2002 Outlook: Crawling back from the bottom

As companies report their 2001 financial results, it's becoming clear just how bad last year was for the semiconductor and semiconductor equipment industries. Global semiconductor sales fell 32%, to US$139 billion, according to the Semiconductor Industry Association. Chip manufacturing equipment sales were hit even harder, dropping 29% to US$25.2 billion, Dataquest said.

Chip market starting to recover
Equipment market braced for long struggle

The first cause of all the mayhem was the Internet boom and bust of 1999-2000. Worried about shortages, electronic system manufacturers loaded up on inventory in 2000. Some telecommunications equipment suppliers accumulated 120-day supplies, more than double normal inventory levels. Chip makers, in turn, believed that the huge demand was real and built capacity accordingly. Equipment sales soared more than 80% in 2000.

Then the bubble burst. Growth of the Internet stalled as companies discovered that falling stock prices could no longer entice investors to support business plans built on traffic and mind share rather than revenues and profits. Next-generation cellular phones loaded software hit the marketplace with a resounding thud. Consumers simply weren't interested. Orders for chips stalled as electronic system suppliers struggled with huge inventory overhangs. Cisco Systems, perhaps the most visible example, took a US$2.2 billion excess inventory charge against earnings for the quarter ended April 28, 2001.

IC manufacturers, in turn, scaled back their equipment orders. Asian foundries and memory manufacturers cut capital spending by 40-50%, making 20-30% cuts in the US and Europe look mild by comparison. Equipment orders peaked in October 2000, then fell sharply until April 2001. Sales continued to decline at a slower rate until September, and appear to have crept up slightly in December.

In 2000, Internet-heavy stock portfolios lost much of their value. In 2001, layoffs brought the reality of the technology bust home to hundreds of thousands of consumers. A US recession officially began in March 2001, driving the unemployment rate to 5.8% by the end of the year. At mid-year, though, the picture seemed reasonably bright. Experts said the recession-which had not yet been officially declared at that point-would be mild, and might even be avoided altogether.

Then, in September, terrorists hijacked four commercial airliners and crashed two of them into the heart of Manhattan's financial district, destroying the World Trade Center towers and closing financial markets for a week. In the immediate aftermath, the travel industry saw nearly 100,000 layoffs. Five months later, air travel remains well below pre-attack levels.

Meanwhile, Enron tumbled into the largest bankruptcy in US corporate history. At this writing, the company appears to have been a victim of bad business decisions and possibly outright fraud. Unfortunately, corporate auditor Arthur Andersen's apparent failure to warn investors and corporate officers of the impending problems has undermined investor confidence on a much larger scale. Investors no longer believe corporate financial reports, particularly when they involve pro forma earnings, one-time charges, or complicated hedging techniques. The more complex the company's financial dealings, the more investors are inclined to stay away.

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Chip market starting to recover

In recent weeks, Enron-related turmoil has largely over-shadowed signs of economic improvement. US unemployment fell in January, to 5.6%. Anecdotal evidence suggests that technology companies are beginning to hire again. Memory prices have been rising since before Christmas. Though mid-January contract prices for 128 Mb DRAMs were still below the estimated US$3.50 manufacturing cost, they were well above late November lows. Spot prices have reached the US$3.00 level, and Samsung and Hynix recently raised their contract prices to US$4.00 for the benchmark chips. Dataquest analyst Klaus-Dieter Rinnen estimates that foundry utilization, which fell to 35% or less at some facilities, has climbed to the 60-70% range.

So what does 2002 hold for chip and equipment suppliers? The first quarter of 2002 is likely to look pretty bad, analysts said, particularly compared to the first quarter of 2001. Year-ago results were relatively strong due to carryover from the end of 2000. For the rest of the year, analysts expect the chip markets will gradually drag themselves up from the bottom, with historical growth rates returning by the end of 2002. Estimates for the semiconductor market in 2002 range from flat to 3% growth. Analysts expect double digit growth to return in 2003.

The rest of the global economy offers little hope for a faster recovery. Continuing turmoil in Central Asia and the Middle East could produce further shocks to the global economy and financial markets. Europe is teetering on the brink of recession. Japan continues to struggle with economic stagnation. Taiwan's electronics-focused economy has been hit hard as well. Though South Korea expects solid 3.6% growth for 2002, many individual companies are carrying dangerously high debt loads.

Mainland China offers the region's, and the world's, biggest economic bright spot: in 2001, IC imports jumped 25%, to US$16.6 billion. Taiwanese chipmakers are asking their government to relax limits on mainland investment, allowing them to join a steady stream of foreign joint ventures. The flow is likely to increase with China's admission to the World Trade Organization last year.

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Equipment market braced for long struggle

For the equipment market, the outlook remains gloomy. Though 60% utilization is a substantial improvement, significant capital investment usually requires utilization rates of 85% or more. According to Rinnen, it will take a further 20-25% capital spending reduction to bring supply back in line with demand. The memory sector in particular seems to be struggling with endemic overcapacity.

On the other hand, the business cycle is taking place against a backdrop of accelerating technical innovation. TSMC claims its sub-0.18 micron fabs are running at 90% utilization. Retiring old fabs while continuing to build new ones may be one way to improve a company's overall technology mix without glutting the total wafer supply.

Intel, which continued to spend heavily throughout 2001, announced it will cut back in 2002, reducing its capital budget from $7.5 billion to $5.5 billion. The company expects 300 mm wafers will allow it to reach its capacity goals with a smaller investment. Spending plans at other companies show no clear trend. Texas Instruments plans to slash purchases because existing capacity will meet its needs, while AMD announced an aggressive increase.

Most observers expect equipment industry growth to resume by the second half of 2002. Because SAB 101 accounting rules mean the revenue can't be booked until the customer actually accepts the equipment, it will probably be 2003 before equipment suppliers' financial results improve. Analyst predictions for the year range from merely pessimistic to outright frightening: VLSI Research predicts a 5% drop in 2002 equipment purchases, while Dataquest predicts a 24% plunge.

As in 1999, rapid acceleration from the bottom would actually be bad news. If strong capacity buying resumes before the current overhang is dealt with, the next cycle is likely to hit sooner and harder. More conservative planning would likely offer companies more stability.