Buyers face impact of chip industry consolidation and higher prices in 2017

James Carbone, contributing editor
James Carbone, contributing editor

A shrinking semiconductor supply base could lead to higher prices for some components and mean changes in commodity strategies by James Carbone

The impact of consolidation in the semiconductor industry, expected price increases for memory chips and other semiconductors, and rising manufacturing costs in China are some of the issues that electronics buyers will face in 2017.

Some buyers are also concerned about if semiconductor and other component manufacturers will have enough capacity to meet expected rising demand over the next several years.  With the U.S. economy growing, some purchasers believe there could be an increase in new orders for computers, smart phones and other electronics equipment, but they are not sure that component makers have invested enough in new capacity because of declining or weak revenue growth.

Buyers are also concerned about supply continuity in the event there are trade issues with Mexico and China if presidential campaign rhetoric turns into reality and the new administration follows through on promises to renegotiate trade agreements and impose protective tariffs on imports.

But as the New Year begins, the shrinking semiconductor supply base appears to be the main issue with buyers. The number of mergers and acquisitions in the chip industry over the last two years has been unprecedented.

In 2015 there were 21 major mergers and acquisitions totaling $103.8 billion, according to researcher IC Insights. For the first three quarters of 2016, there’ve been seven major mergers and acquisitions totaling about $55.3 billion and more consolidation is likely.

The large amount of consolidation has resulted in a shifting semiconductor landscape, which has created a greater need to focus on supply chain risk management and price increases, according to Steve McEuen, vice president of global purchasing for EMS provider Creation Technologies, based in Burnaby, British Columbia. “Through consolidation these manufacturers are able to identify and eliminate duplication of product lines. Consolidation significantly reduces the number of options, or makes certain product lines cost-prohibitive,” he said.  “It also results in changes to operations including layoffs and other cost-cutting measures.”

Not-so-sudden impact
The impact of recent consolidation could start to be felt over the next year. Some buyers believe consolidation will ultimately result in healthier supply base that will be in a better position to meet the needs of OEMs and EMS providers. However, other purchasers say the amount of consolidation that has occurred will shift the balance of negotiating power for many commodities to suppliers and make it’s harder to get advantageous terms from suppliers and result in higher prices.

For instance, if two major suppliers with overlapping product lines merge, there is obviously less competition and it would be harder for OEM or EMS purchasers to negotiate price concessions and other favorable terms from the merged company or from another supplier that is a competitor of the merged company.

John Caltabiano, vice president supply chain for EMS provider Jabil Circuit
John Caltabiano, vice president supply chain for EMS provider Jabil Circuit

In some cases mergers of two companies that did not have overlapping product lines have occurred. If a buyer had been doing business with a company that was acquired, negotiations could still be challenging if the supplier that purchased the other component manufacturer has a different business strategy than the company it acquired. The company may want to grow its market share and increase profit margins and may refuse to cut prices, said Seth Choi, vice president, supply chain management for of SMTC Corp, based in Markham, Ont.

So far the impact of consolidation on prices is unclear.  “At this point I can’t say whether mergers and acquisitions have influenced prices one way or the other,” said Brian Matas, vice president of market research for IC Insights.

“It would seem logical that all the M&As would begin to drive prices upward a little bit more.” However, he noted once a merger has taken place, it takes a while for the merged company to determine which products it wants to keep and how the company will be organized. “Once they have established that, maybe prices will be addressed,” he said.

Impacting sourcing strategies
Besides impacting negotiation and prices, consolidation can also affect sourcing strategies for a commodity. Most OEMs and EMS providers don’t like to have a single source for a commodity. Many have multiple suppliers for a semiconductor and apportion their spend among those suppliers based on the suppliers’ score card performances from the previous year.

For instance, an OEM may have three suppliers for a semiconductor. The supplier that had the highest scorecard rating may be awarded 50 per cent of an OEM’s spend for the  commodity, while the second highest rated supplier may get 30 per cent and the third supplier 20 per cent of the OEM’s business for the part.
If the scorecard performances of suppliers change, the percentage of business awarded to each supplier can also change. However, depending on the commodity, consolidation could make it more difficult to have a multisource strategy and have a competitive tension among suppliers because there are fewer suppliers.

“Consolidation means semiconductor manufacturers have greater power in the market place to assure that their investments in technology, markets and products yield the required returns,” said John Caltabiano, vice president supply chain for EMS provider Jabil Circuit, based in St. Petersburg, Fla.  “This will require purchasers to use longer term relationships to help in commercial discussions versus simple competitive bidding,” he said.

In fact, many large global OEMs often forge strategic alliances with crucial semiconductor suppliers to get access to the latest technology, receive preferential treatment during shortages, and to get to world-class prices for critical components. However, as the supply base shrinks it may be harder for some OEMS and EMS providers to form partnerships with key suppliers.

More capacity wanted
While supplier consolidation is a concern for buyers, so is investment in capacity by component manufacturers. Because of sluggish sales and overall weak demand, capital spending by chip makers for new fabs and equipment has been soft over the past two years.  Worldwide semiconductor capital spending was expected to end 2016 declining 0.3 percent to $64.6 billion, according to researcher Gartner, Inc. Spending was flat in 2015. While industry analysts say there should be enough capacity in 2017 for most semiconductors, supply will likely be tight for some chips such as memory ICs. With the lack of capacity investment growth, if semiconductor demand increases, which analysts say is likely, lead times are likely to stretch and prices for some ICs will rise.

