TAIWAN SEMICONDUCTOR FOUNDRIES BUILDING ON SUCCESS

C O N F I D E N T I A L SECTION 01 OF 06 TAIPEI 000399 SIPDIS SIPDIS DEPT FOR EAP/TC DEPT PASS USTR E.O. 12958: DECL: 02/08/2016 TAGS: EINV ETTC ECON PREL CH TW SUBJECT: TAIWAN SEMICONDUCTOR FOUNDRIES BUILDING ON SUCCESS REF: A. 05 TAIPEI 2743 ¶B. TAIPEI 9 ¶C. TAIPEI 85 ¶D. TAIPEI 211 ¶E. TAIPEI 318 Classified By: AIT Acting Director David Davison, Reason 1.4 d Summary -------------- ¶1. (C) Taiwan firms created the fabless-foundry model in semiconductor manufacturing, and its "foundries" (contract chip manufacturers) continue to dominate this large and growing segment of the industry. Taiwan Semiconductor Manufacturing Company (TSMC) has more than 50 percent of the global foundry market followed by United Microelectronics Corporation (UMC) with more than 20 percent. They face increasing challenges from firms in the PRC and elsewhere. Taiwan tightly restricts semiconductor manufacturing investment in the PRC, but TSMC has constructed a fab near Shanghai. UMC is under investigation by Taiwan authorities for its relationship with He Jian, a PRC foundry. In addition, other PRC foundries have close links to Taiwan. Taiwan's foundries also have strong ties to U.S. firms. North American semiconductor design firms account for more than 75 percent of TSMC's sales. If Taiwan further delays liberalizing cross-Strait investment for the semiconductor industry, it risks diminishing the preeminent role of Taiwan firms in the semiconductor foundry market. End summary. ¶2. (U) Taiwan has carved a unique and essential role in the global semiconductor industry. Taiwan firms created the fabless-foundry model for semiconductor manufacturing, which accounts for a large and growing share of semiconductor manufacturing. Under the fabless-foundry model, "fabless" firms design semiconductor products and then hire "foundries" to manufacture the chips for them under contract. A third link in the chain are packaging and testing firms that take the wafers produced by the contract chip manufacturers, cut them into the individual die, and then package them as integrated circuits (ICs) (ref A). This model contrasts with integrated device manufacturers (IDMs) like Intel, Samsung and Micron, who design, manufacture and package their own ICs internally. ¶3. (U) This cable examines the success of Taiwan's semiconductor foundries and the challenges they face in a highly competitive industry. Septel will look at Taiwan's IC design firms. Foundry Success Story -------------- ¶4. (C) Taiwan's most remarkable success in the semiconductor industry has been in pioneering and maintaining leadership in the chip foundry market. The world's two top foundries are both Taiwan companies, Taiwan Semiconductor Manufacturing Company (TSMC) and United Microelectronics Corporation (UMC). The founders of TSMC and UMC, Morris Chang and Robert Tsao, respectively, both have publicly claimed credit for inventing the foundry model, but regardless, the two Taiwan firms were clearly the first foundries and are still the most successful. UMC Vice Chairman Peter Chang estimates that foundries currently account for almost 20 percent of all wafers produced by semiconductor manufacturers. To more accurately compare the role of foundries in the industry, TSMC Director of Market Analysis and Forecast told AIT/T SIPDIS that many analysts multiply the revenue of high-end foundries like TSMC by a factor of 2.5 in order to obtain a final product value comparable to the revenue of IDMs. By that measure TSMC's final product value would be about US$ TAIPEI 00000399 002 OF 006 20 billion, putting it right behind Intel as the world's second largest semiconductor manufacturer. ¶5. (C) UMC's Chang estimates that Taiwan firms have more than an 80 percent share of the semiconductor foundry market. Among Taiwan firms, TSMC has a strong lead with a market share that exceeds 50 percent of the global foundry market. UMC's share exceeds 20 percent. Maintaining Competitiveness -------------- ¶6. (U) Building on its already formidable lead, TSMC continues to show strong growth in revenue, high investment in the most advanced technologies and aggressive strategies to expand market share. The firm recently released its impressive financial results for the fourth quarter of 2005, showing revenue growth of 17.2 percent from the previous quarter and 27.1 percent from the fourth quarter of 2004. Net income growth was even stronger, up 38.4 percent from the third quarter and 52.8 percent from a year ago. The gross profit margin for the quarter was 49.1 percent. The firm's