A cutback in capital spending by semiconductor companies, including the foundries that many chip suppliers are outsourcing to, will lead to higher prices in 2009.

“The industry is on a collision course,” says Brian Matas, vice president of research for IC Insights, a researcher in Scottsdale, Ariz. He notes that more chip suppliers that had their own fabs are deciding to either go fabless, outsourcing all chip production to foundries, or “fab-lite,” keeping some production in house and outsourcing the rest.

But, the foundries are not adding enough capacity despite the increased business. “With that happening, something is going to have to give and it's going to be prices,” says Matas. “They will go up.”

The situation has buyers at OEMs concerned. Geoff Landon, supply base development manager at Sun Microsystems in Santa Clara, Calif., is one. He is responsible for SRAM, application specific integrated circuits and application specific standard products. He says Sun is buying more standard chips than in the past. Ten years ago, he says, 90% of Sun's semiconductor spend was for custom devices. Today it's 50-50, standard versus custom, and in a few years it will be 60% standard products. Such ICs may be designed by a fabless chip company, but are built by foundries.

“What drives cost in the standard space is what TSMC (a foundry) is charging our suppliers for wafers,” he says. If TSMC raises the price of a chip to a fabless company, that cost is passed on to Sun. “So we are very interested in the doings of the TSMCs and the UMCs and SMICs of the world in terms of capital expenditures,” says Landon.

Matas says capital expenditures for the entire semiconductor industry will be down 15% overall in 2008, although there will be a double-digit increase in unit demand and about a 9% increase in chip revenue.

He says many chip companies that are reducing capital expenditures in an effort to stabilize or increase prices are memory IC manufacturers. “Those companies are really suffering because of low prices,” says Matas. Prices fell 60-70% last year for some types of DRAM although bit demand increased by about 70%.

As a result many DRAM makers in particular have cut back on capital expenditures (capex). Jim Elliott, vice president of memory marketing at Samsung Semiconductor in San Jose, Calif., says the capex-to-total-revenue ratio last year was 56%, based on total memory-IC industry revenue of $58 billion and capex of $32 billion. This year, the ratio will be in the mid 30s, reflecting the cutbacks the industry is making in capex, according to Elliott. “We have not seen such a low ratio since 2004,” he says. “We are setting the stage for an upturn in the long-term.”

The cutbacks have already helped buoy DRAM prices. “The DRAM market has bounced back reasonably well over the last several months,” says Elliott. He says prices for DRAM and flash have increased by about 20% from their low points in 2007.

Contract prices in the first half of May increased by about 10% and spot market prices were stabilizing, according to researcher DRAMeXchange in Taiwan.

The reduction in capital spending will impact prices in 2009 more so than this year. Matas notes that there have been seven years of double-digit unit growth in the chip industry and that level of demand growth will continue. But, he adds, the trimming in the amount of capital spending by semiconductor companies this year means in 2009 and perhaps in 2010 and there could be a strain on capacity and a return to strong pricing across the IC industry.

Matas adds that although memory IC suppliers and foundries seem “determined to restore some profitability by keeping capital spending under control,” there is hope for buyers. “Memory suppliers are “often the worst in keeping their word about cutting back on capital spending,” he says. Often when business starts to improve a memory supplier will break ranks and start to expand capacity. “That move is matched by another memory guy and then the whole bloodbath begins again,” says Matas.

However, buyers need to be concerned about a longer term trend of semiconductor outsourcing and its impact on prices and supply. The high cost of building fabs (between $2-3 billion) is the driving force in more chip companies going fabless or fab-lite and forming joint ventures with other semiconductor companies. This is bad news for buyers because it means fewer sources of supply and fewer suppliers investing in new capacity.

Some large semiconductor companies like Samsung and Intel will continue to invest, but foundries will also have to invest if capacity is to be increased. But, foundries are accounting for more of the manufacturing in the industry, says Matas. They have cut capital expenditures because with low chip prices last year they saw their revenue per wafer drop from an average of $900 to $700. They now want to reverse that trend, he says.

Matas says the growth of chip capacity will be in the hands of fewer IC suppliers.

“Only the biggest companies and those with the deepest pockets will be able to afford new facilities,” he says. Such companies include Samsung, Hynix, Intel and TSMC.

“So rather than 20 different companies investing, you have only a few companies that are willing to expand. You won't see a big flood of capacity being added,” says Matas. With demand increasing at a faster rate than capacity being added, prices for many parts will rise. Prices for DRAM, microcontrollers and digital signal processors and application specific standard products will likely rise as capacity is constrained.

However, price increases will be relatively short lived because pricing in the industry is cyclical. Large OEM and electronics manufacturing services (EMS) providers will leverage their huge purchasing volumes. To keep or grow business with key customers, suppliers will have to reduce prices.

“Cost reduction is an important part of maintaining business with Sun,” says Landon. He says when Sun introduces a product, customers expect that product to be price competitive and for the price to come down over time. “So we depend on continuous cost reduction from our suppliers,” says Landon.