LAS VEGAS (TheStreet) -- Mark Sherwood used to believe the Digital Age's itty-bitty chips and guts were where the big money was. Not anymore.
"I saw this inflection point about two years ago in the semiconductor industry," said the principal and CEO of Consulting Services & Associates, the Cupertino, Calif., market research and analyst firm that specializes in the insular world of semiconductor products, companies and markets. "Now the margins are slowly going negative for most chip makers. And no business can survive in that."
Sherwood and I were living the classic International Consumer Electronics Show accidental deep dive on a newly dying section of the consumer electronics reef. Over finger food and cheap wine at a hotel on the Vegas strip, we were blithely comparing notes on hot new tablets and smartphones we had demoed. But Sherwood was not impressed. Instead, his mood was dark. To him the mega trend in Vegas was the woe that awaits semiconductor and parts makers such as Intel, Qualcomm, NVIDIA and AMD.
According to Sherwood, the timeworn Information Age retailing model of subsidizing new phones, e-readers and tablets to drive content services is sending his semiconductor sector spinning down the digital drain. "Two hundred dollars is now seen as the magic price point for a tablet that can sell worldwide. But there's roughly 225 components in any tablet," he explained. "How can anybody make money charging an average price of 75 cents for each of them?"
"The answer is, they can't," he said. "And unless something changes, they won't."
The no-margin semiconductor recovery
Investors should understand that Sherwood most definitely has the numbers to back up his dark mood. He pointed out that while worldwide consumer electronics revenues grew from $880 billion in 2008 to $1.068 billion last year, the consensus is that global consumer electronics spending will actually decline, to $1.055 billion.
Already the tight market for gadgets will be made that much worse by the never-ending drive by electronics makers to stuff more services -- and therefore, more electronics -- into devices aimed at growing, low-cost global markets.
"You are adding GPS chips, motion-tracking modules and other systems into low cost [devices] for emerging markets," he said. "That's great, but instead of the price for these tablets and smartphones increasing to cover that cost, prices are falling, and dramatically."
Sherwood broke down the relatively obscure world of the timing devices tablets and smartphones use to coordinate the various features inside a modern, integrated mobile device. These so-called oscillator makers, such as Asia's Fox Electronics and Discera, make modules that larger integrated chip makers such as Texas Instruments, Integrated Device Technology and ON Semiconductor use to time their products. Now, traditionally, the oscillator makers worked on roughly 14% gross margins, Sherwood said. But larger makers now must build phones for less money to meet demand for low-cost gadgets in those emerging markets. So price pressure pushes these standard margins down and forces smaller makers to either leave the market or put themselves up for sale.
In fact, the mergers and acquisitions scene in semiconductors has been brisk. Integrated Device Technology bought Fox Electronics in 2012 for $30 million. And San Jose's Micrel announced in August that it intends to buy oscillator-maker Discera for an undisclosed sum.
"What's happening is, the bigger integrated semi-makers are taking these no-margin orders and hoping to make that up on other product," Sherwood said glumly. "But the smaller players will probably have little choice. They either get bought or go out of business."
"Semiconductors has become very tough," he said.
No clear vision for semiconductors
Sherwood is far from the only analyst here wondering how the industry will make ends meet. As if on cue, midway through our chat Victoria Fodale strolled over and agreed wholeheartedly with Sherwood. Fodale is a senior analyst at IHS, the Tempe, Ariz., market research firm with a practice in global digital components
"The demographics of the global consumer electronics is changing," she said. "Emerging markets demand lower prices. So that money has to come from somewhere, and the bigger makers are not afraid to demand concessions in pricing, which ofttimes they get."
That, friends, makes it a Digital Age story investors know well: Fodale and Sherwood agree that what's driving the market in semiconductor oblivion is a blurred consumer electronics model that throws new features onto new devices without a clear vision of where the revenues will come from to pay for them.
"Does everyone really need to have camera phones and navigation? The answer is no," Sherwood said. "What's really happening there is we are cannibalizing several bigger markets to make one smaller market. What, really, is the value of having a phone with a camera? Not that much from a dollar and cents view."
"The big chip makers probably survive. But the smaller operators? I know I am looking for more customers for my research," Sherwood said. "Chips is going to get tough."