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Chips Fall in Place for IBM

Many investors think its semiconductor unit should go, but it may play a huge role.

At first glance,

IBM

(IBM) - Get Report

would seem to have a large problem in its small semiconductor unit.

This week, news leaked that

Apple

(AAPL) - Get Report

, a significant customer of IBM's, might be considering using chips from

Intel

(INTC) - Get Report

. In addition, IBM held an analyst meeting last week that barely mentioned its chip group, IBM Microelectronics.

Those dubious events fall against two backdrops. First, there's the money-hungry nature of the semiconductor business, which appears to be garnering an outsized portion of IBM's capital expenditures while accounting for less than 5% of total sales.

Secondly, IBM has engineered an extensive reorganization in recent years, transforming itself from a technology hardware manufacturing giant into what is now a services-oriented company that makes the chip unit look increasingly like a legacy of the past.

"The reality is that IBM is very different from a few years ago," said CFO Mark Loughridge during the analyst meeting last week. "We see the biggest growth opportunities in a combined solutions offering, combining hardware, software and services."

As IBM has never been shy to discard operations that no longer fit its long-term vision, some company watchers say the semiconductor unit could be the next to go, possibly through an IPO.

However, while the chip unit's fate may be in question, its health appears to be intact, and it is contributing to IBM in unique ways that position it for a growing role within IBM -- and even the chip industry.

IBM says the semiconductor unit provides core technology elements for its servers and storage products. By having the building blocks in house, IBM is better able to design and develop its end products. For example, IBM says increased investment in its Power line of chips has enabled it to gain substantial server market share.

Of course, IBM's chip business doesn't just serve its own internal demand; it also sells chips to other hardware companies, such as Apple, and it makes chips on behalf of other semiconductor companies, such as

AMD

(AMD) - Get Report

. IBM is also active in developing future chips and chip manufacturing processes through several partnerships, most notably the Cell initiative with

Sony

(SNE) - Get Report

, and

Toshiba

.

Some of those dealings have brought problems. Apple complained early last year that IBM wasn't supplying enough chips, while

Xilinx

(XLNX) - Get Report

, one of the largest chipmakers operating without its own factories, shifted away from IBM to Toshiba as a second-source foundry and next-generation development partner.

Still, IBM's Power chips are used in all three major video-game consoles, and its leading-edge factory has improved its performance. The Cell processor, which is based on a Power core, is highly regarded and should make a significant impact on consumer electronics devices in the coming years. And IBM has expanded its developer base for Power chips by making the architecture open-source.

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It's the video-game resurgence and the prospects for the Cell chip that give IBM's chip unit such an interesting competitive position. IBM chips are getting the company poised for an entry into the digital home, which is being billed as the next significant battleground for electronics and semiconductor companies.

"What IBM has in Power is an architecture that scales all the way from embedded products up to the desktop computer and into the back end of the data center," says Charles King, principal with Pund-IT Research. "No one else has anything like that."

Although exact financial metrics for IBM Microelectronics aren't publicly known, IBM has retrenched its unit during the last two years to make it unique. In 2003, unit sales dropped 31.6% as it sold some product lines; last year, sales edged up only 0.6%. Meanwhile, the overall semiconductor industry grew 18% in 2003 and 28% in 2004.

IBM did manage to improve the profitability of its semiconductors last year because of improved manufacturing results. But margins for all of IBM's hardware products last year tallied 29.6%, below the company's overall average of 37.4%, though they were up from 27.8% in 2003. Microelectronics accounted for 0.8 percentage points of the margin increase.

In 2003, IBM opened a state-of-the-art manufacturing facility at a cost of $3 billion. Although partnerships defrayed some of the costs, the investment still was significant, and in many respects it is ongoing. Determined to stay on the leading edge of chip-making techniques, IBM will continue to spend significant amounts on chip development. The company was estimated to have spent $900 million last year and another $950 million this year on capital expenditures for semiconductors, according to research firm IC Insights.

If that estimate is correct, it represents between 20% and 25% of the company's overall capital budget, even though semiconductors account for less than 5% of overall sales. IBM can afford it, though, with a cash balance of almost $9 billion and cash flows from operations last year of $12.9 billion.

Pund-IT's King says this high level of chip spending is OK when the benefits of having an internal chip unit outweigh not having it. "Without Microelectronics, IBM loses a major differentiation point and control over its mainframe hardware evolution, its Unix server products and the Power architecture. A large amount of the company's strategic muscle relies on what that group is doing."

Still, others maintain that IBM and its chip unit would be better served by separating. "IBM is all about services, and the Microelectronics business is off on its own becoming like Intel. If Microelectronics is successful, I could see its strategy and IBM's coming into conflict," says Michael Cohen, chief of research at Pacific American Securities, adding that he wouldn't expect IBM to spin off the unit until it becomes more successful. Cohen doesn't own shares of IBM.

Rob Enderle, principal of research firm Enderle Group, says the Power line could get a bigger boost if it came from a separate company because additional vendors, who currently compete with IBM in other areas, such as servers, would then be free of that conflict.

"Microelectronics would be a pretty scary company

for its competitors," he says. "It could turn into something that would keep Intel awake at night." Enderle doesn't own shares of IBM.

IBM hasn't been reticent in the past to dispatch a unit that hasn't fit with its direction. Besides the PC business sold last year and the hard-disk-drive unit sold in 2002, IBM divested from its flat-panel display business in 2001 and its network and DRAM operations in 1999.

The criteria for each of those sales, according to information presented at last week's analyst meeting, consisted of a five-year performance evaluation that found declining revenue, eroding profit margins and significant capital-expenditure requirements that ate into cash flow.

Certainly, there are precedents for large corporations divesting themselves of their semiconductor units. In the most analogous example,

Motorola

(MOT)

spun off its

Freescale Semiconductor

unit last year as it tried to hone its focus and avoid the high capital costs of the semiconductor industry.

Siemens

(SI) - Get Report

spun off its chip unit into

Infineon

(IFX)

, which is now Europe's second-largest chipmaker. The same divestiture logic can be seen at work in AMD's recent decision to jettison its flash memory business.

On the other hand,

Philips Electronics

(PHG) - Get Report

has retained its semiconductor unit, but there, too, the glaring cyclicality of the chip business has reared up occasionally to drag results of the larger corporation.

As for the immediate future, IBM is wading through a restructuring in Europe centered on its services group. But with its semiconductor unit pressing forward on the gaming front and bolstering its position in the digital home, IBM will undoubtedly get increased attention from company insiders and shareholders regarding what's ahead for IBM Microelectronics.