03/11/85 AMERICA'S HIGH-TECH CRISIS

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AMERICA'S HIGH-TECH CRISIS
Why Silicon Valley Is Losing Its Edge
Item: Homegrown technology enabled two Silicon Valley companies -- Qume Corp. and Diablo Systems Inc. -- to dominate the soaring market for daisy-wheel computer printers. Then came a flood of Japanese machines with lower price tags, and their market share tumbled. Though they tried to compete by moving production offshore, the two U.S. companies now share just 15% of a $1 billion market.
Item: General Electric Co. has concluded there's no benefit in manufacturing consumer electronic products in the U.S. except for "a parochial sense of control," so it is automating its Far East plants.
Item: TIE/communications Inc. started out by buying telephone products overseas, then it gradually pulled back most of its manufacturing to the U.S. Now the company is shifting gears again and is cutting back domestic production. "The competitive position of the Tar Eastern countries is superior to ours," says TIE President Thomas L. Kelly Jr.
Suddenly, such ominous developments are becoming commonplace in California's Silicon Valley and other U.S. high-tech enclaves. America's vaunted leadership in high technology, the wellspring of innovation for the entire industrial sector, is eroding rapidly in every major electronics market. The trend reflects nothing less than a crisis in U.S. high technology.
Even Silicon Valley executives were shocked recently when they toted up last year's preliminary import-export figures for U.S. high-tech industries. For the first time ever, the nation's electronics sector, long a positive contributor to the U.S. trade balance, had gone into the red. And not just slightly. The U.S. chalked up a massive $6.8 billion deficit. And the red tide is rising fast This year the trade deficit in electronic products should hit at least $12 billion, predicts the American Electronics Assn.
Competitive problems in high tech go far beyond current economic problems, such as the overvalued dollar that inflates the cost of American goods. Unquestionably, the dollar's strength has "exacerbated the situation dramatically," acknowledges John A. Young, president of Hewlett-Packard Co., who has just submitted to the White House a strategic plan for dealing with America's overall competitive weakness. But the strong dollar is not the root cause. The balance of trade in the crucial semiconductor industry has been slipping since the late 1970s, or before the dollar began its big climb in 1980.
CRYING UNCLE. The trade tumble is also more than just fallout from the business cycles that rock Silicon Valley. The import-export deficit in semiconductor chips, for example, piled up even during the industry's boom times of 1983.
But the trade problem undoubtedly is accentuating the semiconductor industry's current severe slowdown, which is forcing layoffs or plant shutdowns. Chip demand continues to climb, but bloated inventories are causing real pain. Intel Corp. recently slashed employment by 900, or 4% of its work force. In late February, two more chipmakers cried uncle. Texas Instruments Inc. is extending its reduced work schedules through the first half -- prompting one analyst to cut his earnings forecast for TI in half, which sent the company's stock price down by more than $8 a share on Feb. 25). And Micron Technology Inc., an Idaho chipmaker, says it is slashing its work force of 1,250 in half. If this erosion continues unchecked, America's high-tech sector will soon be in danger of losing its world leadership position. "When you look at the figures on international trade, the trends are not right," says lan M. Ross, president of AT&T Bell Laboratories. He is not about to throw in the towel, however. "We're still ahead in technology, and we can stay ahead," Ross maintains. "But it will take some reordering of our priorities."
The basic problem is that U.S. high-tech companies are no longer consistently able to translate their technology into competitive products. Instead, they are being forced to turn increasingly to overseas suppliers for electronic components they can't make competitively at home. As a result, the electronics industries -- one of the country's largest manufacturing employers, with a work force of 2.6 million -- are in jeopardy of being gradually transformed into a distribution business for foreign manufacturers.
A NEW TUNE. The severity of the situation is masked by the fact that U.S. brand names continue to dominate critical markets, such as computers and scientific instruments -- although many of their components are actually turned out by foreign workers in foreign factories.
A case in point: The U.S. share of worldwide computer sales is holding relatively firm at more than 80%. Yet trade figures by U.S. companies in that market are taking a nosedive because an ever-growing percentage of this equipment is purchased abroad. Most computer terminals, for example, are made in Korea, and Japan has grabbed the lion's share of the business in computer printers and disk drives.
America's high-tech trade problem centers largely on the huge and growing deficit with Japan. The red ink from the exchange of electronic products between the two nations swelled from $9 billion in 1983 to about $15 billion in 1984. That was more than the deficit in automobiles. And analysts at the American Electronics Assn. expect the overall high-tech debit to Japan alone will hit an awesome $20 billion this year.
