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Reality Derails Semi Train

The semiconductor industry has become a popular item of discussion among Wall Street analysts and financial journalists. Everyone seems to think that the semis will lead the economic and stock market recovery. Since the semiconductor industry is very cyclical (even thought everyone forgot this around the peak) and technology has led the decline, it just makes sense that the semis have to lead us out when the economy recovers. There is also the perception that since the industry has never experienced a decline of this magnitude, it must be the bottom. How can it get any worse?

This week Goldman Sachs boarded Merrill's semiconductor train by declaring "the fundamentals are likely to strengthen in the fourth quarter." I might be able to buy the notion that "a bottom" has been put in. After all, just today Credence Systems reported third quarter sales were down 91% from the year ago period to just $18.8 million. With revenues declining more that 90% in one year, I'll admit there is not much more to go. However, bottom fishers that purchased Pets.com, might disagree. But, I just cannot see how a meaningful recovery will happen in the near future.

Since the semi call from Merrill and Goldman received so much attention and debate, I thought I would see how the largest chip companies are doing during this downturn. All of them without question are having one of their worst years ever. More than one dozen semiconductor plants have closed since the beginning of the year. These plants will dampen the effect any upturn will have on semiconductor companies' bottom line. Chip companies are notorious for bringing on additional capacity anytime there is any increase in demand. As more fabs come back on line, supply will increase and push back prices.

** Breaking comment***

Just heard Brian Finnerty, Market strategist at C.E. Unterberg Towbin, on CNBC say that while economic data is showing further declines, it is coming in better than expected. Therefore, it is starting to turn around. Wait a minute, just because it is better than expectations does not mean it is getting any better. He cited Applied Materials beating expectations yesterday and today's release of manufacturing capacity utilization. Applied Materials first. Sales declined 30%, net income down 85%, new orders down 11% sequentially, 63% from the year ago period. Gross margin declined to 40% from 44.8% last quarter and from 50.9% last year. Operating margin collapsed to 1.2% from 17.4% last quarter and from over 30% last year. And those quality earnings, which beat estimates, were mainly from interest income. Income from operations was only $1.2 million, while interest income was $54.2 million. At 42 times earnings, this has to be one of the most expensive money market funds.

Manufacturing capacity for July came in at 77%, down 0.2% from June. This is the lowest level since August 1982. Yet, Mr. Finnerty thinks that because it was better than the 76.6% forecasted the economy is showing signs of getting better?

Ok, back to semiconductors.

Taiwan Semiconductor, the worlds largest chip maker, thinks it might take until the first half of next year before there is a meaningful recovery. Morris Chang, chairman of Taiwan Semi, does see the third quarter as a potential bottom; he points to an improving book-to-bill ratio, which has been hovering around 1 for the last couple months. The book-to-bill ratio is a ratio comparing the amount of new orders the company receives, books, to the number of orders shipped or billed. If the ratio is over 1, then the company is getting more orders than it is shipping and generally indicates increasing business. While business may in fact be increasing and a "bottom" may happen in the third quarter, there is no reason to think that business will get to last year's levels anytime soon. Plus Taiwan and all the others added capacity last year and this year. Some are even adding capacity now. This additional investment increases fixed costs, which makes companies more likely to turn up production in order to cover its fixed cost.

Taiwan Semi sees its utilization rate falling from an already low 44% in the second quarter to under-40% in the third quarter. But, it wants to stay in the game and Taiwan Semi is starting to build out its 12-inch wafer production.

United Microelectronics Corp, world's second largest maker of chips, forecasts that its utilization rate will drop to 30%. UMC has experienced a steady drop in capacity, from 70% in the first quarter to 40% in the second quarter. Chairman, Robert Tsao, does not see a significant recovery until late 2002 or 2003, and "it's unrealistic to predict the current downturn will improve anytime soon." However, UMC is currently expanding its capacity by developing adding a third 12-inch wafer plant.

Chartered Semiconductor, the third largest chipmaker, announced that capacity will fall to mid-20% in the third quarter. During the second quarter some plants were idled for up to 12-days at a time. Overall shipments fell 61% in the second quarter, with revenue falling 63%. It is pushing back production of its 300-mm fab by one year to 2003 and has slashed capital spending plans by $300 million to $700 million. A far cry from the $1.7 billion originally forecasted for 2001 last year.

Fujitsu canceled bonuses and cut 5% of pay for salaried workers at an Oregon plant. It also slashed hourly workers time by 20%. Capacity was cut from 60% to less than 50%.

Infineon, switched to a short-week at its Regensburg and Munich plants, since its plants are running at 20%. Earlier this year Infineon cut 5,000 workers.

NEC's Scotland plant has been operating at 50% capacity. Commenting on the industry Mideto Goto, MD, "the current global semiconductor trading situation, (which) is widely considered to be the worst ever encountered by the industry. I see no indication of any real upturn in the foreseeable future."

Nippon Foundry expects sales to drop 50% this year. It to has slashed utilization throughout the year. After running at 100% last year, Nippon operated at 60% in the first quarter, 35% in the second quarter and anticipates it dropping to 30% in the third quarter. Nippon breaks-even when it can run at 40% of capacity.

Philips Electronics is laying off 4,000 employees and halting capital spending for the rest of the year. Previous plans called for Philips to spend about $2 billion this year, that is now $850 million, of which almost all is already spent. Additionally, next year's capital budget is only $500 million. Philips expects utilization to drop to 35% in the third quarter, down from the 40%-45% in the second quarter. Philips "expectation is that the industry will not see a recover before 2002."

ASML Holding NV is another company that does not see a recovery shaping up until the second half of next year. While its order book is filling up, most orders are for 2002.

Texas Instruments, reduced capital expenditure plans by 35% to $1.8 billion, and STMicroelectronics, slashed its spending by 55% to $1.5 billion.

While most companies have slashed capital expenditures, there are several that are going forward with aggressive expansion plans. Besides UMC and Taiwan Semi mentioned above, ProMos plans to ramp its 12-inch fab into full production during the first quarter next year. Two other firms, Macroniz and Winbond, received approval to lease plots that they plan to spend almost $10 billion on three 12-inch fabs. This will not help the over-capacity situation one bit.

Dataquest analyst, Ben Lee, represents the other side. He thinks that Christmas "will drive a demand for semiconductors and components." He does give himself an out by saying, "But that's under the assumption that the U.S. economy will perform better since Q4. If that does not happen, it will be a disaster." Unfortunately, it looks like the consumer is displaying glimpses of petering out. It looks less and less unlikely that consumers will be able to hold out until Christmas. But, it has been a dangerous proposition to bet against King Consumer.

The first major bust in the semiconductors industry came in 1985, after the build up in semiconductor plants to supply the newly born PC market. It is ironic that on the 20th anniversary of the PC we are experiencing the worst slump in PC sales ever which is causing the worst year ever in the semiconductor industry. For a more detailed analysis of the boom-bust history of the semiconductor industry please read Chip and Dips from last September. As for how the two camps break out regarding the semiconductor industry, Nick Moore, money manger with Jurika & Voyles in California may have stated it best: "Half like them, half can do math."

Not much change in the survey, thank you to all those that participated.
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