Why the Chipmakers Are Down for '07

Semiconductor companies are bullish about 2008. But first, they'll have to contend with loads of challenges this coming year.

Semiconductor companies may be looking forward to a boom year in 2008, but first they'll need to struggle through 2007—which is shaping up as anything but great.

The beginning of January typically signals a seasonal slowdown in demand for chips used in PCs, digital cameras, wireless phones, and other popular consumer-electronics gadgets. And it usually takes two quarters for that demand to heat up again in anticipation of another tech-crazy holiday season.

But as with every year in semiconductor industry history, there are always a few unusual factors that knock the cycles off a tidy, predictable course. This year, two unusual factors stand out: the demand for flash memory and Microsoft's new operating system, Windows Vista. In the case of flash, chip makers can't keep up with demand, but prices aren't growing fast enough to keep manufacturers very content.

Then there's Vista. It's not the first time that high hopes for the revival of a stagnant PC industry have been pinned upon a new version of Windows. And the last time, what revival there was took much longer than expected to materialize. In short: Don't hold your breath.

Bye-Bye, Hard Drives?

Depending on who you ask, there are anywhere from a dozen to 17 different semiconductor factories, or "fabs," that are either under construction or being converted to produce a type of flash memory chip known as NAND-type flash. It's widely used in digital photography and portable media devices such as Apple's iPod nano and shuffle players.

"There are a lot of companies getting into flash," says Brian Matas, a researcher with IC Insights, a Scottsdale (Ariz.)-based chip-market research firm. "There are a lot of joint ventures getting off the ground, and a lot of companies that make DRAM memory chips for PCs converting their factories to build flash."

Additionally, more demand may come from PCs, as PC manufacturers— hunting for ways to hasten boot times and make notebook PCs less susceptible to data loss from hard-drive damage—begin designing flash memory chips into computers. Many contemplate the days when they can replace the hard drive completely. "I don't know if the market is ready for that yet," Matas says. "I'm also not sure if the cost benefit is there with flash memory yet."

Skirmishing for Market Share

Even so, there's no question the flash business is one hot sector of the chip industry. The most visible example is the joint venture between Micron Technology and Intel to build flash memory chips. But others include collaboration between Europe's STMicroelectronics and South Korea's Hynix Semiconductor. Meanwhile, SanDisk and Toshiba , which jointly operate a NAND flash factory in Japan, have another one coming online soon, Matas says.

And while revenue for NAND flash chips grew at a healthy 13% clip in 2006, to about $21 billion, that modest sales growth wasn't reflected in unit demand, which grew at a more robust 48%. Matas says 2007 will look fairly similar to 2006, with demand for chips growing at about 27% while prices grow at a relatively slower 14%. "The factories coming on line in 2007 will add a lot of capacity, allowing companies to cut their costs at the same time," he says.

Also in 2007, the fight for market share between Intel and rival Advanced Micro Devices will remain as nasty as ever. Intel, it seems, will look to holds its own against an increasingly aggressive AMD. In a Dec. 6 research note detailing a survey of the PCs and servers built by Hewlett-Packard and Dell , analyst Chris Danely of JPMorgan observed that Intel's share of this business is shrinking.

Woes in Wireless

True, Intel has the performance edge of the moment, and that should start to make a difference in 2007, Danely said. "We expect Intel's share to stabilize in the first half of 2007…but we believe PC companies will continue to use AMD for pricing leverage," he added. That will pressure profit margins at both companies.

Meanwhile, the wireless business looks far bleaker. Texas Instruments , the market leader in chips used in mobile phones, slashed its profit and revenue forecast for the current quarter, and suggested that sales could slow further in the new year. Merrill Lynch analyst Joe Osha said one big part of the problem was an overhang of unsold chip inventory. "TI put the brakes on production as early as late in the third quarter," he wrote in a research note issued Dec. 12. "We do not believe the internal inventory will come down until the March quarter of 2007."

Warnings at chipmakers Xilinx and Altera are painting a gloomy picture for the first half of the year. Altera said a soft market for wireless infrastructure would force it to forecast a bigger drop in sales—5% to 7% for the quarter, worse than the 2% to 5% drop it had previously expected. Customers are buying fewer programmable gate array chips, which are employed in wireless-networking equipment such as that bought by wireless carriers.

So while it's clear that for chipmakers having a happy new year depends on your end market, what makes 2008 look so good? All the butterflies, kinks, and bugs associated with the adoption of Microsoft's Windows Vista should be worked out, and companies and consumers alike may be eager to revamp aging fleets of PCs. And those PCs will need more memory than ever before to keep up with the new operating system, says Matas of IC Insights. "It takes at bare minimum 750 megabytes of memory to run Vista, and it's much better at one gigabyte," Matas says. "That's going to push the average amount of memory per PC up."

Also, 2008 is both an election year and an Olympic year, with all that implies. "We've often seen good boom years for chip demand in Presidential election years. And we think China will want to show off how technically advanced a place it is during the Olympics in Beijing, so we'll certainly see a lot of action resulting from that."