Faced with such a massive imbalance, even Silicon Valley, traditionally a bastion of free-trade sentiment, is beginning to clamor for protection. "I'm not being asked to seek Detroit-style quotas," says Ralph J. Thomson, who lobbies Washington on behalf of the 2,700 corporate members of the AEA. But he adds that many top executives now are questioning "whether we should retain our unfootnoted free-trade stance."
One person doing more than just questioning is Robert W. Galvin, the silverhaired chairman of Motorola Inc. Furious about what he considers unfair competition from Japan, he is championing a call for several measures to redress trade grievances, including a 20% surcharge on imports. Declares Galvin: "This is street fighting."
'NO HOPE.' For a growing number of managers, the battle is all but over unless Washington acts to offset the advantages that Japanese companies enjoy. "There's just no hope. We're facing a head wind that's impossible to overcome," worries Gilbert F. Amelio, president of Rockwell International Corp.'s Semiconductor Products Div. and a director of the Semiconductor Industry Assn.
In mid-February, Hewlett-Packard's Young submitted his strategic plan to the White House on behalf of the President's Commission on Industrial Competitiveness, a group he chaired and which studied the issues for nearly 18 months. Young says his blue-ribbon group concluded that "there are no simple fixes. What we have to do is rededicate ourselves to the fundamentals, especially manufacturing productivity," since that is the only way to remain competitive without diminishing the U.S. standard of living.
The Young commission's report, which apparently has generated no more than polite applause among Administration officials, criticizes U.S. performance in several key areas:
* Technology. The U.S. is frittering away its lead in high tech by spending too little on civilian research and development. Expenditures there have fallen behind those of our trading partners as a percentage of gross national product. Meanwhile, military R&D -- half of the country's total outlay of $100 billion -- no longer pushes civilian technology as it did in the 1950s and 1960s.
* Manufacturing. Even more damaging is industry's failure to master the discipline of modern manufacturing. "It does little good to design state-of-the-art products," according to the report, "if within a short time our foreign competitors can manufacture them more cheaply." But U.S. companies are hardpressed to match Japanese investments in manufacturing because the cost of capital here is double what it is in Japan.
* Capital. The high cost of capital in the U.S. is the result of three problems: Americans save too little, the government spends too much, and the tax system is biased against investment. "The one thing that's clear is we aren't saving and investing in industry," says Robert N. Noyce, Intel's vice-chairman. "The Japanese can invest twice as much as we can, and [because of the overvalued dollar], their products are 25% cheaper than they should be."
* Antitrust. To determine what is or isn't anticompetitive, the Justice Dept. needs to consider overall world market positions, not just those of the U.S. market. "We have to stop shooting ourselves in the foot," says Ross of Bell Labs, because bigness is sometimes the only way butt heads with the giant, integrated companies in Japan and Korea. Only multibillion-dollar companies, such as International Business Machines Corp., can afford to match manufacturing investments with Japan.
* People. American workers are still mired in adversarial relationships with management that "may no longer serve the best interests of both parties and the public," claims the Young report. Furthermore, the U.S. isn't doing enough to help the workers adapt to changes in technology or to provide engineers in the numbers required by high-tech industries.
* Trade policy. The U.S. hasn't kept up with the new realities of world competition. Washington responds belatedly, if at all, to damage caused by dumping or foreign government policies that distort trade flows. John Zysman, a director of the Berkeley Round-table on the International Economy (ERIE), contends that present U.S. policies, left unchanged, will eventually provoke "a violent protectionist reaction."
Sweeping changes in business and government alike will be needed to address these problems. The Young commission didn't come up with any magic formulas, but it does hammer home the need to get on with previous proposals, such as creating a Cabinet-level Science & Technology Dept. to coordinate research efforts -- and a Trade & Industry Dept. to help focus federal resources on international competitiveness.
As a bare minimum, commission members believe it's essential to retain the R&D tax credit. Better still, the commission would like to see the credit expanded to include all R&D spending. Trimming the federal deficit to ease interest rates is another top-priority item. Finally, says Young, because "tax policy is one of the most important de facto industrial policies we have," the report urges revising the tax code to stimulate savings and long-term investments.
