What is the Semiconductor industry?

The semiconductor industry lives - and dies - by a simple creed: smaller, faster and cheaper. The benefit of being tiny is pretty simple: finer lines mean more transistors can be packed onto the same chip. The more transistors on a chip, the faster it can do its work. Thanks in large part to fierce competition and to new technologies that lower the cost of production per chip, within a matter of months, the price of a new chip can fall 50%.

As a result, there is constant pressure on chip makers to come up with something better and even cheaper than what redefined state-of-the-art only a few months before. Chips makers must constantly go back to the drawing board to come up with superior goods. Even in a down market, weak sales are seen as no excuse for not coming up with better products to whet the appetites of customers who will eventually need to upgrade their computing and electronic devices.

Traditionally, semiconductor companies controlled the entire production process, from design to manufacture. Yet many chip makers are now delegating more and more production to others in the industry. Foundry companies, whose sole business is manufacturing, have recently come to the fore, providing attractive outsourcing options. In addition to foundries, the ranks of increasingly specialized designers and chip testers are starting to swell. Chip companies are emerging leaner and more efficient. Chip production now resembles a gourmet restaurant kitchen, where chefs line up to add just the right spice to the mix.

Broadly speaking, the semiconductor industry is made up of four main product categories:

1. Memory: Memory chips serve as temporary storehouses of data and pass information to and from computer devices' brains. The consolidation of the memory market continues, driving memory prices so low that only a few giants like Toshiba, Samsung and NEC can afford to stay in the game.
2. Microprocessors: These are central processing units that contain the basic logic to perform tasks. Intel's domination of the microprocessor segment has forced nearly every other competitor, with the exception of Advanced Micro Devices, out of the mainstream market and into smaller niches or different segments altogether.
3. Commodity Integrated Circuit: Sometimes called "standard chips", these are produced in huge batches for routine processing purposes. Dominated by very large Asian chip manufacturers, this segment offers razor-thin profit margins that only the biggest semiconductor companies can compete for.
4. Complex SOC: "System on a Chip" is essentially all about the creation of an integrated circuit chip with an entire system's capability on it. The market revolves around growing demand for consumer products that combine new features and lower prices. With the doors to the memory, microprocessor and commodity integrated circuit markets tightly shut, the SOC segment is arguably the only one left with enough opportunity to attract a wide range of companies.

Key Ratios/Terms
Moore's Law: The productivity miracle that has kept the number of transistors on a chip doubling every two years or so. Gordon Moore, a co-founder of Intel, predicted that this trend would continue for the foreseeable future. The challenge now faced by semiconductor research and development (R&D) teams is to push the performance envelope and keep pace with the law.

Semiconductor companies that carry out design and marketing, but choose to outsource some or all of the manufacturing. These companies have high growth potential because they are not burdened by the overhead associated with manufacture, or "fabrication".

R&D/Sales: Research and Development Expenses
Revenue

The greater the percentage spent on R&D, the more opportunities are available for developing new chip products. In general, the higher the R&D/Sales ratio, the better the prospects for the chip maker.

Yield: The number of operational devices out of all manufactured. In the 1980s, chip makers lived with yields of 10-30%. To be competitive today, however, chip makers have to sustain yields of 80-90%. This requires very expensive manufacturing processes.

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At the same time, it doesn't make sense to speak of the "chip cycle" as if it were an event of singular nature. While semiconductors is still a commodity business at heart, its end markets are so numerous - PCs, communications infrastructure, automotive, consumer products, etc., - that it is unlikely that excess capacity in one area will bring the whole house down.

While cyclicality offers some comfort, it also creates risk for investors. Chip makers must routinely take part in high stakes gambling. The big risk comes from the fact that it can take many months, or even years, after a major development project for companies to find out whether they've hit the jackpot, or blown it all.

One cause of the delay is the intertwined but fragmented structure of the industry. Different sectors peak and bottom out at different times. For instance, the low point for foundries frequently arrives much sooner than it does for chip designers. Another reason is the industry's long lead time – it takes years to develop a chip or build a foundry, and even longer before the products make money.

Semiconductor companies are faced with the classic conundrum of whether it's technology that drives the market or the market that drives the technology. Investors should recognize that both have validity for the semiconductor industry. Here is a summary of key drivers and risks that impact fundamentals and stock prices.

What Drives Semiconductor Fundamentals and Stock Prices?

Drivers	Impact	Measured By
Market share gains	Drives revenue and earnings increases	Units shipped vs. competition
Higher margins/profits	Absorption of higher fixed costs contributes to lower unit costs	Manufacturing process efficiencies
Higher product performance vs. the competition	Stimulates greater enthusiasm for end products and support	Performance results based on industry benchmarks

What Can Go Wrong?

Risks	Impact on Fundamentals
Weak economy and/or product environment	Shipment volumes may be negatively affected
Delayed delivery of products	Loss of revenues, profits and competitive position; potential reduction in demand for current chips
Sever price competition	Shrinking profit margins
Failure to keep up with technology	Increasing chip complexity requires more advanced processes to keep costs under control
A slowdown in pace of computer replacement	Depresses industry organic growth rates.