Chipmakers Can Expect Less Bang for Their Bucks

Next year will put to the test a key strategy for chipmakers: Invest as much as possible in technology during the downturn in order to become that much more profitable when semiconductor demand picks up.

The problem is that the recovery for semiconductors next year is expected to produce growth of only about 10% -- a pretty middling rebound. Big, rich chipmakers such as Intel (INTC), Texas Instruments (TXN) and IBM (IBM) probably won't see the returns they would have expected a couple years ago when they started investing billions in state-of-the-art chip fabrication plants.

To be sure, leading semiconductor outfits may not have a choice about whether to invest, assuming they want to gain an edge in the long term. But the takeaway for investors isn't a cheery one: Chipmakers must spend tremendous amounts of capital to stay competitive, and as a result, offer increasingly humdrum growth prospects. That combination is bound to depress profitability amid a recovery -- and probably in the longer term as well.

A look at one measure of profits, return on capital, underscores the trend. A study of 15 chipmakers shows that returns fell to a 10-year low, at an average of 1.59%, in the third quarter, according to a recent report from Banc of America. That compares with an average of 17% annually over the past seven years.

Or consider Intel. In the fat days it boasted a return on capital as high as 30%, but as of the September quarter, its ROC was a mere 6.6%.

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Granted, those numbers will improve when demand for chips picks up again. But analyst Mark FitzGerald still expects future returns for chipmakers in general to fall well below the historical averages, to the 10% range.

"In the '90s, it paid to be aggressive in investing when the market for PCs was high growth. PCs had 15% to 20% unit growth through most of the '90s. But now single-digit growth rates don't justify the same aggressive level of capital spending," he says.

Costs Grow but Returns Shrink

Consider the two parts of the equation: a diminishing growth outlook and the spiraling cost of new chip fabrication plants.

Just last month, the leading trade group acknowledged there's been a long-term shift towards a lower growth rate for semiconductors, given the saturation of markets from PCs to autos. Going forward, the industry should grow at only 8% to 10% annually, the Semiconductor Industry Association said, well below the historical rate of around 16% or 17%.

At the same time growth is flagging, manufacturing expenses have shot up dramatically as technology has grown more complex. A recent Merrill Lynch report noted that Moore's Law (the number of transistors that can be placed on a chip doubles roughly every 18 months) has a practical corollary: The minimum cost of an economically viable fab doubles every three years.

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