The sensitivity to high-tech issues in Congress seems to assure that at least some of the Young commission's proposals will get a hearing, and soon. Representative John J. LaFalce (D-N.Y.), chairman of the House Economic Stabilization subcommittee, plans to hold hearings on Mar. 5. "This is a good report," he says, adding that he is determined not to let it sink into oblivion. He suspects, however, that President Reagan would prefer that to happen, since it contradicts the Administration on industrial competitiveness. "Basically," notes LaFalce, "they've said we don't have a competitiveness problem, and if there is a problem, it has more to do with an overvalued dollar than anything else."
But the Reagan Administration is already on record as opposed to the idea of a Science & Technology Dept. And there is powerful opposition in the Cabinet to a Trade & Industry Dept. Secretary of State George P. Shultz fiercely opposes the concept on the grounds that it would infringe on the conduct of foreign policy. He is backed by Robert C. McFarlane, Reagan's national security adviser, as well as Treasury Secretary James A. Baker and Agriculture Secretary John R. Block.
Without at least the minimum remedies, high-tech companies will have little choice but to more more and more manufacturing offshore. Some executives don't find that notion disturbing. In fact, they believe the U.S. will ultimately end up functioning as a hothouse for new technology and venture capital startups. Then, when a business gets firmly established, it would shift its production to Asia or South America. If that happens, says Simon Ramo, a director of TRW Inc., "America goes into the financial management business rather than the production business."
MAKING BULLETS. Galvin of Motorola practically chokes when he hears that line. He argues that it ignores the disastrous effects on America's small businesses, which employ more people than large companies and create 80% of all new jobs. For companies the size of Motorola competing with Japan isn't a question of survival, because Motorola can simply pick up and move offshore. But smaller companies don't have that mobility -- and they already are in deep trouble. "People we used to do business with, we can't anymore," Galvin says, because they aren't competitive. "Instead of buying a given part from a supplier down the street in Chicago," he asserts, "I buy it from a supplier down the street in Osaka."
The danger in this exodus -- apart from the loss of U.S. jobs -- is that an industry unable to do its own manufacturing may end up vulnerable to competitors that don't have to pay a middle man. That was how the U.S. consumer electronics industry played into the hands of the Japanese back in the 1950s, warns C. J. van der Klugt, vice-chairman of Philips, the Dutch electronics giant. Japan subverted the U.S. industry by first supplying cheap parts, then subassemblies, and finally finished products labeled with U.S. brand names. Eventually, he says, key engineering and production skills in consumer electronics dried up, leaving the U.S. extremely vulnerable in all electronic markets because "the difference between consumer electronics and professional electronics gradually disappearing."
Because the Japanese have made no secret of their goal to dominate the world's computer and communications markets, van der Klugt is incredulous that U.S. companies didn't learn their lesson from consumer electronics. "You are helping make the bullets that will shoot at you in the future," he says. "First you move production to the Far East, then the development of the product will go there," the Dutch executive says. U.S. companies are deluding themselves if they believe they can control their destiny, yet do only 25% of the manufacturing, says F. David Crockett, president of Dataquest Inc., a market researcher specializing in high tech. "American industry is becoming a distribution business," he charges, "and we haven't even noticed we are in trouble."
In computers, a field where the U.S. has held a seemingly unshakable lead in technology, foreign producers have increased their penetration of the U.S. market only slightly in terms of dollars, from 2.9% in 1981 to 4.2% last year. Yet the imports of computer equipment, mainly components and peripherals, doubled to $8.3 billion last year, while exports grew a modest 30% to $13.7 billion, according to InfoCorp, a computer industry market researcher. Even IBM's hot-selling Personal Computer is built largely from pieces made overseas.
For the rest of this decade and into the 1990s, communications technology will be a major battleground. By breaking up American Telephone & Telegraph Co. and deregulating the equipment business in the world's primary communications market, the U.S. provided foreign competitors with the biggest unilateral trade concession of the decade -- with no quid pro quo at all for U.S. manufacturers. Most foreign markets remain safely closed to U.S. products.
As a result, U.S. imports of communications products jumped 31% last year, to an estimated $4.2 billion, while exports grew only 6%, to $3.6 billion. Some 34 million telephones have poured into the U.S. over the past three years, notes James R. Carreker, a senior vice-president of Dataquest. "That exceeded the total available market, and as a result, these products were being given away."
Motorola's Galvin fears that a similar bloodbath is imminent in the cellular mobile telephone market. And another onslaught is likely in sophisticated office telephones and the private branch exchanges (PBXs) that link them to the outside world. Carreker reports that Japan's NEC Corp. more than doubled its share of the $3 billion U.S. digital PBX market last year to 5%.
