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Semiconductor shuffle

Venture capitalists coming off the telecom and networking highs of yore are seeing new growth opportunities for the semiconductor industry in rapidly expanding consumer technology segments, particularly in Asia.

Although growth in the semiconductor industry is expected to be rather flat in 2005, some venture capitalists are looking beyond the traditional telecommunications and networking end-markets that semiconductor start-ups have traditionally catered to in the past. Instead, many VC firms are now placing their bets on companies developing technology for consumer products including wireless handsets, home entertainment devices and PCs – companies that are finding burgeoning customer bases in Asian markets.

Beyond demographics, a very good understanding of the Asian supply chain will be critical in order for venture capitalists to be successful in semiconductor investing.

Brian Antonen, Celtic House

Of course, it wasn’t that long ago that prospects for the whole of the semiconductor industry were in the dumps. The tech collapse of 2001 maimed the telecommunications and networking segment, a major market that microchip companies had up until that time been busily selling into. According to global semiconductor company Freescale Semiconductor, world semiconductor growth fell 32 percent in 2001.

Then came a revival over the last two years as demand for flash memory-based units outpaced supply. The global semiconductor market grew almost 20 percent in 2003, and growth rates for 2004 are being tabulated at anywhere between 23 percent 32 percent by various market sources.

Now, as 2005 wears on, semiconductor expansion isn’t expected to surpass 10 percent, in part due to a lack of new products on the market. But less-than-stellar forecasts haven’t stopped limited partners from entrusting their money to firms with semiconductor specialties. In March, Menlo Park-based technology investor El Dorado Ventures closed its seventh fund on $200 million (€152 million). General partner Tom Peterson says slow growth is viewed as part of the cyclical nature of semiconductors and that his firm sees lots of interesting opportunities in the long-run, particularly in wireless convergence and in the consumer end-markets.

Also in March, Canadian venture firm Celtic House closed an oversubscribed third fund on C$280 million ($225 million; €173 million). According t+o Celtic House partner Brian Antonen, part of his firm’s success in Fund II is that it shifted its investment theme for semiconductors away from expensive and complex telecom and networking chips, as was the trend in the 1990s, to companies who focus on consumer electronics as an end market.

“The North American venture community is used to building complex chips to sell to Lucent and Cisco,” Antonen says. “That worked in the 1990’s.  While consumer electronics (chips) generally deliver lower gross margins, their extremely high volumes provide significant gross margin dollars to leverage the operating infrastructure, which is typically leaner than a communications chip company.  We believe that these companies have a better chance at rapid growth and potential a IPO.”

Antonen adds that the customer base for many of these products has shifted from North America and Europe to Asia. Indeed, according to research firm Gartner, in 2003, sales to the Asia/Pacific region, not including Japan, totaled more than $68 billion, or about 39 percent of the market. Tom Rosch, a general partner at Menlo Park venture firm InterWest Partners, says Asia has great potential because of the combination of an enormous population and a fast-growing middle class. “There are 350 million cell phone users in China alone. That’s more than the entire population of the US.”

In addition to wireless handset companies, which typically have new products out every four to nine months, Rosch sees “explosive growth” in digital television in Asia. “The Chinese digital TV manufacturers have become world-class very quickly. The whole TV industry is going to change over the next three years.  It’s hard to fathom all the opportunities in the digital area.”

Antonen believes that beyond demographics, a very good understanding of the Asian supply chain will be critical in order for venture capitalists to be successful in semiconductor investing. For instance, he says that one of Celtic House’s portfolio companies is staffed with more than 100 people in China and about 15 in the US. However, approximately 80 percent of the operating expenses for that entire company comes from the US location.

Over the next few years, many venture capital firms and their portfolio companies will have to adjust their strategies to account for the new dynamics in the semiconductor market. As with so many other industries, overlooking Asia does not seem an option.