Economic Disruption of the Electronics Industry and its Impact on Data I/o

The Economic Environment

Over the past year we have witnessed an economic catastrophe on a grand scale. The collapse in housing triggered by sub-prime lending and the subsequent credit crisis slowed consumer spending, the fuel for the economy’s engine. The index of economic indicators is now at the lowest level since 2001. Industrial activity seems to be pointing to the first double-digit decline since 1970. The Institute for Supply Management’s index fell to 36.2 the lowest level in 26 years. The big-three automakers in the US are on the verge of bankruptcy. Unemployment stands at a 16-year high in the US. We learned this week that the economy officially entered a recession in December of 2007. Some experts suggest that we will experience the most severe four-quarter downturn in GDP since WWII.

The tremors that started in the US have spread to nearly all economies in the developed world. Credit has impacted world shipping. Home equity values are falling rapidly in the UK with the largest year over year decline on record. Manufacturing activity in the Euro-Zone is falling. Unemployment is climbing in Europe and even in Asia. CEOs of privately held firms in China “go missing” as orders dry up and firms close their doors. Authorities fear a time of civil unrest as 1 in 5 migrant workers lose their job. South Korea’s exports fell last month by the most in 7 years. There seem to be no bright spots.

Recession and the Global Electronics Industry

Forty years ago, John Fluke used to say that the electronics industry was recession-proof. Now, electronics has been so woven into the fabric of nearly every industry that it’s hard to imagine the electronics industry could sail through an economic storm unscathed. Despite some early warning signs, the electronics industry held up quite well until September, but since then the bad news has been coming at an accelerating pace. Analysts began to lower their forecasts for the fourth quarter and 2009; then they lowered them again and in some cases again as industry bellwethers such as Intel lowered their guidance both for the fourth quarter and for 2009. Intel’s CEO recently described this recession as the worst in his lifetime. In the past few weeks, CEOs have used descriptive language such as, “we see skid marks in all geographies” to describe the sudden and dramatic downturn in their business. As shown in the figure below, it has only been very recently that the $1.8T global electronics industry has reached the lofty level of 2000 before the last major recession. The question now is how far down will it go this time?

Source: Henderson Ventures

The finished-equipment sectors of this industry are all showing signs of stress. Heads of Information Technology departments project that spending for computers and business systems going forward to be lower than any time since 2001. Only ten percent expect to increase IT spending above current levels. Server sales fell 5.4% in October. Computer manufacturers such as Dell and Sun that are heavily dependent on business spending are suffering. Companies that provide networking and communication infrastructure are also reporting declining sales with the industry bellwether Cisco forecasting revenue that is down 10% from a year ago.

The third major sector of the industry, consumer electronics is also reporting declining sales. This week we learned that while Black Friday sales were up modestly, the electronics portion of those sales was down 14% year over year. Sales of TVs are also trending downward despite the mandated shift to digital television early next year. Even sales of the ubiquitous cell phone are declining and 2009 is now expected to be the first down year since 2001. Yesterday, LG and Samsung cut their wireless handset projections for 2009 by 12 and 8 percent respectively.

Of the three smaller sectors of the industry, only medical electronics (just 5% of the global electronics industry) is expected to report meaningful growth. The Aerospace and Defense sector is expected to be pulled down by transportation with Boeing recently reporting the lowest level of orders in three years.

Automotive electronics, a very bright spot over the past couple of years (particularly for DAIO) won’t escape from the declining fortunes of their customers like the big-three teetering on the edge of bankruptcy. This week Japanese automobile manufacturers reported that they are seeing the largest drop in their business in 34 years while Ford, GM, and Chrysler all reported sales drops greater than 30%.

The Impact on the Electronics Industry Supply Chain

The electronics supply chain shown in the figure below has become much more efficient than it was before the 2001 downturn. With the markets for finished electronics products (the right-most block in the figure) shrinking rapidly, a down wave (both broad and extremely deep) is traveling back upstream through the supply chain at tsunami speed.

Responding to much lower forecasts from their finished equipment customers, the EMS firms such as Foxconn (Hon-Hai Precision) and Flextronics are slashing production of sub-systems and announcing plant closures and major layoffs sometimes for the second or third time in as many months.

Vishay, a leading manufacturer of passive components reported on November 12th that, “Overall, the last quarter for Vishay and the entire industry has been difficult. Sales and profits have remained lower than expected. The low order intake in October points to a further economic slowdown. . . . orders from global distributors are decreasing rapidly.”

