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Special Report: Gilder Telecosm 2005 Presentation
Editor, Paul McWilliams
Published September 28, 2005

The following is a superset of Paul’s presentation at the 9th annual Forbes/Gilder Telecosm conference.

Semiconductor Cycles – Past, Present and Future
• • • What Drives Semiconductor Cycles and What is Changing Why the Data You Normally Read About Semiconductor Sales May be Misleading Your Thinking Why Some Semiconductor Sectors Move Independently of the Broad Cycle o o • Recent Changes in Supply Dynamics Recent Changes in Demand Dynamics

Why a Slower Rate of Growth is Not Necessarily Bad News for Investors

Willie Sutton said the reason he robbed banks was because that’s where all the money was. In the world of semiconductors, the money is in integrated circuits or, as they are frequently called, ICs. However, the aggregate data we read in press releases and most analyst reports combines IC revenue and unit volume data with the results for opto-electronics, sensors, actuators, and discrete semiconductors such as transistors and diodes. Let’s take a quick look at why this can cause investors to jump to erroneous conclusions.

2004 Semiconductor Product Breakout
Product Integrated Circuits Discrete Semiconductors Opto-electronics Sensors and Actuators Total for non-IC Problems: • • • Minor changes in the unit volume for non-IC products can mask significant changes related to IC unit volume. There are many Asian discrete and opto-electronic manufacturers that don’t report data to the WSTS. This means the data must be estimated. Emerging Asian semiconductor companies have a tendency to feed off the bottom of the semiconductor food chain. This means that non-reporting Asian companies will continue to increase their share of the high-volume, low-cost discrete semiconductors market. Percent of Revenue 84% 7% 6% 2% 16% Percent of Unit Volume 24% 66% 9% 1% 76%

Note: Data is based on actual 2004 results as reported by the WSTS (World Semiconductor Trade Statistics).

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Due to these points, we’re going to focus our attention on only ICs today. The IC Business Model: The IC business model is one of very high fixed costs and relatively low variable costs. Therefore, when there is an unfavorable balance between supply and demand, competitors drop prices in an effort to keep capacity utilization high enough to where they aren’t swamped by fixed costs. This frequently leads to a cyclical decline in revenue and, for some, red ink. You can read more about the dynamics of this situation in my detailed report covering semiconductor cycles that can be downloaded from the Next Inning website. Unfavorable balances between supply and demand are caused by one of two things: 1. A decline in demand 2. An increase in supply that is not matched by an increase in demand

In the most general sense, when the blue revenue line moves from below to significantly above the green volume line, it implies there was a shortage of fabrication capacity and a semiconductor upcycle. When it moves from above to significantly below the green volume line, it implies there was too much capacity and a semiconductor down-cycle. In most cases, these down-cycles were caused by capacity expanding faster than demand rather than by a decline in demand. However, in the most recent down-cycle, the one most of us remember all too well, this was not the case.

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Since the invention of the IC, the only significant year-over-year decline in demand was in 2001 when unit volume dropped by 21% and revenue dropped by 33%. There have been many stories written about the 2001 semiconductor recession that blame it mostly on a glut of capacity. However, this is not a good way to view what actually happened. From the peak of demand in Q3 2000 to the trough of capacity utilization in Q3 2001, capacity increased by only 8%, but wafer starts (demand) decreased by 28%. Therefore, the correct way to view the 2001 semiconductor recession is that it was mostly driven by a drop in demand. Since a significant drop in demand is an unusual occurrence, I’m going to set 2001 aside for now and deal with what has caused every other semiconductor cycle - increases in capacity and demand getting out of sync. As we look at this chart, we can see there were three points when the rate of year-over-year change in unit volume, what we term as demand, dropped to or very close to zero.

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The first of these was in 1992 when volume was exactly the same as it was the previous year. Interestingly, this is the only time unit volume held relatively flat and revenue went up. Three events drove this: the introduction of the 80486 in late 1989, a flurry of military spending, and minimal increases in capacity. The combination of these three events led to higher average selling prices.

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Following this unusual situation, the IC sector enjoyed the best three-year run in its history. Between 1993 and 1995, total IC revenue increased by 152%. This increase was driven by the convergence of three events: • • • Japanese companies slowed capacity expansion from 1990 through 1994. This ended up creating a severe shortage of DRAM capacity and a more moderate shortage of total capacity. Intel (INTC) released the Pentium microprocessor. Capital spending by U.S. companies on computers and peripherals grew 59% from December 1992 to December 1995.

However, as is often the case, what was really happening can’t be seen when you look at only aggregate numbers. Let’s peel the onion back a layer and take a look at the guts of this situation, so we can understand how it set up a critical tipping point we’ll cover in a minute.