capacity utilization was 104 percent during the quarter. (Note: Semiconductor manufacturers measure capacity utilization based on the standard specifications of manufacturing equipment. With additional equipment modification, utilization rates can exceed 100 percent. End note.) ¶7. (U) TSMC is aggressive about maintaining its leadership of the foundry industry. It invested US$ 2.5 billion in capital expenditure in 2005 and plans investment from US$ 2.6 billion to US$ 2.8 billion for 2006. In the fourth quarter, more advanced wafers with feature size of 0.13 microns or finer accounted for 49 percent of TSMC's revenue, including 17 percent for 90-nanometer technology wafers. TSMC is also developing new strategies to expand its customer's access to higher value, more advanced products. It recently developed 80-nanometer technology for those customers unwilling to invest in cutting edge 65- nanometer technology. TSMC also announced at the start of the year that it would provide design assistance for firms that want to use 65-nanometer technology but may not yet have the design capacity. ¶8. (U) UMC hasn't quite matched TSMC's recent performance but remains a strong competitor. Even though UMC's revenue for the fourth quarter was up 16.5 percent from the previous quarter it fell 2.7 percent from the same period a year ago. UMC's capital expenditure is less than half of TSMC's, with investment of only about US$ 1 billion in 2005 SIPDIS and a similar amount planned for 2006 according to Chang. UMC will begin to produce 65-nanometer wafers some time in the first half of 2006, putting it among the most advanced semiconductor manufacturers but still months behind TSMC. Wafers with feature size of 0.18 microns or finer account for about 60 percent of UMC's revenues compared to 81 percent for TSMC. More Growth with IDMs "Fab-lite" Strategy -------------- ¶9. (C) Many analysts believe that the prospects for foundries in 2006 are excellent. Industry research firm IC Insights recently predicted that the foundry market would grow 32 percent in 2006, much faster than their forecast of 8 percent growth for the semiconductor industry as a whole. The firm predicts growth rates averaging 21 percent through ¶2010. One reason that the foundry sector is expected to grow more quickly is the trend of IDMs to increasingly contract wafer manufacturing out to foundries. Analysts call this the "fab-lite" model. Infineon, Europe's largest semiconductor manufacturer, recently announced that it would use foundries for its 65 nanometer manufacturing. TAIPEI 00000399 003 OF 006 According to UMC's Chang, IDM semiconductor manufacturer Texas Instruments is now contracting foundries to produce 30 percent of its output. ¶10. (U) However, Taiwan's foundries also face increasing competition from elsewhere. Chartered Semiconductor Manufacturing of Singapore, the world's third largest foundry, remains a serious challenger. Semiconductor Manufacturing International Corporation (SMIC),a PRC foundry, took 7 percent of the market in 2005, up from just 1 percent in 2002. Other smaller PRC foundries are growing rapidly. In addition, Samsung, the world's second largest semiconductor manufacturer recently announced that it would enter the foundry market, expanding on its IDM operations. Despite Taiwan's Restrictions on PRC Investment... -------------- -------------- ¶11. (U) The Taiwan government tightly restricts semiconductor manufacturing investment in the PRC, which became the world's largest IC market in 2005, according to IC Insights. Such investment was entirely illegal until August 2002, when the government announced that it would permit three firms to each establish an 8-inch wafer fab using older equipment transferred from Taiwan fabs. More advanced and productive 12-inch fabs were prohibited, and only firms that had built at least one 12-inch fab in Taiwan would be approved for such investment. In addition, firms could only build fabs that produced chips with feature-size no finer than 0.25 microns, which at the time was two generations behind the most advanced chips in mass production and is now at least three generations behind. Forging Legitimate Links with the Mainland... -------------- ¶12. (U) TSMC was the first company to apply for such investment and in 2004 started operations at its fab in Songjiang, near Shanghai. It subsequently received approval to expand its operations there, increasing the fab's output from 15,000 wafers per month to 30,000. In 2005, the Songjiang plant produced about 1.8 percent of TSMC's total wafer output. Powerchip Semiconductor SIPDIS