The Only U.S. Chip Maker Not Outsourcing Its Brains

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Here's a warning to all of you technology investors out there: Beware the firms that are outsourcing their brains.

That was one of the take-home messages Clayton Christensen left for his audience at a recent presentation. I'll explain exactly what he meant by that in a second; but for individual investors, Christensen also singled out the only U.S. semiconductor company that wasn't zombifying itself: Intel (Nasdaq: INTC  ) .

Outsourcing and the pursuit of profits
"The problem lies with the business schools," Christensen argues, which teach future business leaders to focus on percentages -- like profit margins -- above all else. By focusing on short-term gains, which improve profitability, many firms are outsourcing their brains in the long term.

Decades ago, semiconductor companies were vertically integrated -- meaning that they were in charge of everything from gathering the raw materials necessary to make their chips, fabricating the individual parts, and assembling the chips, to planning the design and marketing campaigns.

But over the past few decades, more and more companies have outsourced the bottom levels of this process -- the gathering of raw materials and fabrication of the chips -- to firms in Asia, namely companies like Taiwan Semiconductor (NYSE: TSM  ) and United Microelectronics (NYSE: UMC  ) .

Nowadays, almost all chip makers embrace the "fab-less" tag. NVIDIA (Nasdaq: NVDA  ) has used Taiwan Semiconductor for years; AMD (NYSE: AMD  ) has been using United Microelectronics to make some of their chips since 2002.

Because these Asian firms are able to fabricate the chips at a cheaper cost than AMD or NVIDIA ever could, the American firms should be the long-term winners in such deals, right?

Not so fast!
It's here where Christensen sees a problem. As these foreign companies slowly take over more and more of the manufacturing processes, they are gaining a huge knowledge advantage over their American counterparts.

Contrary to popular opinion, he asserts, the plants at Taiwan Semiconductor or United Microelectronics aren't sweatshops solely focused on pouring out as many chips as possible. Instead, they are sophisticated organizations that -- though they aren't there yet -- could one day handle the design of the computer chips.

So while chip makers like NVIDIA and AMD are gaining an upper hand in the short term by cutting labor costs, they are trading away some pretty valuable assets -- like knowledge accumulated from entire fabrication process and the subsequent loss of innovation from that lack of critical knowledge.

Without innovations coming from their own people, NVIDIA, AMD, and their fab-less cohorts could soon realize that it's Taiwan Semiconductor and United Microelectronics that are designing their own chips, which have higher capacity and lower costs. In short order, that could spell doom for the U.S. semiconductor industry.

What's a Fool to do?
Actually, if Taiwan Semiconductor and United Microelectronics design superior chips at cheaper costs, it would spell doom for all but one U.S. chip maker. As I mentioned at the beginning, that chip maker would be Intel. The U.S. company has resisted the temptation to outsource its production process and to this day is the only major U.S. player that fabricates its products.

So while it may have been late to the game in designing chips for the mobile revolution, I'm pretty confident in Intel's future. With the stock currently offering a 3.5% dividend that accounts for only 32% of the company's profits, and trading with a PEG ratio under 1, I think Intel is a great long-term bet.

I own the stock myself and have given the company a thumbs-up on my own CAPS profile.

But if Intel isn't quite for you -- because it's so late to the mobile game -- I suggest you check out our special free report: "3 Hidden Winners of the iPhone, iPad, and Android Revolution." We all know who the big players are in the industry, but this report details the lesser-known and lower-priced companies that are poised to benefit from this revolution. Get your copy of the report today, absolutely free!

Fool contributor Brian Stoffel hopes his brains are never outsourced, though his wife would argue that she often picks up the slack. He owns shares of Intel. You can follow him on Twitter at @TMFStoffel.

