Egos, Big Bank Accounts Keep Comm-Chip Makers Single - TheStreet

After two years of abysmal business in techland, some pockets of the industry still defy basic supply-and-demand logic. As long as that's the case, recovery is bound to be elusive.

Case in point: chipmakers that sell to communications-equipment outfits, arguably the most distorted and overbuilt market of the late 90s. As demand for equipment has shriveled, the pain has reverberated down to the chipmakers that supply the likes of

Cisco

(CSCO) - Get Report

,

Nortel

( NT) and

Lucent

( LU). But there's been no shake-out yet among silicon vendors, and therein lies the problem.

Too many chipmakers continue to sell to a shrinking market, say industry watchers, who believe consolidation would help restore some sanity to the silicon business.

Yet communications IC outfits, bolstered by outsized egos and still holding a lot of cash thanks to lucrative IPOs, refuse to say uncle. And that means investors shouldn't expect a sustainable turnaround anytime soon in a business still struggling with excess capacity.

Consider the bleak outlook for the industry's customers, the equipment makers. Telecom spending is on track to drop in the double digits again this year, and businesses are still reluctant to invest in networking infrastructure. Communications-equipment companies now operate at less than 50% of their capacity and demand is still falling, notes Bill Whyman, president of Precursor Group, a Washington, D.C.-based investor-side research group on tech and telecom. "That's obviously horrible news for their suppliers."

Worse, the same equipment companies that once touted products based on whiz-bang technology are now being forced to compete on price.

Dell

(DELL) - Get Report

is pushing enterprise networking products for 70% off the price of comparable gear from Cisco and

Foundry

( FDRY), notes Ashok Kumar, an analyst at U.S. Bancorp Piper Jaffray.

The takeaway for suppliers is bearish: Further price deflation in equipment is bound to weigh on the price of the silicon that goes into it.

Communications IC outfits have already withstood a world of hurt on the revenue side. In the past two years

Applied Micro Circuits

(AMCC)

has watched sales go into a tailspin, dropping 85% from the peak. Three other companies have all seen revenue shrink more than 70% from the peak.

In a desperate bid to lower operating expenses, all the communications IC players have endured punishing rounds of layoffs and tried to restructure -- albeit halfheartedly in most cases.

One relative success story on that front,

Vitesse

(VTSS)

, has drawn praise for diversifying its business away from the beleaguered long-haul telecom market.

In the most recent quarter it drew half its sales from storage customers, an end market with much healthier growth prospects. But even that hasn't translated to top-line improvement. In the most recent quarter, revenue at Vitesse still fell slightly below last year's levels.

For the most part, business across the comm IC industry remains mired in the dumps.

"The demand is poor, outlook is uncertain and the

chip industry needs to consolidate before a significant upturn can happen," says Jim Liang, an analyst at Pacific Growth Equities. He argues that communications-chip outfits would benefit from merging R&D operations, which represent the biggest cost for companies that already outsource their chip manufacturing.

Plus, a thinning of the ranks would give surviving chip companies more pricing leverage with customers like Cisco, which has managed to expand its margins in the downturn

by squeezing suppliers hungry for sales.

In short, the survival logic of business dictates that some comm IC suppliers either shut down altogether or merge, to slim the number of competitors.

Yet chipmakers have managed to stave off such unpleasant decisions. Probably the most important reason is that many have plenty of cash on hand after selling stock at premium prices in the boom years, and they carry minimal debt. Their financial cushion gives them plenty of breathing room despite the lousy business environment.

The richest of the bunch, Applied Micro, claims $1 billion in cash and short-term investments and no debt. Though the company hasn't posted an after-tax profit since the September 2000 quarter, it's been steadily reducing its losses and now burns cash at the rate of less than $10 million a quarter.

Another practical obstacle to consolidation: Because comm IC outfits have no idea when demand will resume (or even what "normal" demand would look like, following the wild late '90s buildout), bankers would have a tough time assigning value to a potential acquisition candidate.

Many analysts agree that corporate egos are just as important a hurdle. CEOs at communications-chip outfits "tend to believe they are the best-positioned company, that they're likely to be a consolidator rather than be consolidated," says Liang.

Then there's the relatively uninspiring record of chip company mergers. "Historically, consolidation in semis hasn't worked like it has in other industries," says Alex Gauna, an analyst at UBS Warburg. Chip M&A carries special risks due to the built-in obsolescence of semiconductor technology, he explains. "You can get a rich cash balance

from an acquisition, true. But if you don't keep the engineers and design momentum, you've acquired a product that goes out of date 12 to 18 months into the future."

As examples of recent acquisitions that failed to live up to expectations, he points to Intel's $2.2 billion acquisition of Level One Networks and Applied Micro's $4.5 billion purchase of MMC Networks.

For all these reasons, don't expect much M&A among comm IC suppliers any time soon. But don't expect a snapback to health either, because in the absence of consolidation, the industry seems destined to struggle with excess supply and stiff price competition.

That outlook was summed up by U.S. Bancorp's Kumar, who issued a note titled "No Turn in Sight" on the sector this week. "Comm IC stocks remain trades, not investments, as the companies will fail to earn a return on capital that exceeds cost of capital," predicted Kumar.

Having already lost investors' confidence, the industry faces a wrenching path to recovery. "If there's no consolidation and no demand uptick, I think there will be additional rounds of layoffs," predicts Liang. "The way to preserve cash is to reduce expenditures. And the most straightforward way to do that is through continued layoffs."

Even so, the comm IC industry may only be postponing the inevitable. "I think at some point we will see consolidation, but people are trying to hold out," says Whyman. "It's like a game of musical chairs. Everyone wants to believe they'll be in the chair when the music stops."