Shrinking logic: The decline of chip making: Eric Auchard

-- Eric Auchard is a Reuters columnist. The opinions expressed are his own --

By Eric Auchard

LONDON (Reuters) - Shares in the world's chip makers have rallied this year because of the remarkable way the industry has warded off the sort of massive build-up of unsold inventory seen in prior downturns. But to do this, it has sacrificed investment in new production capacity at an unprecedented rate.

Just three of the world's biggest chip makers plan to invest more than $1 billion on production tools and equipment upgrades this year, down from 16 companies at the peak of the cycle two years ago.

Worldwide semiconductor capital spending peaked at $61 billion in 2007 but fell to $43 billion in 2008 and is expected to decline to $27 billion this year. More than 15 firms are planning to close 46 chip plants or test facilities in 2009, according to Nomura's research.

While capacity cuts may cushion the downturn, they will also constrain growth at those firms which have cut back when corporate and consumer demand returns for phones, computers and other gadgets.

The rebound in semiconductor stocks -- most sector indices are up 40 percent to 50 percent this year -- may fizzle without re-investment in upgraded production needed to drive the next cycle of growth.

Intel Corp (INTC.O), Samsung Electronics (005930.KS) and contract chip maker TSMC (2330.TW) are the only three firms that can afford to spend more than $1 billion on new equipment this year, according to industry research firm IC Insights. Gone are many of the European, Japanese and Taiwanese chip producers who once gave Intel and Samsung a run for their money.

Hynix (000660.KS) and Toshiba (6502.T) have scaled back significant capital spending plans earlier this year. Japan's Elpida Memory (6665.T) and Taiwan's memory chip industry have turned to their governments for bailouts. Fujitsu (6703.T) has contracted out new production to TSMC. Infineon (IFXGn.DE) of Germany has been caught short by the dramatic decline in the auto industry, a key market for its chips.

This means Intel, Samsung and TSMC are likely to dominate the scene as the industry recovers. They will certainly have a big head start. They account for $11.5 billion in capital spending this near, or 43 percent of total industry spending, IC Insights predicts. That's up from 25 percent in 2007.

Companies with cash to invest in the next cycle of technology stand to reap the huge efficiencies that come from multiplying capacity on otherwise similar fixed costs. Such profits drop nearly straight to the bottom line. Companies caught short of cash or credit in the downturn will be unable to compete at the cutting edge of new technology and risk becoming also-ran suppliers of commodity products.

The snag is that building production capacity to stay in this arms race is very expensive. Costs for building new semiconductor plants from scratch can run more than $4 billion. The investment hurdle this now poses appears to be leading to the final consolidation of the production end of the business. Annual spending on new semiconductor fabrication plants is expected to fall 56 percent this year to 10-year lows.

The concentration of manufacturing power in just a handful of companies has grave consequences for the pace of innovation across the industry in years to come. It will vastly increase pricing power for a handful of manufacturers, and this will slow the seemingly relentless decline in chip prices over recent decades. The leaders will have fewer incentives to differentiate their products, while the laggards will lack the means.

Intel's relentless drive to almost double its production capacity every two years has left the No. 2 player in the microprocessor business, AMD (AMD.N), unable to invest in the emerging market for netbooks, or mini notebook computers, the latest PC growth market. Similarly, Samsung's ability to invest in new memory capacity means it can keep prices low to sweat other memory chip makers.

TSMC has been forced to pick up its own spending simply to keep pace. In effect, the leading contract chip manufacturer supplies advanced capacity for many of the rivals of Intel and Samsung -- companies such as Qualcomm, Nvidia, Broadcom, Marvel and Altera. But less favored customers will find themselves caught short of capacity when wider economic demand returns.

The silver-lining for the industry is that shortages of cutting-edge capacity should drive up prices for cutting-edge products between now and 2012. But these benefits will flow mainly to the few manufacturers with the cash to invest in the next cycle of technology. If leading edge manufacturing does consolidate around a handful of producers, the era of "cheap as chips" semiconductor technology may be over.