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This chart displays the year-over-year percentage changes in revenue for three different product groups of ICs. The highly volatile red line is DRAMs, the considerably less volatile green line is all ICs, and the even less volatile blue line is all ICs other than DRAMs.

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Remember, I said total IC revenue increased by 152% during the three-year period that started in 1993. However, when we look at the details, we can see this was driven by a 379% increase in DRAM revenue and, if we take DRAM out of the equation, the balance of the IC sector grew only 107%. One of several things that is important to understand about this is that much of the DRAM growth was caused by average resale prices going up from $5.42 in 1992 to $19.20 in December 1995. However, as they say, what goes up must come down. Well, maybe this isn’t always true, but DRAM prices certainly followed this rule.

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The thing that very few people realize is that there was not a broad IC recession in 1996. In 1996, aggregate IC revenue outside the DRAM sector grew by 9%, while DRAM revenue fell by 39%. What we did have in 1996 was a major DRAM recession that was driven by excess capacity. As Japanese and Korean capacity came on line starting in 1996, DRAM prices fell with a vengeance, finally bottoming in July 1998 at $3.23.

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The broad supply glut that began with DRAMs in 1996 spread to other product areas by 1998. By Q3 1998, capacity utilization dropped to 81% from a very comfortable 93% a year earlier. This glut of supply converged with flat demand and resulted in the semiconductor recession of 1998.

Bottom Line:
• There were two broad IC recessions during the last 15 years o There was not a broad IC recession in 1995 – only DRAM revenue declined and revenue for all other IC types increased o The 1998 recession was driven mostly by excess supply o The 2001 recession was driven mostly by a decline in volume During any given year, it’s not uncommon for at least one or two types of ICs to move independently from the broad semiconductor cycle

Now that we understand past cycles better, let’s peel the onion back one more layer and evaluate changes in supply and demand dynamics

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Changes in the Supply Side of the Semiconductor Industry
I’m not going to say we’ll never see another situation like we did with DRAMs in the mid-1990s; as a matter of fact, I’ll be somewhat surprised if a similar situation doesn’t pop back up in the memory sector some day. However, there have been fundamental changes that I believe significantly reduce the risks of supply side issues weighing as heavily on the broad IC market today as they have in the past. Contract Fabricators Act as a Buffer to Business Cycles Q4 2004 Contract Fabs Semi Companies Total Utilization 81% 87% 86% Q1 2005 75% 87% 85% Q2 2005 83% 90% 89%

Contract fabricators are acting as a buffer for semiconductor companies running a “Fab Light” business model. This is a model where semiconductor companies split up their fabrication requirements between internal fabs and external contract fabs. This allows smart companies to maintain reasonable levels of utilization as demand fluctuates and, thereby, not be forced to sell at a loss just to avoid being swamped by fixed costs. The advent of contract fabricators has also reduced the need for many semiconductor companies to expand capacity as aggressively as they have in the past. This means depreciation costs, which are mostly the fixed costs of building fabs, are declining at most semiconductor companies. These lower fixed costs lessen the need to reduce prices in an effort to keep internal capacity up during downcycles. Even Texas Instruments (TXN), which executes a fab-light model, will see annual depreciation drop below $100M in 2005 for the first time in many years. Other Supply Side Changes that Will Moderate Supply Driven Cycles • • Supply channels have matured. The result is shorter and more efficient supply channels. Inventory has been pushed back in the supply channel to die bank. This allows for more efficient fabrication cycles and keeps lead times short without incurring the full investment of finished goods. Semiconductor companies have matured as businesses and, through this, they have learned to control operating costs.

Through Fab Light operating models, more efficient supply channels, and a variety of other improvements, the better-managed semiconductor companies are growing operating profits faster than they are growing revenue.

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With only one exception, all the leading analog / mixed signal companies grew operating margin more than sales during Q2 2005 Sequential Revenue Change Cal. Q2 +8.6% +4.0% +2.0% -3.5% +0.0% Sequential Operating Profit Change Cal. Q2 +27.6% +15.6% +2.9% +0.5% -0.2%

ISIL NSM LLTC ADI MXIM

Note: Operating profits are pro forma

While these changes are all good and important, particularly when it comes to selecting investments, the really big change that will drive the markets in the future is what finally resulted from the tipping point I mentioned earlier. Sometime during the early 1980s, following the release of the DOS PC and a wide variety of productivity software, capital spending by businesses overtook military spending as the primary driver for semiconductor sales. CapEx spending was certainly less volatile than military spending, but still subject to some pretty wild swings.

This chart shows the near perfect correlation between CapEx for IT equipment and IC revenue. However, what it doesn’t show is the effect of the tipping point that started in 1995. This was masked by a 74% increase in IT CapEx during the five years leading up to 2000. It took a decline in CapEx and the convergence of a few more events for the tipping point to elevate the consumer as the top user of semiconductors.