Corporation and ProMOS Technologies, two DRAM producers, also applied in December 2004 to build fabs in the PRC. It now appears that the Taiwan government has no intention of approving the applications until there is a consensus for further liberalization of cross-Strait economic restrictions. (reported ref D). ...And Questionable Relationships -------------- ¶13. (U) UMC never applied for permission to invest in the PRC, but instead developed close ties with He Jian, a PRC semiconductor foundry that was founded by former UMC employees. UMC's former chairman Robert Tsao was indicted on January 9 by the Hsinchu County Prosecutors Office for breach of trust and violations of Taiwan's Business Accounting Law for failing to properly report UMC's relationship to shareholders or in financial reports (reported ref C). UMC admits that it provided management assistance to He Jian but claims that it neither invested funds in the firm nor transferred technology. At the time of Tsao's indictment, Taiwan officials acknowledged that they still lacked sufficient evidence to show that UMC had invested illegally in He Jian. ¶14. (U) Taiwan's new Minister for Economic Affairs announced on January 26 that he would convene an interagency meeting after the Lunar New Year holiday to make a final decision on whether UMC had violated Taiwan's investment restrictions and to decide what action to take on UMC's application to acquire 15 percent of He Jian's TAIPEI 00000399 004 OF 006 stock in exchange for the assistance that it has provided (ref E). However, there has been no further indication of when this meeting might take place. It may have to wait until after the ruling Democratic Progressive Party (DPP) further clarifies its cross-Strait policy in debate planned for March. If UMC is eventually allowed to acquire a substantial stake in the PRC firm, it will be an important victory for the firm and justify the legal problems that have arisen from its relationship with He Jian. He Jian is growing quickly. It is currently the PRC's third largest foundry in the PRC after SMIC and Shanghai Huahong NEC, according to a report by Price Waterhouse Coopers. ¶15. (C) Taiwan has close ties to PRC foundries in other ways. SMIC was founded by Taiwan born Richard Chang, who is now a U.S. citizen. He was one of the firm's original major investors and remains its chairman. Chang has been fined twice a total of more than US$ 300,000 by Taiwan authorities for his investment in the PRC firm. SMIC Americas President Samuel Wang told econoff that many of the other initial investors were Taiwanese-Americans. Wang said that SMIC currently employees 1,100 Taiwanese, making up about 14 percent of the firm's total employment. These employees tend to hold senior management or engineering positions. Similarly, Grace Semiconductor Manufacturing Corporation, the Mainland's fifth largest foundry, was founded by Taiwan CEO Winston Wang, who is the son of Formosa Plastics Chairman Wang Yung-ching. At least two other Taiwanese businessmen have been fined for their investment in Grace. Taiwan's Foundries Still Have the Lead -------------- ¶16. (C) Taiwan foundries believe that they still have a strong advantage over their PRC competition. Earlier in 2005, TSMC Chairman Morris Chang told AIT/T he was confident that Taiwan's manufacturing cluster for ICs would remain intact for several years to come. UMC Chairman Jackson Hu commented to AIT/T in December that SMIC's technology was still more than a year behind TSMC and UMC. He said that while SMIC would not be able to produce 90- nanometer chips until the second quarter of 2006, UMC began production in the first quarter of 2005 and TSMC in the fourth quarter of 2004. Powerchip Chairman Frank Huang recently argued to AIT/T that although SMIC is good at building fabs, it was not good at running a foundry and noted that the firm still loses money. SMIC Americas President Samuel Wang told econoff that the PRC is still far behind Taiwan in terms of the infrastructure and materials supply chain for semiconductor manufacturing. Close Integration with U.S. -------------- ¶17. (C) Taiwan's foundries are closely integrated with the U.S. semiconductor industry. TSMC has particularly strong links to the United States. TSMC Vice President and General Counsel Richard Thurston told AIT/T that in many ways TSMC considers itself an American company in addition to a Taiwan one. He pointed out that the official language for internal communication at TSMC is English. In addition, TSMC owns the largest semiconductor foundry in the United States. WaferTech L.L.C. in