March’s ‘one-two-three’ calamity! What now for chip industry?

This is a summary by Malcolm Penn, chairman and CEO, Future Horizons. For those who wish to know more, please get in touch with me or Future Horizons.

It was all going so well at the beginning of March when January’s WSTS results were released. The oil and North African issues were being taken in their stride. Then, less than two weeks later, the earthquake and tsunami disaster struck Japan and by the close of the month, the Gaddafi Libyan regime was under western international airstrike siege.

Given the fragility of industry’s confidence since the Lehman Brothers crisis, the industry has weathered these ‘incidents’ with remarkable sanguinity, with concerns focused purely on supply not demand-side issues. In our view this underlines what we have been saying all along; the 2010 recovery and 2011 outlook were both stronger than most people thought.

The industry’s biggest problems in 2011 were always going to be supply not demand driven; the situation in Japan has simply amplified and accelerated their coming.

The chip industry took March’s one-two-three knocks with remarkable calm, hit first by the spike in oil prices following the politic unrest bordering on civil wars in North Africa, then the dreadful 11 March earthquake and Tsunami in Japan, culminating on 19 March with a multi-state coalition military intervention in Libya to implement United Nations Security Council Resolution 1973.

Last year, any of these events would probably have been enough to deal the industry a knockout blow, as with the September 2008 Lehman Brothers collapse; this time around, despite the still fragile global economic confidence, the industry seems to have taken these events in its stride.

Whilst it is far too early to quantify exactly what the industry impact will be, the oil price and North Africa situation pales into insignificance when compared with the aftermath of the earthquake and tsunami. Japan is too important a cog in the global electronics industry for its impact not to have serious global repercussions. It has also brought to a head the far deeper industry problems that we have long warned of – man-made in the corporate boardrooms – that could (should) have been avoided.

In this aspect, Japan’s disasters do have parallels with the Lehman Brothers collapse and its impact of worldwide finance; we hope that the current disruption to manufacturing worldwide from will force a rethink of how the world manages production.

In the meanwhile, we believe that the repercussions will be manifested in four waves: the immediate, the near-term, the medium term and the longer term. The immediate – some minor disruptions due to logistic-related issues but otherwise ‘business as usual’; there is sufficient inventory in the supply chain to keep the processes rolling, other than maybe the NAND Flash memory spot market (30 percent of the whole) where some price hikes are inevitable and unavoidable.

The near-term (next 1-2 months) – supply shortages caused by the destruction of work-in-progress; anything being made at the time of the disaster would have been lost and unsalvageable.

The medium-term (next 3-6 months) – further supply shortages caused by reduced production capacity, either due to factories destroyed, factories unable to restart for (lack of) electricity supply issues, lack of piece parts – from resins to wafers; ICs to displays.

The longer term (next 6-24 months) – supply chain constraints while damaged factories get repaired or replaced and new capacity comes on line. The industry thus faces an extended period of supply chain uncertainty and a frantic order book re-jiggling by firms directly hit by factory disruptions, seeking to reschedule their orders with alternative suppliers.

This will not be as easy as it sounds. For a start, the pre disaster the supply chain was already maxed out so even if a firm wanted to place an order elsewhere, there is little spare capacity to service these new requirements.
Secondly there are issues of qualification. For consumer products, changing suppliers at a whim might be de rigour, but for other applications this inevitably involves a qualification and testing process, often requiring 1,000 (i.e., three months) life tests.

There are also potential yield and reliability issues in changing wafer substrate suppliers and packaging materials, some of which manufacturers may take a risk and hit on, some of which they will not be allowed to do. For example, change the airbag controller or other safety critical MCU and you almost certainly have to re-run the airbag qualification test once you get qualified samples of the new parts from the new sources, adding even further delay.

It is here where the real supply chain risks, so readily cast aside over the past decade or so, are the most profound. We have squeezed inventory and just-intime beyond all degrees off reasonableness.

Just as a 30:1 loan to equity ration sowed the seeds of self-destruction for Lehman Brothers, whereby just a 3-4 percent fall in asset values triggered the company’s downfall, so the ridiculously low inventory levels in today’s ever-tightening just-in-time lean supply chain equally over-leveraged manufacturing environment will trigger a supply shortage that will take several years to unravel.

The fact is, the IC production cycle, from order placement to final end product delivery to the customer is typically six months, and that is when everything works like a dream. That would mandate a global inventory level of at least three months overall; today’s industry, and especially the financial community, would fret if this started to come close to half that level.

Add to that the passion to out source everything – with no one responsible for overseeing the overall increasingly extended and complex supply chain links, just their own in-out interface to an increasingly reduced often single/dual-sourced number of suppliers means a supply chain balancing like an inverted triangle. On March 11, 2011, that triangle fell over.

What then is the likely impact on our forecasts? As mentioned earlier, the current industry robustness to these issues underlines our fundamental premises; predisaster the 2010 recovery and 2011 outlook were incredibly strong. We are thus keeping this still firmly in mind together with the fact we are not in the business of making headline-grabbing pronouncements.

The truth is, no one knows what the factual impact will yet be. Crises, by their nature, generate clouds of uncertainty and it is far too early and too complex for these to unravel. Traditionally businesses postpone capital spending and hiring plans until the clouds clear but there is little evidence that this is so far the case.

The industry’s biggest problems in 2011 were always going to be supply not demand related; the situation in Japan has simply exasperated the underlying problems. As such, our instinct is that there will be little overall change to our 9 percent semiconductor market growth forecast for 2011, with any reduction in unit shipments off set by price hardening. We are also mindful to keep with our longer-term outlook of 18 percent growth for 2012, slowing to minus 2 percent in 2013.