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Last updated: July 31, 2008 8:10 pm

TSMC set to forge a path through gloom

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In spite of a dim outlook for the global chip market, the mood could barely have been better when Taiwan Semiconductor Manufacturing (TSMC) announced its second-quarter results on Thursday.

TSMC, the world’s largest contract chipmaker, predicted flat sales and a slight squeeze on margins in the current quarter. Nevertheless, many analysts are keeping their overweight or buy ratings on the stock. They argue that, if anyone can survive, grow and make money in this industry, it will be TSMC.

Five years ago, the opposite appeared likely to happen.

TSMC and United Microelectronics (UMC), its smaller Taiwanese peer, invented and built up the business of contract chipmaking. The foundry industry, as it is known, thrived for more than a decade before the Taiwanese groups started facing competition. Chinese companies moved in at the low end of the foundry business while IBM started offering services at the top end.

By 2003 iSuppli, the market research group, warned that TSMC’s market share was slipping. Media reports started predicting that IBM would muscle its way to the top whereas TSMC and UMC would be squeezed out.

IBM had succeeded in snatching orders from some key TSMC and UMC customers such as Nvidia, Xilinx, Analog Devices, AMD and Broadcom. Meanwhile, Semiconductor Manufacturing International (Smic), China’s largest contract chipmaker, squeezed in to rank fifth among the global foundries.

Robert Tsao, then UMC chairman, even predicted the demise of the existing foundry model.

But, says Ming-kai Cheng, head of technology research at CLSA, “they were all wrong”.

China has not become a meaningful player in chip manufacturing nor have big integrated players such as IBM captured leadership in the industry.

Instead, TSMC has now pulled far ahead of everybody else. Over the past five years it has been the only foundry that has managed to hold on to its market share, remain cost-competitive, enhance technological capabilities and shield its profits from cyclical downturns.

TSMC spends almost one-fifth more on research and development than its three biggest rivals combined. The Taiwan group’s dividend pay-out is larger than the revenue of Chartered Semiconductor, the third-largest foundry. UMC and Chartered pay 20 per cent more for new capacity than TSMC, while Smic pays 50 per cent more, according to CLSA.

And with the prohibitive cost for fabrication plants – or fabs – at the next generation it is set to open an even wider gap.

TSMC’s continued market lead in the foundry industry owes much to the gradual adjustments it has made to its business model.

With the increasing complexity of more advanced process technology, TSMC’s customers need help in making their designs ready for production. IBM had thought it would have an advantage in this area, but TSMC has cornered this market.

As a result of this vertical expansion, “TSMC now looks more like Intel than like UMC,” says Mr Cheng.

This has limited IBM’s forays into foundry. The Big Blue, which at one point had a 6.1 per cent share of the foundry market in 2003, has now dropped to 2.7 per cent.

Taiwan semiconductor industry

Meanwhile, the entry of the Chinese players has still made little impact on the market leaders. Smic, Hejian and Grace Semiconductor, however, have driven others, such as Dongbu-Anam of South Korea, into irrelevance. The Chinese foundries’ cut-throat competition among one another has all but driven Grace out of business and made Smic a chronic money-loser.

Meanwhile, US-based Intel is building a fab in China’s north-eastern city of Dalian that will make wafers 300mm in diameter – the most advanced size – and use process technology that counts as advanced.

The Taiwanese government intends to allow the island’s chipmakers to use more advanced technology in China and could open up investments in 300mm fabs on the mainland this year.

But even these moves are unlikely to change the picture in the foundry industry.

“When the Intel fab comes online in 2010, the technology they use there will already be mature, so there’s no pressure for the Taiwanese to jump into advanced processes in China – the nature of such investments remains a strategic one,” says John Jahn, a semiconductor expert at the Industrial Economics and Knowledge Center, a government-backed industry think tank in Taiwan.

Taiwan’s deregulation of chip investments on the mainland will not make a difference either. UMC made it clear this week that Chinese investments are not a priority for it at all.

The future for the smaller foundries looks bleak. Analysts say UMC, Chartered and Smic will have to look for niche markets where they can leverage their technology.

Others say they expect further consolidation, and frequent attempts by Smic to sell a stake is certainly evidence of that possibility.

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