Camas, Washington, is a wholly-owned TSMC subsidiary with capacity to produce 389,000 8-inch wafers in 2005, about 6.5 percent of TSMC's total production. ¶18. (C) TSMC has close ties with a range of U.S. semiconductor firms that are its most important customers and suppliers. North American IC design firms and IDMs accounted for 77 percent of TSMC's total revenue in the fourth quarter of 2005. TSMC is also a major customer of U.S. semiconductor equipment and materials supplier. As TAIPEI 00000399 005 OF 006 reported ref D, Taiwan was the largest market for U.S. semiconductor manufacturer Applied Materials for the year ending the third quarter of 2005 with sales of US$ 1.9 billion, accounting for 25 percent of Applied Materials total revenue. Applied Materials divides the Taiwan market into two accounts - TSMC and all other Taiwan companies. TSMC makes up 40 percent of Applied Materials business in SIPDIS Taiwan. According to Edward Tjan, Senior Director for Operations as Applied Materials Taiwan, Applied Materials has a higher market share for TSMC's equipment purchases than for Intel's purchases. ¶19. (C) UMC also has close relations with U.S. firms, but not to the extent of TSMC. UMC's Chang told econoff that sales to U.S. firms account for only 40 percent of the UMC's revenue, about the same percentage as sales to Asian firms. The firm is also a big buyer of manufacturing equipment, wafer materials and gases from U.S. suppliers. U.S. Interest in Expansion to PRC -------------- ¶20. (C) As a result of these links, U.S. firms also have an interest in the expansion of Taiwan's semiconductor manufacturing to the Mainland. Equipment suppliers are eager to sell the equipment that would be required for such expansion. At least one industry contact has told econoff that U.S. design firms would like to be able to contract Taiwan firms to produce chips in the PRC. He argued that producing all the chips in Taiwan unnecessarily concentrates the design firm's risks. U.S. firms that belong to the U.S.-Taiwan Business Council, including Applied Materials, support the Council's efforts to lobby the Taiwan government to liberalize investment restrictions. Comment - The Silicon Triangle, Opportunities and Risks -------------- -------------- ¶21. (C) Taiwan's policy of tightly restricting semiconductor manufacturing investment in the Mainland (as well as IC design and IC packaging and testing) may diminish Taiwan's strong advantage in the foundry segment, even as these policies aim to preserve Taiwan's semiconductor cluster. Acer founder Stan Shih once argued that if Taiwan loosened restrictions on semiconductor investment in the PRC, Taiwan firms could dominate the market and wipe-out nascent competition from PRC companies. But if Taiwan delayed such liberalization, he believed that PRC competitors would be able to get a foothold and become a more permanent threat to Taiwan's semiconductor manufacturers. Events are proving his analysis correct. Restrictions were not adequately loosened and PRC foundries like SMIC are becoming more competitive. Moreover, Taiwan investors and engineers are funding and driving the technological achievements of these PRC foundries (often in violation of Taiwan law),underscoring the fact that Taiwan firms could have controlled the PRC foundry market if they had been allowed to enter the market legally and compete. UMC's Hu summed up this situation for AIT/T arguing that the Taiwan government doesn't understand the concerns of firms like UMC in three ways: it doesn't understand the need to go to markets where they can compete, it doesn't understand the urgency of that need, and it doesn't understand the need to use incentives instead of restrictions to keep investment in Taiwan. Other, including deep green, businessmen have succinctly said that "Taipei doesn't understand economics." ¶22. (C) The United States, Taiwan and the PRC increasingly form a "silicon triangle" with the potential to create economic growth in addition to the risk of the transfer of jobs and sensitive technology. Taiwan President Chen Shui- bian's New Year's call for "active management" in cross- TAIPEI 00000399 006 OF 006 Strait economic relations highlighted once again that the Taiwan government is particularly sensitive to the dangers (ref B). However, it needs to pay more attention to the opportunity costs that investment restrictions impose on Taiwan firms. The longer Taiwan delays further liberalization of those restrictions, the more it puts at risk the preeminent role of Taiwan firms in the semiconductor foundry market. End comment. DAVISON