Fabless Firms Feel the Pinch From Taiwanese Earthquakes, Rising Demand

The firms, which depend on others for chip production, stumble after the quakes hamper production and demand soars.
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SAN FRANCISCO -- Suddenly, it's not so fabulous being fabless.

Fabless chip companies don't own their own manufacturing plants, contracting the work out to others instead. During a chip glut, fabless companies like

Genesis Microchip

(GNSS)

and

Sipex

(SIPX)

crow about how they aren't burdened with the costs of maintaining idle plants. But in times of high demand, they face higher production costs -- if they can even get the chips made at all.

The Sept. 21 earthquake in Taiwan delivered a sobering reminder of this downside. Fabless companies that depend on

Taiwan Semiconductor

(TSM) - Get Report

,

United Microelectronics

or other foundry companies with plants in Taiwan suffered when production was interrupted.

In the weeks following the quake, Genesis warned of low revenue growth in the fourth quarter, while Sipex posted disappointing earnings. Genesis stock fell 31% in the month after the quake and Sipex fell 26% in the same time period. Since Oct. 22, Genesis has risen 25% on Taiwan's recovery from the earthquake, while Sipex has risen only 1.5%.

But that doesn't mean the headaches are over. The Taiwan quake was just the beginning of the chip shortage. Demand is surging for telecommunications chips because of explosive growth in the Internet, cell phones and handheld devices like the

Palm Pilot

. According to

Merrill Lynch

, sales of chips for wired communications systems like local and wide area networks are expected to grow from $8.2 billion in 1999 to $12.8 billion in 2003, a jump of 56%. And research firm

Micro Logic Research

forecasts wireless chips will grow from $5.1 billion in 1999 to $12.7 billion in 2003, an increase of 150%.

Manufacturers will have a hard time keeping up. Companies that didn't have orders in years ago may have trouble placing new ones. Hardest hit may be the smaller fabless companies such as

Pericom Semiconductor

(PSEM)

and

8x8

(EGHT) - Get Report

, both of which have warned in filings that tight supply could hurt their performance.

The Taiwan quakes offer a test case of the worsening chip shortage, says

Morgan Stanley Dean Witter

analyst Mark Edelstone. Companies that have fared well likely have a track record of careful planning and have built strong ties to their foundry partners, he says, citing

Broadcom

(BRCM)

as an example. "So far they have been able to deliver upsides to their customers and meet earnings targets when others had to scramble," says Edelstone, whose firm has an underwriting relationship with Broadcom. He rates the shares a buy.

The physical damage from the series of earthquakes in Taiwan has largely been repaired. "We are up to full pre-quake capacity," says Charles Byers, a spokesman for Taiwan Semiconductor. But the logjam of orders may not clear for months. For every new line and plant that the company can build, there's more than enough demand to fill it, Byers says.

Taiwan Semiconductor, which controls 30% of the foundry market, was producing chips at 105% of its capacity

before

the quake. Only now is the company getting close to meeting demand again. But Byers expects demand to surpass capacity by the second quarter of 2000, and if that happens "the situation will be horrendous," he says.

At Taiwan's United Microelectronics, the fabrication plants have been completely filled since June. That means only customers that ordered far enough in advance will get product, says Jim Ballingall, vice president of worldwide marketing. "We can't accommodate a surprise order right away," he says.

That supply-and-demand imbalance has caused wafer prices, which typically drop 30% a year, to hold steady this year, Ballingall says. For customers that need to renegotiate contracts, that may mean higher wafer prices than they expected, maybe even higher than they paid in the past.

Meanwhile, chip designs have become so complex, they can only be made in specialized facilities, says Bruce Entin, vice president of worldwide marketing for

LSI Logic

(LSI) - Get Report

. That limits the flexibility of chip manufacturers to shuffle orders from one facility to another.

Not all chip companies are suffering. Some like LSI and

Texas Instruments

(TXN) - Get Report

, which can help address demand by making their own chips, are benefiting from growing demand and rising chip prices.

And some fabless companies that are the top customers of chip manufacturers, such as Broadcom and

Xilinx

(XLNX) - Get Report

, will be safe, says

Lehman Brothers

chip analyst Daniel Myers, who doesn't provide coverage on those companies. Lehman has no underwriting relationship with either Broadcom or Xilinx.

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