LRCX Lam Research Corporation

The Semiconductor Industry serves as a driver, enabler and indicator of technological progress. Developments in the industry determine the way we work, transport ourselves, communicate, entertain ourselves and respond to our environment. The PCs we work on, the cars we drive, the phones we communicate with, the electronic gadgets on which we watch movies, listen to music and play games on, and the planes and weapons used to transport or protect us use semiconductor devices.

As environmental issues have become more of a concern today, semiconductor devices are being made to reduce power consumption, reduce heat dissipation, capture solar energy, create more efficient lighting solutions, and so forth.

The past decade has seen big changes in the industry, with most players streamlining operations and transferring more routine production to low-cost locations. This led to the development of the Asian market, where most memory production and backend operations have shifted.

2010 Grew Off a Recession-Dampened 2009

The year 2010 started with a bang, as most companies reported results that were significantly better than the prior year, exceeding the companies’ own expectations and blowing past consensus estimates.

However, most of the excitement started wearing thin by the middle of the year, as order patterns and customer inventories indicated slowing demand. Industry watchers contended that the strength in the first half was more on account of pent-up demand than the beginning of another growth phase.

With the third quarter results, it was apparent that fears of a jobless recovery persisted. As a result, consumer spending failed to pick up in line with normal seasonality and holiday buildups dropped below expectations.

Net-net, global sales of semiconductor devices came in at $298.3 billion for the year, or a 31.8% increase from 2009, just slightly short of the Semiconductor Industry Association’s (SIA) expectations of a 32.8% increase.

The SIA stated that growth was broad-based across all major categories of semiconductors, which were each up double-digits from 2009. New products and innovations, as well as the broader application of semiconductors helped this growth. Of course, the fact that 2009 was weakened by the recession made comparisons easier in 2010.

Growth was also broad-based across geographies. The SIA estimates that around 54% of revenue came from the Asia/Pacific region (excluding Japan), followed by the Americas with an 18% share, Japan with 15% and Europe the remaining 13%. The Americas grew the strongest in 2010, followed by Asia/Pacific, Europe and Japan in that order.

Expectations for 2011 are varied. While the SIA’s projection of around 6% growth this year was similar to estimates put forward by iSuppli (5.1%), Gartner (4.6%) and VLSI (4.4%), others, such as IDC and IC Insights differed widely, with expectations of 9% and 10% growth for the year, respectively.

Computing and Consumer Markets Biggest Drivers

These two end markets together consume around 60% of total semiconductors sold. Therefore, they have the ability to significantly influence total sector performance.

Computing

A number of factors, in combination, are bringing about a complete turnaround in the computing market. Gone are the days when component suppliers were limited by a maturing market, worsened by commoditization and corresponding pricing pressures.

Today, the computing business is being driven by Microsoft Corp’s (MSFT) Windows 7 for one. Even with operating systems, such as Apple Inc’s (AAPL) Macintosh platform gaining popularity, and cloud alternatives such as Google Inc.’s (GOOG) Chrome coming to market, Windows 7 adoption rates have been high.

Second, Apple’s run of success is a big driver, since the Macintosh OS runs on Apple devices alone, which means more hardware and consequently, more semiconductor devices being sold. Third, with the advent of less sophisticated and ultra mobile devices (netbooks and tablets), the market continues to expand. Fourth, increased computerization in emerging markets such as China, India, Brazil and Russia are also helping growth.

Perhaps the biggest driver of business is the growth in the data center segment, which has increased focus on servers, storage and networking equipment that consume semiconductors of the high-end variety. The cost advantages of moving to the cloud are encouraging many small and medium-sized businesses, as well as some large organizations to transfer either a part or the whole of their operations to the cloud. We expect this change to be a major driver of growth for the industry in the foreseeable future.

Consumer Electronics

With ultra-portable computing devices gaining popularity, the distinction between consumer and computing is blurring in some cases. Of course, the consumer electronics market also includes other gadgets such as LCD TVs, Blu-ray players and smartphones.

The problem with this segment being a major driver of revenue is its inherently low margins. Competition is fierce and aggressive pricing is the rule of the day. Since semiconductors made for consumer goods are in the nature of components, there is ever-increasing pressure on their prices that correspondingly squeeze margins.

The Consumer Electronics Association (CEA) is very upbeat about solid consumer electronics sales this year. Accordingly, these products are expected to grow 10% this year on the back of a 13% increase in 2010 to $964 billion. The CEA believes that strong demand from the BRIC countries (Brazil, Russia, India and China), as well as moderate spending in developed countries will drive this growth. Smartphones, TVs and mobile computing products will be the hottest products this year.

The CEA’s expectations are reflected in the domestic market. Consumer confidence in the U.S. economy touched bottom early in the third quarter of 2010, improving steadily thereafter. However, the recovery is slow and very gradual, resulting in a muted 2010 holiday season. An offsetting factor noticed by the CEA is individual buying habits during the holiday season that were increasingly favoring electronic gadgets, with 3 of the top 5 and 4 of the top 10 most-wished-for items being electronic goods.

