Markets & Finance

Poor Foundations for Asian Foundries


By Chuan-Yang Lim When chip foundries in Asia reported their fourth-quarter results in late January, executives did their best to paint a positive picture. Taiwan Semiconductor Manufacturing (TSM), United Microelectronics (UMC), Chartered Semiconductor Manufacturing (CHRT), and UMC Japan (the stock trades only in Japan) each assured investors that a recovery in chip demand would stimulate business in the second half of the year.

Still, foundry shares largely fell on the news, and a closer look shows why. All four companies cut their 2003 capital spending plans, and most couldn't offer sales trends predictions beyond eight weeks, suggesting executives weren't fully convinced of a near-term recovery.

Taiwan Semi, the world's largest foundry in both size and technology, cut its 2003 budget to a range of $1 billion to $1.5 billion, from $1.6 billion in 2002. No. 2 foundry United Micro slashed its spending plan to $500 million, from $800 million last year. Similarly, Chartered Semi now plans to spend $275 million this year, a big drop from $420 million a year ago. UMC Japan, the smallest of the four, says its budget will stay below $200 million.

DEPRESSING FUTURE. Chip foundries are still struggling with excess capacity and pricing pressure, with no sign of a turnaround. We at Standard & Poor's are keeping an underweight recommendation on Asia's foundry industry. With expensive valuations and limited earnings visibility, we think the shares are likely to stay depressed for the next 6 to 12 months.

Asia-based foundries supply chips to the PC, consumer, and communications sectors. From our conversations with two of the companies, we found a number of PC makers have cut orders so they can purge excess inventory from last year's sluggish back-to-school and Christmas seasons. Demand from the consumer sector should stay rather flat in the current quarter, while orders from wireline communications outfits are likely to keep sliding.

One pocket of strength is the wireless communications sector. Demand for wireless local area network chips is still high, especially for the 802.11 technologies for Wi-Fi and baseband chipsets that are used in cellular phones. The foundries' revenue from wireless customers, however, is relatively small compared with other sectors. A jump in sales to wireless outfits won't be enough to offset weak sales to PC and wireline customers.

REPEATED HITS. Such anemic demand has forced Asian foundries to curb production, just a few years after investing millions of dollars to boost capacity rates. Utilization rates in the fourth quarter of 2002 at Taiwan Semi (ranked 2 S&P STARS, or avoid) and United Micro (2 STARS) were between 60% and 70%, while UMC Japan (3 STARS, or hold) recorded a 55% rate. Chartered Semi (1 STARS, or sell) was the worst performer, with its fabs running at only 39% capacity.

This capital-intensive business requires high fixed costs, especially for a new foundry such as Chartered Semi, which makes chips for Intel (INTC). After a drawn-out economic recession that led to lower utilization rates, the Singapore-based company reported a net loss for the eighth straight quarter for the period ended in December, and its shares sharply declined. Chartered shares had already taken a hit once before when Intel announced spending cuts for 2003.

On Thursday, Feb. 13, Chartered Semi announced plans to shut an old wafer fabrication plant, cut 500 jobs, and boost capacity for newer generation silicon wafers. We at S&P expect the company to remain in the red through all four quarters this year. Chartered's return to profitability in 2004 will depend on market demand -- and that's still unknown. The discouraging earnings outlook will undoubtedly limit Chartered's spending ability and its chances of keeping pace with the top two foundries.

PRICED OUT. Although the four foundries are producing fewer chips, supply will probably stay above demand. And without a pickup in demand, prices will keep dropping. For the current quarter, Taiwan Semi forecasts a 7% decline in its average selling price from the fourth quarter. Chartered forecasts a 10% price drop.

Chip pricing will also be hurt by the emergence of new foundries in Asia, especially in China. Our estimates show that 70% of the additional capacity (about 200,000 units per month of eight-inch-equivalent wafers) will come from Chinese fabs. We think this makes the selling environment highly competitive for Chartered Semi and threatens to price it out of the lower-end markets.

It's hard to tell when chip prices and demand will pick up meaningfully, and we at S&P recommend that investors and speculative traders avoid foundry stocks. Despite the poor fundamentals, their valuations remain expensive. Taiwan Semi and United Micro are trading at 67 times and 40 times our fiscal 2003 earnings estimates, respectively -- hardly a bargain in an industry that's suffering from cloudy earnings prospects. These valuations would be even more stretched if we used Standard & Poor's Core Earnings, which include stock options expenses. In the coming months, we think foundry stocks will likely remain more vulnerable than other Asian tech industries, and we would place bets elsewhere. Analyst Lim follows Asian technology stocks for Standard & Poor's in Singapore


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