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Let’s take a look at the converging events that spurred the consumer into action and the evidence that supports the contention that consumer spending became the number one driver for semiconductor sales in 2002. The Convergence of 1995 • • • • • Windows95 Pentium Pro 1995 Web Browsers 1995 DRAM prices drop 83% from 1995 to 1998 Gen-X spending became an important factor

The convergence of these events in 1995 led to a flood of consumer computing that pushed Internet usage from roughly 10M in 1995 to over 100M by the end of 1997. This easy user interface of the web and Windows95 indoctrinated tens of millions of consumers and gave them a reason to overcome their fear of tech. However, this was just the start, it would take a few more years for us to put together the rest of the ingredients we needed to entice enough consumer spending to push CapEx back to second place.

In this chart, you can clearly see where the consumer finally took the lead in 2002. In 2002, CapEx declined for the second straight year, yet due to the many consumer devices that hit the market during the previous 12 months, IC revenue grew. This increase in sales was driven by millions of digital cameras, cell phones, DVD players, flat screen TVs. and, of course, the Apple (AAPL) iPod.

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The convergence of 2001 • • • • • • DSP prices dropped by 50% from 1995 to 2001 The average selling price for a PC microprocessor dropped below $100 for the first time in history Digital camera technology became affordable and the web allowed instant picture sharing Low-cost NAND Flash memory Gen-Y joined Gen-X in the market The iPod became a fashion symbol>

In 2002, Geek emerged as chic. However, this isn’t just a story about fashion or even time and place. This is a story about economics – the economics that Carver Mead named after the immortal words of Gordon Moore, which is known today simply as Moore’s Law. Moore’s Law not only drove the average selling prices for DSPs and microprocessors down to new record-low levels, it facilitated the introduction of low-cost / high-resolution image sensors and allowed manufacturers to rapidly reduce the cost for what I like to call the “consumer memory device” – NAND Flash.

Remember when I told you there is usually at least one semiconductor product type that doesn’t follow the trend of the aggregate market? Well, this was even the case in 2001, the worst downcycle in the history of semiconductors. While total IC revenues declined by 33% in 2001 and revenue for the leading memory technology, DRAMs, fell more than 60%, NAND Flash memory revenue increased by 138%. In total, NAND Flash revenue grew from $370M in 2000 to what I believe will top $10B in 2005.
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Now, before you all rush out to buy stock in a NAND Flash memory supplier, please take the time to read our Flash memory primer and our special report, “The Intersection of Vision and Value.” There’s much more to winning at this game than just finding rapid growth.

Semiconductor cycles should be less volatile going forward
• The level of influence consumers exert on IC demand is now significant and will grow stronger in the future. Since consumer spending is less cyclical than CapEx, this change should buffer the volatility of demand cycles. Contract fabricators and better business practices will likely buffer the effects of unfavorable balances in supply and demand

Due to these points, we believe the volatility and frequency of semiconductor cycles will lessen in the future. Let’s quickly recap what Andy Kessler would term, “How we got here.”

The Elasticity of the Transistor
Year 1971 1981 1995 2005 Transistors per Buck 1 100 25,000 1,000,000

At our first tipping point, which started in 1981 and led to CapEx surpassing military spending as the number one market for semiconductors, transistors sold for around a penny each. By the time we hit the second tipping point in 1995, average transistor pricing was about 25,000 per dollar. And today, only three years after when the consumer was crowned king, we’ve finally hit the magical point where the average price of a transistor is a million per buck. Today, transistors are so cheap to produce that there will be enough built in 2005 to sell 35M to every man, woman, and child on earth, but that will only take about one square mile of silicon wafers. As consumer demand increases and Moore’s Law marches forward, this number will probably double within a couple of years. However, this certainly doesn’t mean revenue will double. Revenue won’t double because by 2007, transistors will be selling for much less than they are today. This is why pundits are quick to remind us that even though transistors will permeate our lives in ways we can’t even imagine today, the revenue growth rate for semiconductors has slowed and will likely continue to slow going forward.

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While this certainly means it will be harder for investors to make money in the semiconductor market, it doesn’t mean there won’t be wonderful opportunities. When the IC was invented nearly 50 years ago, individual transistors often sold for $50 to $100. Today, the average cost of all the transistors sold is about one ten thousandths of a cent. As we move forward, transistors will continue to get cheaper, faster, and consume less power. This will continue to open doors as designers leverage the cheap and abundant to develop new technologies and creative human interfaces. While the aggregate growth rate will slow, the time it takes to grow the next $100B will continue to shorten. It took 40 years for IC sales to reach the first $100B. The next $100B will take only about 12 years, and the one following that might only take 6 years. Within each of these $100B steps, there are enormous opportunities for the investors who find the “Intersection of Vision and Value.”

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