Credit quality stable among Asian high-tech firms though conditions tighten

Rating agency discusses the credit quality of Asia''s high-tech sector.

Despite swiftly evolving technologies and tumbling prices, Asia's high technology leaders maintain generally sound credit quality. But pricing pressures and intense competition have hastened consolidation among smaller players, even in markets that have not yet matured, and the sector as a whole will likely see more mergers in the longer term as conditions tighten and China joins the fray.

High-tech industries suffer from significant business risk due to the short lifespan of their technologies, cyclical demand, and - for many suppliers - large capital expenditure requirements. Fiscal 2003 marked a turnaround year for some high-tech markets, such as semiconductor chips, while price pressures have become intense for liquid crystal displays (LCDs). Still, lingering doubts about future demand trends persist for many technology sectors, and margin pressures threaten to eliminate the weaker, less-capitalized players.

In personal electronics, many advanced technologies are hitting the market at once, perhaps too fast for consumers to absorb. The result is falling prices for products that require large R&D and capital expenditure to produce efficiently. Even so, chip and flat-panel makers are forging ahead, building new plants and expanding into China, aiming to maintain market share.

Standard & Poor's technology analysts covering Asia recently commented on the dominant trends they see affecting the region and its important tech markets.

Semiconductor Sales Trends

Despite efforts by market players to insulate themselves from demand volatility, the semiconductor industry remains quite cyclical. Revenue growth rates were nearly 30% in 2004, although growth flattened in mid-year and sales declined coming into 2005. Early indications are that the business cycle has begun to recover, judging by recent favorable mid-quarter earnings guidance from Intel Corp. (A+/Stable/A-1+), Texas Instruments Inc. (A/Stable/A-1), LSI Logic Corp. (BB-/Negative/--) and others. Still, Standard & Poor's believes that sales will actually decline moderately by about 5% in 2005, due to softer demand and excess inventories, and that chip sales growth will settle at around 8%-10% per year in the long term as the industry matures.

Additionally, conditions will vary across the industry. The memory sector, for example, will face some pricing pressure, as indicated by recent reports from Samsung Electronics Co. Ltd. (A-/Stable/A-2) and Hynix Semiconductor Inc. (B-/Stable/--).

Demand conditions for semiconductors are rapidly changing, and consumer electronics applications will become increasingly important sales drivers. Total semiconductor revenues for consumer electronics surpassed industrial and corporate applications revenues for the first time in 2004. As the PC industry matures, chip and memory sales growth will depend more and more on demand for third-generation cellular handsets, music players, home and personal wireless networks, advanced televisions, digital still and video cameras, and other advanced consumer electronics.

Another possible growth driver will be automotive applications. Onboard navigation, emergency service, and entertainment systems are becoming increasingly common in autos, and will likely become standard for most cars in the coming years. Hybrid auto engines, which have quickly gained popularity amidst rising fuel prices, require specialized memory and processing chips, and should provide a fertile market.

As with many industries, China is fast becoming a key strategic region for both production and sales growth. Major semiconductor producers are setting up facilities in China primarily to serve that market, but in the longer term, Chinese firms will likely begin exporting chips to the global market, which could have profound supply and demand effects.

Chip Foundries

Since 2003, semiconductor foundries experienced a seven-quarter recovery that reached its peak in the third quarter of last year, when sales began to sag. Chipmakers are now bogged down with excess inventory, which should be divested by the second or third quarter of this year, and hopes remain that sales growth may resume in 2006. In general, foundries should have a better growth rate than the overall semiconductor industry, as the cost of new factories becomes increasingly uneconomical, particularly for mid-scale companies that had previously been vertically integrated.

With sales down from last year's peaks and margin pressures mounting, a number of chip manufacturers are looking for ways to trim their capital expenditure costs. Chip fabrication facilities are becoming increasingly expensive, and the efficiencies they offer do not always balance their cost. Only the largest companies can benefit from large-diameter 300mm wafer production, including Intel, Samsung Electronics, Taiwan Semiconductor Manufacturing Co. (TSMC), and United Microelectronics Corp. (UMC, BBB+/Stable/--). There has been some discussion of setting up semiconductor consortiums as an alternative to foundry models, whereby several firms would share manufacturing facilities and capital expenditure, but these considerations are still preliminary.