So far sluggish capital spending by semiconductor manufacturers has not been a problem because demand for chips has been soft for most of the last two years. However, demand for many semiconductors picked up in the second half of 2016 and there was an undersupply of certain chips such as DRAM and NAND flash, said Gartner.

Demand may weaken in the first quarter of 2017, but will pick up after that. “At the start of 2017, a weaker demand environment will create a brief technical oversupply, but the industry will then move back into an undersupply for the remainder of 2017 and into 2018,” said David Christensen, senior research analyst with Gartner.

He noted there was a shortage of NAND flash in the third quarter of 2016. As a result, memory IC makers likely will increase capacity for NAND and DRAM. Other chipmakers will also increase capacity in 2017 as well. Gartner forecasts that capital spending by semiconductor companies will rise 7 per cent in 2017, said Christensen.

“Logic manufacturers will focus their spending on ramping fabs for the introduction of high-volume 10-nanometer production in 2017,” he said. “Memory IC manufacturers will move production to 3-D NAND flash.” he said.

Semiconductor manufacturers will increase spending on wafer-level manufacturing equiment from $33.2 billion in 2015 to $37.7 billion in 2018
Semiconductor manufacturers will increase spending on wafer-level manufacturing equiment from $33.2 billion in 2015 to $37.7 billion in 2018

Certain end equipment segments such as 4G LTE smart phones are driving investment in advanced process technologies. The adoption of fingerprint sensors, touch display drivers and active-matrix dynamic light-emitting diodes (AMOLEDs) by Chinese smartphones has made full use of 200mm foundries’ 0.18-micron capacity.

Even with expected increases in capital spending, prices for some semiconductors will rise in 2017 because of weak capital spending over the past two years. IC Insights says the average DRAM price will increase 5 per cent in 2017. In 2016, the price dropped 16%. The average price of NAND flash will fall, but only 2 per cent in 2017. The price had fallen 6 per cent in both 2015 and 2016, the researcher said. Prices for microcontrollers will also rise on average 2 per cent in 2017, the researcher said. Prices are expected to increase 2 per cent for 16-bit microcontrollers and 3 per cent for 32-bit MCUs.

Besides rising and firming prices another challenge memory IC buyers in the computer industry may face is the transition of more DRAM production from computing and graphics applications to mobile phones, solid-state drives and other storage devices. Chips for those devices have higher profit margins than memory ICs used for computing and graphics applications.

While increasing prices for semiconductors can be challenging for both OEM and EMS buyers, rising manufacturing costs in China will be primarily a challenge for OEM purchasers involved in outsourcing decisions. Many electronics OEMs decided to outsource production of their equipment to China years ago because of low labor rates.

But wages have been rising steadily in China and will continue in 2017 and beyond, said Dan Panzica, principal analyst with IHS Markit Technology.  Labor rates in China will surpass labor rates in Mexico sometime next year or in 2018, he said. In fact in some regions of China labor rates are already higher than in Mexico.

By 2020, the labor rate in China will be $5.50 per hour compared to $5.18 in Mexico, the researcher said. It is unclear if rising labor rates in China will mean more OEMs will outsource manufacturing to Mexico rather than China. Many OEMs have been building their products in or near the markets where the products will be sold.

Most OEMs that have their systems built in China will likely stay in the country to service the Chinese market. They may also have manufacturing in Mexico for the North American market.

However, many buyers involved in outsourcing decisions and are looking for low labor rates are taking a close look at Vietnam. The country is increasingly becoming a manufacturing center, although it lacks the resources of China and Mexico. Vietnam’s hourly labor rates are cheaper than China’s or Mexico’s. For instance the labor rate in Guangdong, China in 2016 was $4.00/hour and $4.14/hour in Mexico. In Vietnam the rate was $2.42/hour, according to IHS Market Technology.

Of course, electronics OEMs outsourcing to EMS providers in China or Mexico could potentially face a serious supply chain challenges in 2017 if the Trump administration imposes up 35 per cent tariff on products built in those countries or gets into a trade war with China over Taiwan.

During the presidential campaign, Donald Trump said he might impose tariffs on China. He also had a phone conversation with the president of Taiwan, which did not go over well with China, which claims sovereignty over Taiwan. Matas said a “wild card in what happens to the IC business next year could be a cat-and-mouse game between Trump and China.” He noted that there is a lot of foundry IC production in Taiwan and many of those chips are shipped to China to be used in computers, smart phones and other electronics equipment built in the country.

“With so much of the IC industry’s foundry capacity being in Taiwan, and a lot that goes to China’s electronics assembly plants, the threat of new trade barriers between the island and the mainland seem to be significant,” said Matas.

If trade issues between the U.S., China and Taiwan escalate it would be disruptive to the electronics supply chain and would seem to be as “much a risk as any of the other usual disruptors” to the supply chain such as earthquakes, North Korea tensions, challenges with economies in Europe and terrorism,” said Matas.