Yesterday, Advanced Semiconductor Engineering (ASX) the largest supplier of IC assembly and test services announced that they expected their Q4 business to be down 25-28%. Today Siliconware Precision (SPIL) a competitor followed suit and cut its fourth quarter outlook.

Looking further upstream, we find that semiconductor sales in the US were down 22% in October from the same month of 2007; sales in Europe were down 13%. November is likely to continue the trend downward so semiconductor manufacturers are slashing capital spending as well as employment particularly in the hardest-hit memory segment where DRAM spot prices are at the lowest levels in history and trading at roughly the packaging and test cost. TSMC the leading semiconductor manufacturer in Taiwan announced today that all employees would be required to take 4 days of unpaid leave each month.

Demand for Electronics Capital Equipment Plummets

The contraction in the supply chain has resulted in a sharp rollback in spending plans for the capital equipment that provides the industry’s infrastructure as shown in relation to the electronics supply chain in the figure below.

The majority of the $55B is spent on expensive process equipment used in the production of semiconductor devices. The remainder is spent on equipment used in circuit board production and assembly including test and programming [equipment manufactured by DAIO]. As noted by Walter Custer, an industry expert, demand for capital equipment is “whipsawed” by the economy particularly in a downturn. When the electronics industry supply chain is operating substantially below capacity, spending for capital equipment slows to a trickle.

This pattern is reflected in SEMI’s forecast for semiconductor capital equipment spending released this morning that shows a 28% decline in 2008 compared with 2007, and another 21% decline from 2008 levels in 2009. This will put capital equipment at 64% of 2007 levels. (Some forecasters are even more pessimistic and believe the number could fall below $25B in 2009. Ugh!)

What Does This Mean for Data I/O?

Data I/O is not immune to the economic influenza impacting the electronics industry. At the same time, the company is positioned to succeed in this environment. The company has a base of recurring revenue that remains even in a downturn. Our newer products provide much more than mere capacity. They are solutions to our customers’ business problems and therefore reduce operating costs and improve quality. This has led to established relationships with well-known customers that have sound business models and substantial cash on their balance sheets. We are working hard to become indispensable to many of these.

During the past two years, the company has strengthened its balance sheet while reducing its ongoing expense to allow it to survive and prosper whether the downturn lasts for six months or for years. We have transferred activities to our lower cost base of operations in China. As the company is sized appropriately for the business at hand, all managers including the CEO become very tightly connected to operations and we are able to act and respond swiftly as conditions warrant. It is important to note that none of our development capabilities were affected in this latest reduction, and the ongoing efforts in this area will lead to the stream of new products mentioned above.

We have strong sales management teams in place in Europe, Asia, and the Americas. We are continuing to add representatives and distributors to provide additional sales coverage in regions where we haven’t had a sales presence and we are doing it with a variable cost model so we don’t add fixed expense. We are replacing existing sales channels where the existing ones have shown to be ineffective. We are taking action to improve our sales effectiveness throughout the downturn and gain market share.

The Impact of the Downturn on Industry Share Prices

It is not surprising in this environment that share prices of electronics companies have been hammered. The Russell 2000 index is down 40% just since October 1st. RF Micro-Devices with $1B in revenue (solid Nokia is its largest customer) was trading recently at 98¢, down nearly 85% from the $6 share price one year ago. Nokia itself has lost two-thirds of its share price in the past few weeks. RIM that was as recently as July trading at $147 was trading below $40 this morning. Teradyne was recently trading at a low of $2.97 compared to a high last June of $14. Even Intel, another industry bellwether, was trading at $12 down from $28 a year ago. So, it’s not surprising, albeit disappointing, to see our own share price fall from the $6 range earlier this year to under $2 recently.

One of our leading investors commented to me during my trip to New York last month that in this market environment share prices are being driven more by investor liquidity issues rather than intrinsic value. For several months now, the market for equities has been overwhelmed by fear. This will subside over time and the market is likely to turn up before we see an improvement in the electronics industry fundamentals. We have been fortunate to see a number of strategic investors pick up our shares at these depressed prices.

We all look forward to better times. Meanwhile we are taking actions to help us do well during the downturn and be prepared for the upturn which will come.  

Sincerely,

Fred Hume

President and CEO of Data I/O Corporation