A Chip Industry Takes Off in China

For China's industrial planners, accustomed to success in making everything from toys to solar panels, the semiconductor industry has been the one that got away. Over the past decade, young, local chipmakers, backed by state banks and local governments, have thrown billions of dollars into semiconductor plants. It was good money after bad: Despite years of effort, homegrown chipmakers such as Shanghai's Semiconductor Manufacturing International (SMI) remain distant also-rans against global powers Intel (INTC), Samsung Electronics, and Taiwan Semiconductor Manufacturing (TSM).

Don't write off the Chinese just yet, warns Leo Li. He's the chief executive officer of Spreadtrum Communications (SPRD), a 10-year-old chip designer based in Shanghai that went public in 2007 and trades on Nasdaq. Spreadtrum is what's known in the industry as "fabless," meaning it outsources production to other companies and focuses on what it does best. In Spreadtrum's case, that's designing processors and other chips for mobile phones. With China's large export-driven electronics industry, growing domestic market, and deep pool of inexpensive and talented engineers, the fabless model suits Chinese companies like Spreadtrum just fine, Li says. "We are closer to the customers, the manufacturers, and the market," he says. "Only in China will fabless companies grow in size in the future."

That may not be quite true. Revenue at Qualcomm (QCOM), the U.S. fabless chip giant, has risen 46 percent since March 2010. Still, there's a reason for Li's bravado. In the past two years, Spreadtrum has come out of nowhere to become the second-largest supplier of chips for mass-market phones, behind Taiwanese rival MediaTek. While Apple's (AAPL) iPhone and Google's (GOOG) Android army get most of the attention, the market continues to grow for stripped-down handsets that allow texting and voice calls but have no 3G or Internet access. Manufacturers shipped 750 million such devices this year, up from 620 million a year ago, according to Andrew Lu, an analyst at Barclays Capital (BCS). Demand is especially strong in China and India, where Spreadtrum offers chips and software at prices between 10 and 30 percent lower than what Media Tek offers. "Spreadtrum got their act together," says Jack Lu, an analyst in Taipei with Royal Bank of Scotland (RBS) who expects the company's earnings to grow 95 percent this year, to $131 million, on a 90 percent jump in sales to $658 million.

Other Chinese chip design companies, many smaller and less established than Spreadtrum, are following Li's playbook. "You are starting to see the beginnings of an indigenous chip design industry," says Richard Hsu, managing director for China at Intel Capital.

Li's rivals in Taiwan are waking up to the Spreadtrum threat. Media Tek has been slashing prices and launching new products. The company "can defend and win back some share from Spreadtrum," says Barclays analyst Lu. Worries about a MediaTek counter attack has helped drive down Spreadtrum's stock price, which is off 19 percent since the start of the year. On June 9, Spreadtrum said it bought a 48 percent stake in MobilePeak Holdings, a company with offices in Shanghai and San Diego that specializes in WCDMA, a 3G standard that hasn't been a Spreadtrum strength. The deal should help Li move beyond basic phones into smartphones and tablets.

The bottom line: Chip designer Spreadtrum has become the No. 2 player in 2G handsets. Now it's poised to expand into tablets and smartphones.

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