Europe swings like a pendulum too

The semiconductor industry has historically been fraught with insidious cycles as the pendulum swings from one peak to another valley. Robert Castellano is from the Information Network in the USA and covers the global semiconductor market. He comments on the state of the industry and points out that the global market has created global cycles.

Between January 95 and January 2001, the industry went through three "full cycles" of semiconductor sales. Semiconductor equipment moved in lock step with semiconductor sales by two to three months.

Beginning in January 02, the fourth semiconductor cycle began. Equipment sales followed historic patterns by moving upward from the January inflection point for the next six months. While semiconductor sales continued upward equipment bookings started dropping, exhibiting a divergence for the first time since January 95, and lasting 11 months until August 2003 before started back on upward slope that lasted only until April 2004 - a period of only eight months. Bookings have been flat for the past four months.

The burning question is whether the disconnect between the semiconductor and equipment sectors will continue or whether both sectors will move up or drop in tandem.

In recent weeks announcements suggest that potential problems are in these sectors:

Semiconductor manufacturers such as Intel, Texas Instruments, Broadcom, and LSI Logic have reported inventory builds. The number of unsold chips industry wide has increased to $830 million at the end of the June from just $12 million at the end of March. Nearly 20% of SMIC's customers experienced inventory problems.

These problems may in fact only reflect miscalculations on the supply side, not softness on the demand side. The outcome could be that semiconductor growth will continue and what we've been witnessing are merely inventory adjustments.

However, TI stated that its inventory problems stemmed from distributors slowing their pace of orders in the second half of the quarter due to their own inventory increases. So, the problem may not be with only the semiconductor manufacturers, but further down the supply chain - a more serious problem.

Novellus issued the following: "We have experienced some rescheduling of shipments." A few days earlier from Credence Systems: "...towards the end of the quarter, we were disappointed to see weakening fundamentals in the test sector, primarily from our test house customers in Asia." Cirrus Logic on August 26 said it will lay off 7 percent of its employees.

Do these statements portend the dreaded scenario that both semiconductor and equipment market will drop in tandem? The Information Network sees that a mix of excessive inventory, slow economic growth, terrorism concerns, and high oil prices may cause the chip sector to peak earlier than expected. It has already been growing for 32 months, longer than any upward cycle shown in the above figure.

Excess inventory problems indicate that semiconductor companies do not have a firm grip on production. This is normal, since the entire production process is dynamic with new tools coming online, yields improving, die being shrunk, and next-generation nodal points being reached.

But with the anticipated slowdown in revenues for semiconductor companies from27% in 2004 to the 10% range in 2005, we are concerned for the potential of weakened third-quarter and fourth-quarter semiconductor equipment growth.

Already Applied Materials, Novellus and Lam Research have forecast 0-5% and 5% order growth, respectively while KLA-Tencor and ASML forecast 0% order growth.

Has the pendulum swung too far?

Failure to cut back production despite surprisingly weak semiconductor sales in June led surplus inventories to swell. Semiconductor manufacturers have grown increasingly cautious as they expanded capacity, choosing to build out a fab in three or four phases rather than all at once.

In addition, the semiconductor industry went through a paradigm shift during the past recession, moving to more aggressive die shrinks and to 300mm processing to increase production. In order to avoid another massive inventory buildup, semis also won't be investing frivolously in equipment but will instead be closely monitoring real demand.

While semiconductor growth is directly tied to the economy and GDP, semiconductor equipment growth is subject to the purchasing decisions of the semiconductor manufacturers.

If they now feel that they have too much capacity on hand, then they can just as easily turn off the spigot. In other words, there does not have to be a downturn in semiconductor sales to initiate a downturn in equipment sales.

As the pace of semiconductor sales slow, we will see equipment pushouts and eventual cancellations, beginning Q3 and lasting through the year. Year-on-year equipment sales will drop well below the 50% growth already witnessed, as semiconductor manufacturers rein in expenses and recognize that they overshot their needs. Equipment companies face tougher year-over-year revenue comparisons in the second half of 2004 because performance in 2003's second half was stronger than the first six months of the year.

The semiconductor industry has historically been fraught with insidious cycles as the pendulum swings from one peak to another valley, as illustrated in the figure above.