Design wins with personal computer makers put many semiconductor firms on the path to riches.
"Winning a socket" — getting a chip designed into a hot-selling product, still determines winners and losers in Silicon Valley. The difference is that smartphone makers now call the shots. When heavyweights like Apple (AAPL) or Samsung redesign a product, chipmakers hold their breath, says Dale Ford, an analyst at IHS iSuppli.
"Chipmakers have to continually work to defend their positions in slots in next-generation devices," he said. "No one has room to be comfortable.
1. Business Fabless semiconductor firms specialize in design, creating electronic circuitry that, for example, whisks voice signals or video over wireless communications networks.
Fabless firms outsource production to foundries, such as Taiwan Semiconductor Manufacturing, which use specialized equipment to cut thin silicon "wafers" into hundreds of pinky-nail-sized chips.
The highly specialized manufacturing facilities, called fabs, and equipment cost billions of dollars. Intel (INTC) and other large chipmakers leverage such manufacturing assets to gain a competitive advantage.
But fabless firms have lower capital costs. This usually gives them higher profit margins than chipmakers that build their own factories, says Standard & Poor's analyst Christin Armacost. Many also pour a higher percentage of sales back into research and development.
The downside comes during the industry's cyclical supply squeezes. Fabless chipmakers, dependent on contract manufacturers, sometimes get snubbed.
During periods of rapid industry growth, when demand is strong and manufacturing capacity tight, "fabless firms may be unable to procure enough chips to satisfy their customers' requirements," Armacost wrote in an Aug. 30 report.
Some are taking a hybrid approach, investing in foundries or forming manufacturing partnerships to help ensure "dedicated capacity" — foundry space set aside to meet demand in crunch times. Barclays analyst C.J. Muse expects more fabless chipmakers to follow this path.
But the fabless business model has clearly gained favor. Hundreds of chipmakers are now fabless compared to around 50 a decade ago. IBD's fabless semiconductor group is up 8% so far this year, and held a No. 14 ranking Friday out of 197 industry groups. The chip manufacturers group ranked No. 179 and has a 1% gain for the year. The chip equipment makers group ranked No. 150, with a 2% loss since Jan. 1.
• Name of the game: Fabless firms must pinpoint an emerging market and develop innovative chips.
"Having intellectual property that is measurably better than the competition is a big advantage," said UBS analyst Steven Chin.
2. Market The semiconductor market topped $301 billion in 2011, up 3.7% from a year earlier, says the Semiconductor Industry Association. Fabless chipmakers grabbed 24% of that market, up from 9.6% a decade earlier, says the Global Semiconductor Alliance, an industry trade group.
Semiconductor demand is intensely cyclical. The market slumped 27% in 2001 after the dot.com bust. It fell nearly 14% in 2009 after the global financial crisis hit. Chip sales bounced back strongly in 2010, growing 34%, as customers restocked.
In spite of the rise of smartphones and other mobile devices, personal computers are still the biggest users of semiconductors. Computers and peripherals, like printers and disk drives, were 35% of the semiconductor market in 2011, followed by wireless communications at 21% and consumer electronics at 15%, says Gartner.
But PC sales are slowing as consumers shift to tablet computers. Analysts say that means the semiconductor market could contract in 2012. But the wireless communications market will grow 7.7% to $74.4 billion, forecasts market research firm IDC. It estimates that the semiconductor market for wireless communications will hit $93.1 billion in 2016.
One way to illustrate the changing market is to compare the sales growth of U.K.-based ARM Holdings (ARMH), which licenses microprocessor designs, to Intel, the biggest supplier of chips to the PC market.
In the June quarter, revenue at ARM, which dominates in smartphones and tablet devices, rose 12%. Intel's sales climbed 4%.
The fabless firms that count Apple or Samsung as customers include several companies ranked near the top of IBD's fabless semiconductor group, such as Broadcom (BRCM), Cirrus Logic (CRUS), Peregrine Semiconductor (PSMI) and Avago Technologies (AVGO).
Wireless growth propelled Q2 sales this year at Qualcomm and Broadcom, the two biggest fabless semiconductor firms in the world. (Qualcomm belongs to IBD's telecom/consumer products group.) Qualcomm's revenue jumped 37% in the June quarter. Broadcom's rose 10%. Among other top fabless firms, U.K.-based Dialog Semiconductor saw a 51% revenue gain. LSI Logic (LSI) jumped 32% and Himax Technologies (HIMX) rose 17.4%.
3. Climate "We have seen a perfect storm of weak demand in nearly every market outside of Apple or Samsung... .We want to avoid the PC supply chain," said Morgan Stanley analyst Joseph Moore, in an Aug. 24 report.
Intel on Sept. 7 cut its current-quarter sales outlook by 7%. Dell (DELL) and Hewlett-Packard (HPQ) also lowered Q3 expectations. Downgrades followed semiconductor stocks with exposure to the PC market, including Advanced Micro Devices (AMD), Marvell Technology (MRVL) and Nvidia (NVDA).
Sales of new, thin "ultrabook" notebook computers have been soft. And PC makers face an onslaught of low-priced tablets such as Google's Nexus 7, Microsoft's Surface and Amazon's Kindle Fire SD/HD, not to mention the possibility of an iPad mini from Apple.
And analysts are beginning to doubt the upside effect from the pending introduction of Microsoft's updated operating platform.
"We were hopeful for a boon to PC unit growth from Windows 8; it is increasingly evident to the supply chain that this is unlikely," said Citigroup analyst Glen Yeung, in a Sept. 12 report.
Slumping PC orders have left distribution channels stuffed with unsold chips. RBC Capital reported the inventory buildup this summer has been higher than usual as global economies slow. Semiconductor firms "are running 14% above their five-year average in terms of inventory days," the note said.
One plus: Fabless firms generally hold less inventory than chipmakers with factories. That's because they can notify foundry partners to make fewer chips if their customer orders fall, says UBS' Chin.
4. Technology Fabless firms are better off when they focus on specific customers and end-markets, says IHS' Ford. Many are currently homing in on devices for 4G wireless networks using LTE (long-term evolution) technology.
NXP Semiconductors (NXPI), spun off from Philips in 2006, aims to be a leader in NFC (near-field communications) chips built into smartphones. NFC is a short-range wireless technology used for mobile payment systems.
Makers of "analog" and "mixed-signal" devices such as Peregrine and Avago are seeing strong demand in wireless, though demand has weakened in industrial markets. In smartphones, mixed-signal devices convert and boost radio frequency signals.
5. Outlook Nomura estimates that smartphone shipments will jump 32% from last year to 612 million units in 2012.
"Wireless semiconductor stocks should continue to outperform in the back half of the year," boosted by Apple's iPhone 5 ramp and new devices launched by Samsung, said Nomura analyst Romit Shah.
Intel, Nvidia and other PC-centric firms are rushing to develop chips for mobile devices.
Still, it's not all about wireless. Shares in Mellanox Technologies (MLNX), a supplier of chips used in data centers packed with computer servers, have tripled in 2012.
But even for companies doing business with Apple and Samsung there's cause for concern.
Both Apple and Samsung are designing more of their own chips internally, says Barclay's Muse. They use foundries to manufacture the devices. As Apple and Samsung integrate more features into homegrown chips, they'll have less need for outside suppliers — unless they offer something special, he warns.