Analog Devices Harnesses a Wii Hit

The console's success has the chipmaker looking elsewhere to place its hot MEMS chip.
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For more than a decade,

Analog Devices

(ADI) - Get Report

has supplied automakers with a special kind of chip that deploys airbags during crashes.

While these chips -- known as MEMS, or micro-electro-mechanical systems -- bring in respectable revenue, turn a profit and save lives, the business has existed as a little-known venture within the $2.6 billion chipmaker.

At least that was the case until

Nintendo's

(NTDOY)

Wii gaming console hit the scene, bringing ADI's MEMS business to celebrity status inside and outside the company.

The runaway success of the Wii, which uses an ADI chip for its most popular feature, has turned ADI's MEMS business into one of the company's fastest growers, with sales up 23% sequentially in the most recent quarter, and sent management scrambling to find other consumer devices to use the chip.

The consumer MEMS opportunity is a much larger potential market than the company ever anticipated, says CEO Jerry Fishman. "It's a good intersection of very new markets developing and only a very few companies with the expertise," he says.

ADI's plan to conquer the consumer world with the MEMS chip means it must find a way to kick-start what is essentially a new market without derailing its own progress on profitability. The chipmaker says it is aggressively investing to capitalize on the opportunity, but the results in the coming months will demonstrate to what extent its MEMS business has really changed -- and how far MEMS can go in transforming the company.

As it is, ADI's MEMS business now represents a small portion of its overall revenue, with sales totaling $47 million, or 7% of total sales, in the last quarter.

Deutsche Bank analyst Ross Seymore estimates that the consumer portion accounts for about 2% of ADI's $47 million in MEMS sales.

"You have to always keep the perspective of what the percentage of revenue is for a given new product and what the percentage of earnings is. And in both cases, the consumer MEMS is very small," says Seymore.

Deutsche Bank makes a market in ADI securities and owns 1% of more of ADI common stock.

But he notes that MEMS have serious growth potential in the consumer market.

"You're only limited by your own creativity in what these sorts of things

MEMS chips can be applied into," says Seymore. "The good news is, the sky's the limit on what that could be."

MEMS are essentially mechanical devices built on the same tiny scale and using similar processes and materials as in the manufacture of semiconductors. In many cases, MEMS are used as sensors to measure changes in motion, sound and pressure, with the resulting data shuttled to an electronic device's nearby processors.

The MEMS chip that allows a person to play video games by waving a Nintendo Wii control around in the air is a so-called accelerometer, capable of detecting motion in three axes: up-down, left-right and forward-backwards.

This new generation of triaxis accelerometers, which translate three-dimensional real life movement into digital bits, are among the MEMS chips most likely to gain a foothold in consumer devices, say analysts.

"The Wii has probably done more to bring visibility as far as the potential of what accelerometers can do than any other product that I've seen," says Marlene Bourne, president of research firm Bourne Research. "It sparks the imagination about what we can do with these kinds of devices."

The billion-unit cell phone handset market, in which ADI already provides some MEMS chips, is the most obvious candidate for expansion.

Rival MEMS makers are also positioning themselves.

Freescale

announced a triaxis accelerometer this week that it says is the thinnest available and is specially-designed for integration into portable devices.

And

STMicroelectronics

(STM) - Get Report

is rumored to be providing a MEMS chip in what could be technology's next smash hit:

Apple's

(AAPL) - Get Report

iPhone.

ADI's gameplan involves taking its consumer MEMS manufacturing out of its Cambridge, Mass., fabrication facility and outsourcing the job to third-party chip manufacturers. That way, the company can build MEMS for price-sensitive consumer applications at a lower cost and increase its production capacity.

The plan requires ADI to devise a way of making MEMS using standard CMOS manufacturing techniques, instead of the more expensive BiCMOS process it currently uses. The company says it hopes to accomplish this early in its next fiscal year.

But will the new manufacturing approach produce profit margins that are at or above the company's corporate average?

"We'll sell a lot of products that go to consumers that we make very good margins on," says Fishman, without commenting on the MEMS group's current or future margins.

While ADI says its MEMS business is profitable, analysts believe the group's gross margin is below ADI's 57% level. And it's likely that the consumer portion of the MEMS business sports lower margins than the automobile and industrial portion, since the latter require chips with greater reliability and precision.

As with any consumer gambit, of course, the idea is to offset lower profit margins with massive volume. And the deep bench of consumer electronic devices offers plenty of opportunity.

To become a viable technology in cell phones, ADI will need to reduce the price of its MEMS to about $1 per chip, reckons Deutsche Bank's Seymore. An ADI spokesman says the company currently sells MEMS for as low as $2 a chip and expects to hit the $1 level in the next few years.

The bigger rub is that for MEMS to really take off in consumer electronics, ADI is dependent upon potential customers coming up with a revolutionary idea for its chips -- the next Nintendo Wii. That's a much different proposition than selling a radio chip for cell phones, in which the need for the component is already well-established and understood.

Many of the initial ideas for marrying MEMS and cell phones aren't the kinds of things that would make consumers line up outside a store at midnight.

Handset makers such as

Samsung

and

Nokia

(NOK) - Get Report

have introduced certain models that use MEMS chips to offer a pedometerlike feature, allowing consumers to count their paces and measure other types of physical activity.

Another frequently touted idea involves a MEMS chip that detects when the handset has been lifted toward the user's ear, switching off the phone screen's backlighting to conserve battery power. Clever as this is, it's hard to imagine handset makers incurring the extra costs of adding a MEMS chip into a phone for such a feature.

For all its potential to shake-up consumer electronics, ADI's MEMS plan hinges on somebody else's dream.