Other Markets

Communications infrastructure spending is currently being driven by China and India. The SIA expects infrastructure spending in these geographies to remain the major driver of semiconductor sales. The domestic market will be driven by increasing data volumes.

Medical Devices is an upcoming area and semiconductors targeted at this market are beginning to do well.

Earlier this year, Gartner estimated that the automotive semiconductor market would grow 4% in 2011 to $22.707 billion (the market was up 40% in 2010), as automotive inventory appeared stable. The research firm also estimated that production of light vehicles (the primary consumer of semiconductors in the auto market) would slow down to around 5% this year, after the 19.9% increase in 2010, marking the first year of sales above pre-recession levels. Infineon Technologies, Renesas Electronics and Freescale Semiconductor are the major beneficiaries here.

However, we may see some changes in days to come, since nearly a fifth of vehicle production has moved to China and we may expect more to follow. Moreover, semiconductor manufacturers serving this market have a few advantages. The most important is the growing electronic content per vehicle, driven by the need for fuel efficiency, entertainment and automated navigation.

As a result, in normal circumstances, semiconductors serving this market could have been expected to grow stronger than the industry over the next few years -- particularly since an automobile model has a significantly longer life than a consumer device model. Therefore, once a semiconductor has been designed in, it continues to generate revenue for a number of years. However, the Japan crisis will hurt results this year and possibly in the next, as discussed below (“Recent Developments”).

The aerospace and defense markets are considerably dependent on government spending and policy making. The commercial aerospace market (which lags an economic downturn or recovery) has started looking up, given the increasing passenger and cargo traffic.

The outlook for defense spending on the other hand is not as bright. Moreover, the focus on terrorist activity remains, so spending on intelligence systems and basic weaponry is stronger. A longer-term driver for semiconductor manufacturers is the growing importance of electronic weaponry. So semiconductor manufacturers serving these markets continue to see mixed results, depending on the customers served.

Given the end markets driving the current strength in the industry, we believe that manufacturers of flash memory (particularly NAND and also NOR) will continue to see strong demand. The transition from DDR2 to DDR3 will add to growth in this segment. However, the crisis in Japan could be a restricting factor on the supply side, limiting growth.

Ever Smaller & More Powerful

The demand for greater functionality in smaller and more power efficient gadgets is leading to greater integration within the semiconductor device. This is leading to increased demand for the system-on-a-chip (SoC), which is a single device incorporating a microprocessor, digital signal processor or graphics core, as well as memory and logic.

Within SoCs, both application-specific integrated circuits (ASICs) and application specific standard products are expected to do well (ASICs are usually customized for a single buyer, while ASSPs may have multiple buyers).

Major Players

The major players in the industry may be categorized into chipmakers (OEMs-whether fabless or otherwise), equipment and material suppliers, and foundries.

Chip-makers

According to Gartner Dataquest and iSuppli Corp, Intel Corp (INTC), Samsung and Toshiba Corp were the top three semiconductor suppliers in 2009. Texas Instruments (TXN) remained in the fourth position, as the company continued to phase off its wireless baseband business.

While the two research firms were slightly divided regarding the order of the next three, both estimated that that they were STMicroelectronics (STM), Renesas (helped by its acquisition of NEC) and Hynix. Micron Technologies (MU) and Qualcomm (QCOM) occupied the eighth and ninth positions. iSuppli allotted the tenth position to Elpida, while Gartner estimated that it went to Broadcom (BRCM). The most disappointing was Applied Micro Devices (AMD), which slipped from the eighth position to number twelve.

Equipment Makers

Gartner estimates that semiconductor equipment sales by the top ten suppliers increased 2% in 2010, following a 38% decline in 2009, accounting for 63.4% of total equipment sales. The overall equipment market is estimated to have increased 143% to around $41 billion in 2010. Automated test equipment (ATE) was the strongest segment (up 149%), wafer fab equipment (WFE) was close behind with a growth rate of 145%, while packaging assembly equipment (PAE) was third, having grown 127%.

The very strong growth may be traced to a particularly weak 2009, when the recession impacted demand for semiconductors and capital spending was minimized. In this environment also, Applied Materials (AMAT) easily maintained its number one position, followed by ASML Holdings N.V. (ASML) and Tokyo Electron Ltd in that order. Lam Research Corp (LRCX), KLA-Tencor (KLAC) Dainippon, Teradyne, Inc (TER), ASM International (ASMI) Nikon and Novellus Systems, Inc. (NVLS) were the others in the top 10.

Foundries

The Foundry segment has undergone significant changes over the past few years and the top five positions have changed again, according to research from IC Insights. Although Taiwan Semiconductor Manufacturing Company (TSM) remains the leader by far, followed by Taiwan-based United Microelectronics Corp (UMC), GlobalFoundries has now taken the third position in the pureplay segment, pushing the Chinese foundry Semiconductor Manufacturing International Corp (SMI) to the fourth position.