Japan also intends to "privatize" much of the business that had been monopolized by Nippon Telegraph & Telephone Public Corp. (NTT), and U.S. trade negotiators are in intense discussions now with Japanese officials. They hope to ensure that U.S. equipment makers will get fair access to Japan's market. So far, the negotiations have centered on such specifics as how U.S. telecommunications gear will be certified (page 67). But many Washington insiders privately say the Japanese are stalling, as usual, until subtle anti-American provisions are published. "Unless they make major changes in their proposed ordinances," warns Commerce Secretary Malcolm Baldrige, "they will have the ability to keep out American competition."
CHIP WARS. The mood in Washington seems primed for retaliation. Mark S. Fowler, chairman of the Federal Communications Commission, has openly hinted that he might use his agency's licensing and certification powers to curb Japan's access to U.S. markets. Representative Matthew J. Rinaldo (R-N.J.) has introduced legislation that would require the FCC to deny certification to telephone equipment from countries that are deemed to have violated fair trading practices with the U.S.
The battle over communications is especially critical to the competitive position of the U.S. semiconductor industry. "The major driving market for the remainder of the decade is telecommunications," says Michael G. Borrus, who tracks the chip business for BRIE, a think tank funded partly by Silicon Valley companies. Japanese producers have already taken major strides toward wiping out the U.S. lead in semiconductors, Borrus observes, and he worries that gains in communications will help them finish the task by providing new mass markets for advanced chips.
Japanese producers have been gaining market share in computer memory chips since the late 1970s. Last year their dominance of the market for workhorse 64K RAM chips, which store more than 64,000 bits of data, helped the Japanese add 3 percentage points to their share of the U.S. market, bringing it to 16%. Analysts at the Semiconductor Industry Assn. figure that Japan's penetration this year will climb close to 20% as 64K memory chips are displaced by 256K RAMs -- a major new product almost completely dominated by Japanese makers. G. Dan Hutcheson, executive vice-president of VLSI Research Inc. in San Jose, Calif., says he is "very pessimistic about the U.S. semiconductor industry. The Americans have lost the battle in memories but haven't recognized it."
SPLITTING THE MARKET. Chipmakers in the U.S. meanwhile, are bitter about the lack of progress under a 1983 agreement designed to open Japan's market. Although their penetration did expand from 9% to 11% last year, the gains evaporated during the fourth quarter. W. J. "Jerry" Sanders III, chief executive of Advanced Micro Devices Inc., says that after his chip sales doubled in Japan, "that business died" by yearend. Once the supply crunch abated, Japanese buyers went back to local suppliers.
Meanwhile, the current downturn in semiconductor orders is likely setting the stage for another leap ahead by overseas competition. While the Japanese continue to add capacity at a freetic pace, "the U.S. has cut back quite a bit from what we originally planned to spend," says President Charles E. Sporck of National Semiconductor Corp. He insists that the U.S. has made progress toward removing Japan's advantage in high-volume production, but he admits that "the U.S. industry is in deep trouble, long-term, if the Japanese keep their cost-of-capital advantage."
About the only feather in America's high-tech cap that no outsider yet threatens is the ability of U.S. engineers and entrepreneurs to come up with technical breakthroughs and creative software products. Fortunately for the U.S., some industry trends appear to be playing to these strong points.
Technology improvements are driving the semiconductor industry away from the commodity products targeted by Japan and toward custom-designed parts. The resulting product proliferation and market fragmentation will make it more difficult for the Japanese, suggests Wilfred J. Corrigan, president of LSI Logic corp., a leader in semicustom chips. "It doesn't favor their disciplined, high-volume approach," he explains.
Similarly in communications and computers, the accelerating importance of software may give U.S. companies a continuing edge. "The real cost issue is the cost of developing and maintaining software -- and of installing and supporing the equipment," says M. Kenneth Oshman, president of Rolm Corp., the communications company acquired last year by IBM. "And nobody has jumped ahead of us there."
Whether the U.S. can arrest the shrinkage of its manufacturing base in time to curb high-tech imports and boost exports is unknown. "National dialogue is so focused on military vs. social expenditures," says Ray Stata, chairman of Analog Devices Inc., that the country is "overlooking what we have to do to ensure long-term economic development." In any case, meeting this clear and present danger will require a combination of political fortitude and management discipline that neither Washington nor Silicon Valley is well known for.

By John W. Wilson in San Francisco, with bureau reports