"Blood, blood and more blood," is how one semiconductor industry analyst describes last year's price cutting by memory chip companies.

However, this year there will be less blood-letting as chipmakers try to stabilize prices by slowing capacity additions and reducing the growth rate of chip production.

Many semiconductor makers, especially memory IC makers, have announced plans to reduce capital spending. The reduction will mean capacity won't grow as much as previous years. With unit demand expected to rise, there will be less inventory and price declines should be less than last year.

But semiconductor buyers—especially those who don't purchase memory ICs—should not be overly concerned with the decline in capital spending by semiconductor manufacturers and the impact on chip prices, especially in the first half of the year. While the capital spending cutbacks will eventually result in tighter supply and firming prices, its impact will be felt primarily with memory ICs. DRAM prices will still fall, but not as much as last year when they dropped 35% on average. Some DDR2 DRAM prices fell 70% last year.

The price drops resulted from oversupply and efforts by chipmakers to gain market share or protect the share they owned.

"The industry has been in overcapacity and the net result was aggressive price reductions," says Len Jelinek, director and principal analyst semiconductor manufacturing with researcher iSuppli in El Segundo, Calif. He termed the pricing scenario as "bloody," saying overcapacity was the result of aggressive capital spending in 2006.

"Semiconductor companies are now saying 'we have to stop this because we can't afford to keep it going,'" says Jelinek. "They are saying 'we have to stop making conversions to 300mm wafers. We have to use some of our existing capacity and get inventories down and maybe we can stabilize pricing.'"

Jelinek says in the semiconductor industry, memory chip manufacturers make the most capital expenditures. "When you look at capital spending, about 60% of industry's capital is spent by memory suppliers," he says. The DRAM industry spends a lot to add capacity because the amount of memory used in a computer each year increases by about 50% and the number of computers shipped increases by about 10% each year. Non-computer equipment is also starting to use DRAM further boosting demand.

DRAM prices in the first half were still falling in January and early February, according to DRAMeXchange in Taiwan. For instance, the average spot market price of a DDR2 400MHz (64Mb x 8) DRAM fell from $2.54 in early January to about $2.25 in mid-February, according to the researcher.

Prices are falling because of high inventory levels, says Jelinek. He says memory suppliers fill their factories with production lines and pump out product. When prices are low, "they gather inventory and wait for prices to turn around and that is the position they are in now."

"Their lack of spending capital in the near term is their attempt to modulate that mountain of inventory down as well as stabilize pricing," says Jelinek.

Some purchasing executives are worried about the lack of investment by chipmakers because of the potential impact on supply and prices in the future.

"I am concerned about the DRAM industry," says Greg Shoemaker, vice president of procurement at Hewlett-Packard, based in Palo Alto, Calif.

"The supply base is in the midst of cutting back on their capital spending because they can't afford it. They don't have the cash or the financing to continue to invest at the same rate as the last several years because they aren't getting the returns they need," he says, adding that HP and other computer manufacturers count on the DRAM industry to make those investments both in capacity and research and development.

However, one reason why chip suppliers aren't investing is because computer manufacturers have aggressively negotiated price concessions and that will continue.

"A good purchasing professional would never say he was not aggressive in negotiations," says Shoemaker. "We are cognizant of what the industry would bear in terms of prices. We have to be competitive so we can't overtly leave any nickels on the table because someone else will take advantage of it."

However, HP purchasers look very closely at the supply base, what their suppliers' plans are, what their financials are and that "influences our decisions in negotiating," says Shoemaker. And while he is concerned about the capital expenditure cutbacks by chip companies, the current supply/price scenario is part of the semiconductor cycle.

"There are periods of very good economic returns for semiconductor manufacturers and that's when they are aggressively spending capital," he says. "They do so to increase their capacity to gain market share."

But at some point in the cycle, too much capacity is added. "That's what appears to have happened now and suppliers are under economic stress and cutting back on their plans," says Shoemaker, adding that the reduction in capital spending is "very concerning because it is a precursor to industry shortages in many cases."

As a big company, HP can usually get all the materials it needs during shortages although it may have to pay higher prices. "However, there is a lot of stress on the supply chain and there is the potential that some suppliers will exit the business because stress becomes so great," says Shoemaker.

Buyers can expect prices for other semiconductors including logic, analog, microprocessors and digital signal processors to fall during the year. Logic should fall about 3%; analog, 5%; microprocessors, 7% and digital signal processors, 7% according to market researcher IC Insights.

But chip suppliers say the price reductions for those products are the "normal" result of cost reductions from manufacturing efficiencies and die shrinks, some of which are passed on to buyers.

Steve Kelley, vice president and general manager for standard, linear and logic products for Texas Instruments in Dallas, says prices are stable overall, but there is always some price pressure on some products.

"It is a big market and each niche—from bipolar logic to the latest wafer chip scale packages—has a different set of competitors and there is price pressure in some areas," Kelley says.

There is a lot of competition for standard logic and commodity linear products and that affects prices. "We keep pricing on par with the market but we counterbalance that with new products which come in with higher prices because there is more value," Kelley says.

He says TI also tries to have one price for products in all regions of the world which wasn't always the case.

"The biggest source of discontent was pricing variation. Very often buyers could get a better price in another region," says Kelley. "That has changed. We have become more consistent in our pricing and we don't hear complaints from customers anymore."

Kelley says big customers in China and Taiwan drive overall business since 75% of its business in logic and linear sales are in those countries. TI is making investments in capacity for logic and linears, but it goes into assembly and test.

"One-hundred percent of our products are sourced internally and it is typically in wafer fabs that are almost fully depreciated. They are commodity type fabs 6- and 8-inch fabs," he says.

Buyers can expect price erosion for analog chips through the rest of the year. However, savvy buyers will know the market strategies of analog suppliers because some are more focused in market share and will more likely reduce prices.

"There is an interesting dynamic in the analog business," says Bob Conrad, executive vice president of analog products for Fairchild Semiconductor in Portland, Maine. "We have some well-known suppliers choosing between growth and continued margin expansion," he says. Those choosing margin expansion are less likely to be price competitive because they want to maintain their high margins.

Conrad says analog market leaders have margins in the 75–80% range. "If they can't get those margins, they won't go after an OEM's business," he says. "That behavior is seen as being greedy in the eyes of the purchasing departments."

If a supplier walks away from business it makes it harder for buyers to get lower prices. Buyers need to go to other suppliers that are willing to take fewer margins.

Conrad says Fairchild's margins are in the 30–35% range but it also is trying to boost margins. "We are also focusing on growth and think we can expand margins up into the 45–50% range. "

Buyers can expect processor prices to fall, but not as steeply as 2007 because the price war between Intel and AMD has eased. AMD had been slashing prices to try to win market share and Intel had been matching or beating the price cuts.