Manufacturing lines that aren't operating to their potential, along with steadily falling chip prices, will haunt the semiconductor industry for some time to come, analysts said.
"We will continue to see over-capacity for the sector over the next two to three quarters," said Hans Mosesmann, an analyst at Prudential Securities.
Industry observers note that excess chip manufacturing capacity is at an all-time high, signaling that the semiconductor sector as a whole is not operating in balance.
"These companies tend to fill up their factories with parts, regardless of whether there is demand," said Shekar Wadekar, an analyst at investment banking firm Raymond James. "When you have more supply than demand, that causes a lot of pricing pressure."
According to data provided by the Semiconductor Industry Association (SIA), plants manufacturing integrated circuits reached 80.8 percent of their capacity during the third quarter of 1998, marking their lowest levels since the SIA began compiling such data in 1994. The figure compares to a capacity level of 92.6 percent for the year-ago period and 85.3 percent for the prior quarter.
"It was pretty ugly in 1998, to say the least," said Wadekar. "As long as excess capacity exists, the sword of pricing pressure dangles over your head at all times."
Other analysts, however, already are looking past the capacity issues that have been plaguing the semiconductor sector, and are somewhat more bullish on the industry's prospects.
"We believe the [manufacturing capacity] dynamics will progressively improve in the next year, and cause pricing power to return to the sector," said Louis Gerhardy, an analyst at Morgan Stanley Dean Witter.
Pointing to his recent research report, Gerhardy noted that the semiconductor industry's capital spending-to-sales ratio is declining toward an all-time low.
If the industry sees solid growth in unit shipments in the near future, he said, the market could absorb the remaining excess capacity. Such a turnabout would lead to accelerated revenue growth during the next several years.
Gerhardy predicted that semiconductor revenues could jump by the mid-teens this year, and ultimately could exceed the industry's long-term trend line of 17 percent in the years 2000 and 2001.
The SIA also sees reason for optimism in the semiconductor sector's future, despite its own projections last year that global sales of semiconductors would fall to $122.3 billion in 1998, a 10.9 percent decline from the previous year.
Even in the face of that challenging prediction, the industry association forecasts a strong rebound, with overall growth of 9.1 percent on sales this year, reaching $133.4 billion. The SIA predicted additional increases of 15.2 percent in 2000 and 18.2 percent in 2001.
But whether the realization of even those best-case projections can make up for the losses of the past year remains to be seen. A torrent of layoffs swept through the chip industry in 1998, leaving thousands upon thousands unemployed.
Semiconductor equipment maker Applied Materials cut 3,500 positions or 23 percent of its workforce last year, while chip bellwether Intel announced plant-closing and workforce-reduction plans that trimmed 3,000 jobs or 4.6 percent from its employee base. National Semiconductor also cut 2,500 positions or 18 percent of its workforce.
However analysts agreed that, as painful as those layoffs were, the cost-cutting measures were absolutely necessary for the long-term strength of the semiconductor industry, and are the only way it can return to profitability going forward.
"It is imperative that the sector curtail its capital spending," said Raymond James's Wadekar. "There should be, if there isn't already, a realization among industry executives that the era of tremendous growth because of strong average selling prices has come to an end."
But the belt-tightening put a damper on what otherwise has been a hot Silicon Valley market in recent years--one that up until 1998 was characterized by labor shortages and skyrocketing housing prices rather than job cuts and plant closings. The semiconductor industry often has been credited with setting the breakneck pace of growth in the area, which ultimately led to the fostering of new markets in the Internet space and the booming of the software industry.
Analysts noted that--perhaps unfortunately for the short-term--the Silicon Valley economy remains closely linked to its silicon namesake, the building block of the high-tech revolution.
"Silicon is the enabling technology, and has been the growth engine in the Valley," said Scott Allen, a spokesman at chipmaker Advanced Micro Devices. "The Internet looks to people as the next great opportunity, but you're not going to get there without the innovations in chip design and technology that both software and hardware vendors base their end products around."
It is those innovations that give analysts and observers of the chip industry continued hope for the semiconductor sector's prosperity, even in light of gloom-and-doom predictions related to the Asian flu and the overall downturn in global markets.
Semiconductor companies in Silicon Valley seem to have done their part to adapt to new market realities, with many shifting the focus of their operations during recent years. The region now does more chip design, development, prototyping, and custom semiconductor production than ever, rather than the large-scale chip production that once was typical, analysts said.
Many chip companies also have relocated their fabrication plants overseas. So while chip sales to struggling regions like Asia have slipped, semiconductor companies have benefited from the lower production costs that resulted from more favorable currency exchange rates, according to several economists.
"Sales are slowly increasing in all markets, fueled by PCs, telecommunications, and Internet applications," said SIA president George Scalise. "We're optimistic that a new semiconductor growth cycle will take hold in 1999."
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