By Len Jelinek, iSuppli Corp. EETimes Supply Network (03/19/2007 12:52 PM EST)

Semiconductor foundries in early 2007 are facing their second consecutive quarter of falling manufacturing utilization rates and significant declines in sales.

The first quarter of 2007 is expected to deliver a more-than-seasonal decline in revenue, with no real recovery in fab utilization rates. This discouraging turn of events has left foundries to wonder what went wrong, how long the bad times will last and whether this snafu will recur.

The inventory effect

Most pundits would like foundries to believe that the answer to what went wrong can be summed up with one word: inventory. However, the real cause of the rapid decline in factory utilization and sales can be traced to issues that had been building up during the past two years.

The inventory increases actually resulted from the industry's misreading of true levels of supply and demand and the unwillingness of companies to take proactive steps to deal with the situation, rather than simply reacting to it. Inventory was only the effect--and not the cause--iSuppli believes.

From shortages to gluts

But how did the semiconductor industry transition into an oversupply situation in the fourth quarter of 2006 so quickly after it had reported shortages in the first quarter of the year? The answer to that question is much more complex.

Total semiconductor capital spending as a percentage of global semiconductor revenue reveals that the industry shifted from oversupply in 2004 to a more balanced position in 2005. However, starting in the second half of 2005, when chip manufacturing capital spending as a percentage of revenue exceeded 22 percent, the industry returned to a state of oversupply.

Shortages identified during most of the first quarter of 2006 were not caused by front-end foundry production, but rather by a lack of back-end semiconductor packaging and test capacity. These constraints were resolved by the middle of the second quarter of 2006. However, companies in the electronic supply chain misread the situation and incorrectly concluded that the front- end semiconductor manufacturers, including foundries, did not have sufficient capacity to meet market demand for 2006.

The complicating factor was that as companies devoted more production resources to transition to next-generation process technology, capacity was made available that could be used to support production at mature nodes. The industry lost sight of this newly freed-up capacity. When demand increased, there was a substantial amount of capacity already available that previously had not been used.

Since these signals were missed, companies aggressively spent capital for capacity that simply was not needed. Capital spending as a percentage of the total industry revenue immediately reversed its downward trend in 2006. This caused the industry to transition back to an overcapacity position.

Fortunately, by reducing factory manufacturing rates starting in the fourth quarter of 2006, the semiconductor industry has taken the appropriate and difficult actions that will consume products manufactured in the second half of 2006, cutting excess inventory levels and paving the way for a recovery this year. iSuppli predicts global semiconductor revenue will rise by 10.6 percent in 2007, compared to 9 percent in 2006.

-------------- Len Jelinek is a director and principal analyst for semiconductor manufacturing with the market-research firm iSuppli Corp. (El Segundo, Calif.)