As a recent participant in semiconductor consolidation, I think I can safely say that there is going to be a lot more. There are too many chip companies out there chasing too little growth.
The industry still views itself as a growth industry, but really it is big and cyclical, and resembles the steel industry as much as anything else. The growth days are behind most companies, the future is going to be managing cycles and costs. Albeit with the very real risk of facing oblivion if they miss a product cycle. This is going to require a big change in thinking for many management teams.
In many categories, this consolidation has already taken place. There are only four memory companies left. PC CPUs have been what could generously be called a duopoly for over a decade. Mobile basebands – there are really only three vendors left. I think we could still see a lot of growth in semiconductor content in cars. And there is that whole Internet of Things (IoT) . But in autos, there is not likely going to be much disruption to market share for most pieces of semis, the big guys will get much of the share. And as I noted last week, IoT is not guaranteed to bring the riches that many in the industry hope for. Beyond that, what is there? ARM servers? Maybe, but that will also likely bring about a massive deflation in pricing. If it ever happens. Custom silicon for networking? Facebook, Amazon and Google all seem to be designing their own chips, but it is hard to see how big a market that will ultimately be beyond a few web giants, and works against most of the established chip houses.
Now to be clear, I am not forecasting a doom and gloom scenario. Chip companies will still grow, just at a much slower pace than over the past 20 years.
When industries make this kind of transition, strategies change. The power center moves from R&D and sales, to the finance team. Winning market share is less about having the great new technology and more about scale. This leads to M&A as the only way to gain share and bulk up. This is especially true in semiconductors. There are very real cost advantages available to the companies who put in the bigger orders. While few companies have their own fabs or manufacturing lines, the foundry partners tend to give the best service and best pricing to the larger customers. And for those companies that still own their fabs, volume is life.
This leads to the question of who gets consolidated next. Most investors would agree that there are still far too many analog chip companies out there, something like 150 depending on how you count them. These are companies that make decidedly unglamorous products – interfaces, microcontollers, timers, the list goes on. This is big business, but competition is less about technology and more about pricing and distribution.
Despite pullbacks this year, many semiconductor stocks are trading at healthy prices and multiples. My sense is that these will not last, so the time to strike is coming soon, while capital is still ‘cheap’.
I am not going to name specific names here, maybe some other day. However, a few things to look out for. First, companies that know how to integrate acquisitions should do well. Much of the value in a chip company is the talent of its engineering team, and other intangibles. Very few mid-size chip companies have this integration expertise, as very few have done many deals. But having a integration plan in place before the deal closes matters. Let employees of the new company know where they stand right away, even better leave them mostly alone. Most important – communicate clearly as early as possible.
Second, operations will matter tremendously. By operations, I am really referring to general management skills. Well-run companies will prosper. It will not be enough to simply throw engineering resources at a few key customers. The companies that can best balance having the right portfolio of products against a reasonably sized engineering team should do well. Capital allocation will matter.
Offsetting this, companies are going to need to make some big bets, soon. There a half dozen mega cap chip companies out there, but below that there are dozens of companies that risk being swallowed up. Once upon a time, having an $8 billion market cap for a semis company made you untouchable, even a $25 billion market cap. But today even those companies are potential targets. Management teams who want to remain in business ten years from now will have to bulk up quickly. Smartly, but quickly.
None of this is lost on the industry, and my guess is that many potential targets have high expectations for takeover values, which means potential acquirers will need to pay up. Of course, this creates a dilemma. The best acquirers will be the most capital-disciplined companies, but they may not be willing to pay top dollar in an auction.
I am not clear how this will play out. I know a few companies whose stock I would like to buy, because they are good at what they do. But in the back of my head, I am worried that they will have to start paying dilutive prices for good acquisitions to survive.
Good times to be an M&A banker, tougher times for stock pickers.