The Motley Fool owns shares of and has bought calls on Intel. Motley Fool newsletter services have recommended buying shares of Intel and NVIDIA, writing puts in NVIDIA, and creating a bull call spread position in Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (16) | Recommend This Article (25)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 05, 2012, at 2:11 PM, prginww wrote:

    Anyone who doubts that outsourcing leads to disaster should pay attention to Kodak, the company that outsourced itself into bankruptcy. By letting cameras be manufactured overseas, Kodak gave up its business.

  • Report this Comment On January 05, 2012, at 2:17 PM, prginww wrote:

    Good points on what they lose. I expected ARMH to be mentioned on the upper end as the chipmakers effectively outsource R&D and architecture design to ARMH, but also important to look at the lower end fab side with TSM, UMC, etc.

    -- Evan

  • Report this Comment On January 05, 2012, at 3:38 PM, prginww wrote:

    Sorry, AMD and Nvidia completely design their chips in house. TSMC and UMC provide their customers with a set of rules they must follow for production. It is up to the customer to follow those rules but other than that the manufactures have no role in design or development.

    You also fail to mention Global Foundries which is the unit that AMD spun off in order to return to profit. GF has a foundry in Germany that produces ALL of AMD's 40nm and new 32nm processors, (with the exception of the Brazos processors fabbed by TSMC)

    GF is in the process of building out a new FAB (8) in New York which started in 2009.

    AMD and Nvidia do use TSMC for production of all their graphics processors.

    To the best of my knowledge, AMD does not use UMC for chip fabrication.

  • Report this Comment On January 05, 2012, at 3:52 PM, prginww wrote:

    Although, I agree with your basic premise that outsourcing your supply chain makes it more difficult to innovate and differentiate, you are forgetting some of the basic economics of Silicon Mfg. Only a handfull of companies have the volume and scale to fill a 300mm Fab, let alone a 450mm Fab.

    You are also forgeting that there are still several GAs Fabs located in the US, i.e. RFMD, Anadigics, Skyworks and Triquint. These companies make RF devices that are key components in Smartphones. The wafer size for GAs is still relatively small, so these companies are still able to justify the cost of running their own Fabs.

  • Report this Comment On January 05, 2012, at 5:22 PM, prginww wrote:

    @mamisano/ @TMFNewCow

    I realize they the Asian companies don't do their own designs...yet. The examples that Christensen used in his speech dealt with how Dell lost its competitive edge. It started out with small chips, then the motherboard, then design, etc.

    If you've got some free time this weekend, it's definitely worth a watch.

    Brian Stoffel

  • Report this Comment On January 05, 2012, at 9:32 PM, prginww wrote:

    QCOM, BRCM, NVDA and others outsource manufacturing because the cost of building a semiconductor manufacturing plant is in the $billions, and their product differentiation is in the design of the chips not the manufacturing.

    These companies also outsource the design of certain parts of their chips to companies like ARM and Synopsys because designing a modern advanced chip is a monumental task and intelligent make-buy decisions can reduce this task somewhat.

    BTW, IBM are leaders in semiconductor manufacturing technology, licensing their know-how to companies like Samsung and Global Foundries and doing their own manufacturing though on a smaller scale than TSMC and UMC.

    I don't agree that semiconductor companies who outsource manufacturing have made a mistake, nor that TSMC and UMC can challenge their customers in the design of semiconductors.

  • Report this Comment On January 06, 2012, at 1:53 AM, prginww wrote:

    The fabless semiconductor business model is great. Actually it is the only option for startup "idea" companies.

    With Intel focused on their core processor business and the foundries focused on everything else, the foundries have NEVER had to face the prospect of competing head on with Intel.

    Intel needs to continue the tick-tock shrink cadence until they reach the necessary power level to play in the mobile market. That point is maybe 32nm, and certainly 22nm TriGate. Those chips will be 1/4 the size of the 45nm chips in the mobile sector today.

    So, the fabless model is great unless the competition is at the bleeding edge of high technology manufacturing.....then the wheels come off in Intel's favor.

