-venture partner Hynix, hopes to launch a China plant by the second half of this year. "You have to produce where your customers are," says Laurent Bosson, corporate vice-president for manufacturing at Geneva-based STMicro. "China is becoming the manufacturing workshop of the whole world."

China's lower prices could pressure the entire chip industry. Chipmakers that don't produce there will suffer as their rivals come out with lower-cost products, says Joanne Itow, an analyst at chip consultancy Semico Research in Phoenix.

Of course, the Chinese won't be able to offer dirt-cheap prices for too long. Many local chipmakers would like to go public, and investors won't accept massive losses as the government does. Customers also look for more than low cost: "Price is just one of the factors," says Chuck Byers, director of worldwide brand management for Taiwan Semiconductor in San Jose, Calif. "Customers come to us for quality and reliability." By going to China, companies still face an increased risk of delays and glitches.

Still, with glitches less common, what was a small slice of business could multiply many times.

By Olga Kharif in Portland, Ore.

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