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Managing Profitability
through the Cycles

A Flexible Yet Socially Responsible Perspective Is Essential

by Bijan Moslehi

Bijan Moslehi, PhD, is chief technology officer and senior vice president, semiconductor technology research, for The Noblemen Group, a boutique investment banking, strategic advisory, and business development firm. Moslehi has 20 years' experience working in the semiconductor and semiconductor equipment industries. He can be reached at

Business cycles have been an unwelcome but integral part of the semiconductor industry. To further complicate matters, the industry faces many other challenges brought about by numerous concurrent technical, business, and markets changes and trends that resonate through all segments of the supply chain. Although change could create growth opportunities in most cases, many of these complex, fast-paced, and expensive trends also lead to such difficulties as the need for increasingly higher levels of investment, escalating R&D costs, higher risks, and even more uncertainty. At the same time, the growing consumer electronics market share and maturing end-markets have put persistent downward pressure on average selling prices, pushing margins lower and slowing overall growth rates. All of these factors—when combined with shortened product life cycles—can result in a somewhat questionable return on investment (ROI).

The severity of the most recent downturn and the challenging business implications of current and emerging trends have forced many companies to create strategies for managing profitable business models through the cycles, with a basic objective of controlling costs and achieving margin, profit, and ROI targets in a high-risk environment. Larger companies can leverage their scale (company size) and diversity of products and markets as powerful advantages in dealing with volatility and cyclicality.

Although some current flexible business models have been reasonably successful in improving the management of the business cycles, many still suffer from several major shortcomings. For example, many flexible models rely on outsourcing, alliances and joint ventures, and massive hirings and firings. A fundamental question is: Who pays the price for the kind of flexibility that results in massive ramp-ups and ramp-downs? Is outsourcing pushing the disruptive impact of volatility farther down the supply chain? To examine these issues, one must have a better understanding of the implications of flexible business models across the semiconductor industry supply chain.

Overcapacity, supply-chain issues, and excessive inventory have all contributed to the instability of the business cycles. The complexity of the supply chain has often been compounded by its poor management, which has caused such problems as limited visibility across the chain and the dreaded build-up of excess inventory. Many supply-chain issues are unique to each industry segment, with major differences existing among systems companies, chip manufacturers, equipment suppliers, materials houses, and various service providers. For instance, the impact of the 300-mm transition, improved fab investment efficiencies, efforts by chipmakers to further extend equipment lifetimes, and escalating R&D costs each have had different implications across the supply chain.

Because of the domino effect of disruptive decisions by systems, chip, and tool suppliers and outsourcing service providers across the value chain, smaller companies face more pressure than ever before on their margins, putting their very survival at risk. This kind of dysfunctional decision-making underscores the need for flexible, profitable business models specific to each segment. It also points to the critical need for achieving better operational efficiencies as well as improved supply-chain and inventory management.

The complexity of the chip industry supply chain has often been cited as a major contributing factor to the industry cycles. Insufficient visibility and poor management of the supply chain have adversely affected many companies and occasionally the entire industry. Supply-chain dynamics must be fully understood so that the issues of a changing, ever-more-complex chain can be addressed. 

System suppliers occupy the top of the supply chain, followed by chip manufacturers, including integrated device manufacturers and fabless companies, which themselves are customers of providers of outsourced manufacturing services, such as foundries, assembly test and packaging houses, photomask shops, and design houses. Next in line are the semiconductor capital equipment and materials suppliers (wafers, gases, chemicals, consumables, etc.), which in turn are served by various subsystem, components, and other support companies.

A close examination of the financial performance of the various segments shows that those organizations farther down the supply chain suffer from much lower margins and returns. It appears that, to some extent, they are paying a disproportionate price for flexibility at the top of the chain. One could argue that this is a fact of life and business returns are value based, which is a valid point. However, in recent years an increasing percentage of the R&D burden has been pushed down the supply chain, forcing those lower-segment companies to produce higher-value offerings than before. Yet this has occurred without any tangible improvement in the companies?f returns. This trend may lead to more volatility and further weakening of this critical part of the industry?fs infrastructure.

The International Technology Roadmap for Semiconductors (ITRS) details the technical requirements that are necessary for continuing on a path similar to that exemplified by the tremendous progress in semiconductor technology over the past several decades. Since the industry faces an unprecedented number of technological obstacles with no known solution, significant levels of research will be required to meet the challenge.

Despite the increasing R&D investments by the industry, there still exists an estimated gap of $1.5 billion in the annual investment required for the research to keep the advancement of semiconductor technology on track in the near future. According to the SIA, the R&D investment by the semiconductor industry has increased from $2.6 billion in 1990 to $14 billion in 2003. In contrast, the investment in basic research by the U.S. federal government has steadily decreased since 1980 (by about 30%).

Over the years, the burden for process development has steadily shifted to the semiconductor capital equipment companies, and chipmakers have also increasingly relied on the materials and tool suppliers to provide process and technology solutions. For example, equipment and materials firms have become solutions providers: in addition to their traditional offerings of tools and materials, they must also provide a complete process package that works well with the targeted modules. The result has been a steady increase in the R&D investment made by the semiconductor materials and equipment companies.

Equipment manufacturers have started to pass more of the R&D burden to their suppliers, which are under even greater margin pressures than the OEMs. On average, for each step that one moves down the supply chain, the operating margin drops by between 4 and 6%. Consequently, when combined with the impact of severe pricing pressures, companies at the third, fourth, or lower tiers of the supply chain have difficulty making money or even surviving. For instance, many materials suppliers have seen few profits and have had difficulty recouping their R&D investments on new chemicals, substrates, and the like. As an example, many still question the ROI for the multitude of low-k materials developed over the past few years, with most having little chance of being adopted. Consequently, while some equipment companies have managed to improve their margins, others down the chain have not—a situation that alarms many in the industry.

Another tool used to provide flexibility relies on mass hirings and ramp-ups in an upturn and mass firings and ramp-downs in a downturn. The disruptive impact of this approach needs to be carefully examined, in order to get a better understanding of its financial and social implications, such as the huge costs and waste of layoffs, rehiring, and retraining. When companies focus on fiscal responsibility, flexibility, and profitability, they should do so with a socially responsible outlook—a rare practice these days, yet one that makes sound business sense. Historically, companies like Hewlett-Packard (at least in the pre-Compaq era) and Xilinx that have followed a more socially conscious path and properly addressed workforce and human issues have done well. When employees recognize this, they do their best to make the business successful, plus companies always benefit from an experienced and loyal workforce.

Sound strategies for a lean operation—with reduced fixed costs and increased flexibility in operating expense budgets—permits companies to react faster and to scale up and down more efficiently. Further improvements to the current flexible business models for managing profitable, more-stable businesses through the cycles will create increased value for shareholders and stakeholders alike.

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