    Morris Chang, the Chairman of TSMC had this to say the other day:


    13 hours 20 minutes ago - Asia Pulse via Comtex

    Taiwan Semiconductor Manufacturing Co. (TSMC, TAIEX:2330), the world's largest contract chip-maker, views Intel Corp. as a special rival because the U.S. chip-maker is competing against TSMC's customers, company chairman Morris Chang said Monday.

    "TSMC's technologies and performance have reached quite a high level, bringing us into contact with different rivals," Chang said in an interview with Chinese-language Economic Daily News.

    "The competitors we face are Samsung Electronics Co. (KSE:005930) and GlobalFoundries Inc., with Intel standing 'behind a veil' because it is a rival against many of our customers," Chang said, adding that these TSMC customers include integrated circuit designers and integrated device manufacturers.

    Intel, the world's top chip-maker, currently has two contract foundry customers making field programmable gate array (FPGA) products, which do not compete directly against Taiwan Semiconductor Manufacturing Co. (TSMC, TAIEX:2330), Chang said.

    He said the semiconductor sector used to be led by giant U.S. and Japanese companies, but TSMC has been viewed by these companies as a "formidable" rival since two to three years ago due to its upgraded competitiveness.

    Samsung and GlobalFoundries are newcomers in the industry, Chang said, and suggested that TSMC's customers should diversify their foundry sources rather than rely on TSMC only.

    "All of our customers rely on TSMC in foundry production, and Intel relies on its own foundry plants," he said. "If our technologies are not improved enough and Intel keeps improving its technologies, our customers' products will lose competitiveness to those of Intel. It's horrible to imagine the outcome."

    "TSMC will stand behind our customers and cooperate with them. The battlefield between our customers and Intel is where we compete against Intel," he added.

  • Report this Comment On January 06, 2012, at 7:56 AM, prginww wrote:

    Another question - what type of chips does Brian think that TSMC or UMC will develop? They can not build x86 CPUs because AMD and Intel would never let them have a license to do that.

    Second, GPUs are VERY complex to design. Nvidia and AMD have 15+ years of experience in this realm.

    Intel, with their infinite resources and cutting edge FABs have tried but failed to penetrate this market. Their latest GPUs that are embedded into their CPUs don't hold a candle to the AMD or Nvidia based products, not to mention the lack of proper driver support (a huge undertaking on its own).

    That would leave something like an ARM design which already has a crowded field of designs.

    And for that matter, what about Apple which has always been fabless?

  • Report this Comment On January 06, 2012, at 9:19 AM, prginww wrote:

    Design houses have been seeing design and manufacturing interactions for a while now. While the less sophisticated users, use the recommended design rules, the more sophisticated ones can get special waivers and therefore possibly gain some advantages over their competitors. Of course they need to know what they are doing when they do this. For this good simulation tools are needed. Similarly foundries provide access to all the chip yield information and this can use this to identify and fix design related yield limitations - all without telling the foundry what they are doing.

  • Report this Comment On January 06, 2012, at 10:38 PM, prginww wrote:

    Let's not forget Micron Technology. Will their fab assets benefit then in the long run?

  • Report this Comment On January 07, 2012, at 4:21 AM, prginww wrote:

    What a stupid article. Outsourcing the FAB work is irrelevant. What counts is the design NOT the fabrication. UMC, TSMC and GF are not design houses you moron. They are factories.

    Please allow me to elucidate. AMD makes graphic chips and outsources them. Intel makes graphics chips too but fabs them in-house. What the difference? The Intel graphics chip really sucks wind. Despite being not only a chip designer AND fabrication house they still can't design a decent GPU. It doesn't matter where the chip is made, just who designs it.

    nVidia too outsources FAB work.

    Sometimes the Fool really lives up to it's moniker.

  • Report this Comment On January 13, 2012, at 1:08 PM, prginww wrote:

    At the very bleeding edge of the semiconductor industry, such as where Intel and IBM (with their Power architecture-based chips) operate (for the chips that go into servers), it makes sense to keep manufacturing and design all together under the same roof. At this end of the performance curve, it absolutely does matter that the two be together, as design influences process and vice-versa.