In general, Asian semiconductor foundries have better prospects than some of their global peers due to their newer facilities and frequently favorable cost structures. But among them, credit qualities are now starting to diverge, with Taiwan's TSMC as the strongest. TSMC has been best able to defend its position in rough markets because of its leading market position, strong technological abilities, and diverse customer profile. Taiwan's UMC and Singapore's Chartered Semiconductor Manufacturing Ltd. (BBB-/Stable/--) are the next tier down.

Chartered Semiconductor has been aggressively trying to catch up with TSMC in technology and capacity, but its customer base is not large enough to maintain good return on investment. The company recently struck a business alliance with IBM, which should help the chipmaker in its efforts to catch up to industry leaders. The deal will bolster Chartered Semiconductor's brand name and technological base, while allowing it to share R&D and capital expenditures with IBM.

Chinese firm Semiconductor Manufacturing International Corp. (SMIC) recently overtook Chartered Semiconductor to become the third largest chip foundry in the world. Although there are other chipmakers in China, SMIC is the largest and has received the most attention; the company recently had a public offering in Hong Kong and U.S., allowing it better access to global equity markets. Its aggressive capacity expansion and pricing strategies will to have a significant impact on chip supply coming out of Asia.

TFT-LCD Displays

The display market has already begun to consolidate, despite the fact that it is still relatively young and growing. This reflects the extreme margin pressures in the consumer electronics industry. The display market has above-average business risk because of its largely commodity nature and high capital expenditure requirements, which are only partly mitigated by the industry's good growth prospects.

Taiwan and Korea have become the global market leaders for TFT-LCD displays, used primarily for flat panel monitors and notebook PCs. Japanese manufacturers, which still hold many patents on the technology, have become more conservative, choosing to focus on low-volume, customized TFT panels.

The industry rebounded from the first quarter 2003, but underwent a roller coaster year in 2004. LCD prices reached a peak in the second quarter of 2004, but then fell off dramatically. All five Taiwanese makers recorded net losses in the last quarter of 2004, a stark contrast to their mid-year results.

Fifth to seventh generation plants are crucial to capture economies of scale in the industry, but capital expenditure costs are high. These pressures will likely lead to consolidation amongst the Taiwanese makers in the mid to longer term.

Samsung Electronics and LG.Philips LCD, a joint venture of LG Electronics Inc. (BBB-/Stable/--) and Koninklijke Philips Electronics N.V. (BBB+/Stable/A-2), are the major Korean players in the TFT industry, and both benefit from stronger brand names and financial resources than makers in Taiwan. Consolidation is likely among the smaller players, as they will find it increasingly difficult to compete with the economies of scale enjoyed by Samsung Electronics and LG.Philips.

Although margins have fallen dramatically and demand growth remains in doubt, the large Korean TFT makers have shown a strong commitment to the technology. For example, LG.Philips is slated to make capital investments of over Korean won (W) 5 trillion in TFT technology over the next two years.

DRAM Manufacturers

Dynamic Random-Access Memory (DRAM) makers had a good year in 2004 because of a beneficial pricing environment. Along with slowing growth in PC sales, 2005 will likely feature a mild downturn. As a market leader, Samsung Electronics should demonstrate higher resilience to the weaker market, backed by its broad business base and ample liquidity.

Hynix Semiconductor Inc. is continuing to restructure itself into a pure memory player. The company is planning significant capital expenditure of about W2 trillion this year, meaning it will not be able to improve its balance sheet or liquidity position, and it will remain vulnerable to a cyclical downturn. Hynix will have a critical need for more cash with about W1.6 trillion of restructured debt maturing in 2006 as well as its plan to invest in China that year.

[The article is an abstract from RatingsDirect, Standard & Poor's Web-based credit research and analysis system (www.ratingsdirect.com).]