Also, specialty foundry Tower Semiconductor (TSEM) has jumped to the fifth position. A few clear leaders are emerging in the foundry segment -- Taiwan Semiconductor at the trailing edge, GlobalFoundries at the leading edge and Tower Semiconductor in the specialty category (analog). Additionally, Intel and Texas Instruments’ foundries make them two strong contenders with leading edge capabilities.

Recent Developments -- The Japan Crisis

Japan is one of the largest producers and consumers of semiconductor devices. Therefore, the crisis in Japan has had a significant impact on the semiconductor industry.

On the production side, there are issues with respect to facility repair, reliable power supply (which is essential for chip production) and availability of contingent supplies, which may be hindered (given the difficulties in transportation following the disaster and the fact that Japan is accustomed to operating under the just-in-time model).

Again, facility repair, if it includes fab equipment would not an easy task, since the equipment is built according to specifications that could not be replaced easily. This would normally impact semiconductor supplies. However, what makes it extremely difficult to gauge the near-term impact is the fact that many large companies with Japanese operations, such as Texas Instruments, Freescale Semiconductor and NEC, among others, also have operations in other regions, to which they could probably move production temporarily.

The saving grace is that production in Japan was centered on the automotive industry. A March 24 report from IHS iSuppli stated that in 2010, Japan produced $11 billion of automotive infotainment electronics and $7.3 billion of automotive semiconductors, for a 35% and 32% share of the two markets, respectively. Therefore, other markets, such as communications, industrial, computing and consumer will see relative smaller impact.

The crisis also has an effect on equipment manufacturers as well. Given the uncertainties in the supply chain, inventory imbalances are very likely, which would prompt semiconductor manufacturers to get conservative about further capex builds. As a result, equipment manufacturers could see an increased rate of delays, push-outs and cancellations of bookings over the next few quarters. If there are no further calamities, they are likely to see improvement some time in 2012.

OPPORTUNITIES

Manufacturing digital ICs is expensive, as it requires state-of-the-art technology and processes. On the other hand, digital products are cheaper, so cost recovery is more difficult. This has led to specialization in the industry and a greater contribution from Asian manufacturers. However, a significant portion of the intellectual property remains with the domestic companies.

One of the primary beneficiaries of the growth in mobile phones, tablets and the like is ARM Holdings (ARMH), with its power-efficient low-performance chip architecture that dominates the growing mobile phone and tablet markets. Others would be Qualcomm, Samsung and Texas Instruments. As such, we remain relatively positive about these companies in 2011.

We are also optimistic about Intel and AMD, given their focus on the data center segment. Although we are a wee bit cautious on Intel’s other growth initiatives and believe that execution will be key to delivering on its plans with the two big acquisitions, the company’s market position, cash balance, technology lead and management strategy and execution are positives in our opinion.

AMD is also worth watching, as management has been delivering on its promises. Moreover, the company is seeing some real success in its graphics business, which should complement initiatives targeted at rationalizing its debt, increasing focus on R&D and operation of a lower-cost model.

The analog and mixed-signal market is dependent on innovation. Consequently, these products generate higher margins than digital products. They are also more customized and have longer life cycles. These advantages are not lost on U.S. players, so the number of companies entering the market is on the rise.

Our favorites in this area include Texas Instruments, Analog Devices (ADI) and ON Semiconductor (ONNN). Also, while some companies, such as Linear Technologies (LLTC), Semtech Corp (SMTC), Intersil Corp (ISIL) and Maxim Integrated Products (MXIM) will have mixed performances given their varied dependence on the auto market, they are, for the most part, highly diversified, high-margin businesses. We believe these companies will generate moderate growth in 2011, representing good defensive plays as the cycle peaks.

WEAKNESSES

We believe that the good fortune enjoyed by equipment suppliers in 2010 will not continue in 2011. All the companies here had been severely impacted by the recession in 2009, as foundries, memory and logic makers decided to cut capex. This made for easier comparisons in 2010, so most equipment makers saw triple-digit growth.

Growth in 2011 was expected to be driven by the memory segment, which will be impacted by the crisis in Japan. Therefore, results are likely to come in weaker than earlier projections by SEMI and Gartner.

We have therefore turned a bit cautious about companies like Applied Materials, KLA-Tencor and Novellus Systems, as well as test equipment providers, such as Teradyne and Agilent.

We started the year with a positive feeling about foundries, but have turned more cautious following the Japan crisis, since they are likely to feel the impact pretty quickly. In fact Taiwan Semiconductor was quick to lower its expectations for the year. We also believe that investors should treat other foundries, such as United Microelectronics, and Semiconductor Manufacturing International with caution.

We do not anticipate significant growth in the semiconductor sector in 2011 given cyclical considerations, although we do not really see any great weaknesses either. However, we would caution investors about companies with relatively weak financials, such as Exar Corp (EXAR) and FormFactor (FORM). For instance, FORM continues to burn cash despite stronger demand for its specialized probe cards. It also has significant customer and market concentration that increase execution risks.
 
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