    The other requirement (than high-performance) to be able to afford your own manufacturing is that you have to have enough volume to justify the R&D and enormous capital investment ($3B - $5B) required to build a leading-edge fab (300mm wafer diameter, 32nm or less process geometry). Intel can manage it on account of their dominance of a huge market for PCs and laptops. AMD cannot, for the reason that their low share of that market does not allow for sufficient economies of scale to pull it off. They have a close alliance with Global Foundries (and, I think, IBM too) to make up for their inability to afford their own R&D and manufacturing. IBM does own their fabs, but that's because they also sell capacity to other companies that need the capability (i.e., they're a bit like TSMC).

    Perhaps the only company that could own its own leading-edge fabs and does not is Qualcomm, given their dominance of the high-volume cellphone chipset market. They have chosen (wisely, IMHO) not to, since the interplay between process geometry and design is not as critical for them as it is for performance players like the server chip vendors like Intel and IBM.

    As other commenters have pointed out, fabless semi companies are not being foolish (in the non-TMF sense) to outsource their manufacturing. They simply would not EXIST without the availability of outsourced manufacturing. It takes an enormous amount of capital to get a fab up and running, and you can't do it if you're a little-bitty startup. Without this model, companies such as Silicon Labs, Broadcom, Marvell, Nvidia, Cirrus Logic, etc. would not have come into existence and would not be thriving today.

    The more important question is, why are all these fabs overseas? The reason is NOT labor, but subsidization of capital. The most important driver of cost for a fab is capital expenditure, NOT labor. TSMC, UMC, etc. benefited (and likely still do) from massive subsidies sent their way by the Govt of Taiwan. And, it took over two decades of such subsidization for them to hit their stride. Virtually every fab that Intel builds in the US is the beneficiary of largesse from the local state government (New Mexico and Arizona, to name two). Similarly, IBM's and Global Foundries' fabs in upstate NY have received huge subsidies from an NY state Government looking to revivify upstate NY's moribund economy. Thanks to years of free-market ideologues dominating the discourse, the Federal Government of the US has not got into the game, though one previous intervention in the semiconductor market (the Sematech consortium) was deemed successful in restoring competitiveness to US companies fearful of Japan.

    You do have Analog and RF companies owning their own fabs, but these are generations behind the leading edge. The smartest of these companies (e.g., Microchip, Maxim) buy old, fully depreciated fabs from the leading-edge players and then milk them for all they're worth. But that's a wholly different ballgame, even within semis.

  • Report this Comment On January 14, 2012, at 11:01 AM, prginww wrote:

    grandpaduck: Kodak also ignored its own invention, the CCD. Stodginess on steroids. GM, bailed out, ignored market. Outsourcing fundamental operations (often the mission itself) in favor of short term profit seems to reveal a positive correlation to laziness and arrogance infecting upper management. Netflix most recently.... so severe that reversal was better than a lynching. Sony is on the same course as Kodak.

  • Report this Comment On January 14, 2012, at 6:41 PM, prginww wrote:

    Dumb article. Stoffel has no understanding of the semiconductor industry or chip design.

  • Report this Comment On January 14, 2012, at 11:31 PM, prginww wrote:

    No. 2 chip maker in the US: Texas Instruments. (#5 globally)

    According to their website they operate 20 fabs worldwide.

    IMHO, Intel needs to watch out somewhat. The days of all of us needing the most powerful PC or laptop are going away. ARM core processors combined with cloud-based services are going to meet the needs of most people moving forward. I have no doubt that Intel's chips will be faster, but they will also most likely continue to be more expensive and power hungry.

  • Report this Comment On January 16, 2012, at 10:31 AM, prginww wrote:


    I suggest you check out the speech I'm referring to:

    Brian Stoffel

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