OEM Re-Verticalization is Squeezing Semiconductor and Distribution TAM

Verticalization – or the more modern version of it – is in vogue again and its embrace by the biggest and most powerful OEMs is roiling the electronics industry as the opportunities and sizes of markets served by semiconductor makers, component distributors and software developers shrink further, forcing a re-evaluation of their roles, offerings and partner alliances.

The driver for a renewal of verticalization at OEMs is greater control of the design chain and the sourcing environment. Their tactical moves have also been textbook-perfect. They contest for and pay top price running into billions of dollars for IP useful in their competitive areas but also in adjacent markets. One of the earliest salvos in this battle was fired at the beginning of this decade when Apple partnered with other companies to purchase the intellectual property of Canada’s Nortel Networks. The $4.5 billion deal started a race by other OEMs to build patent portfolios that have since morphed into the rebuilding of dormant IC design expertise.

Since the Nortel transaction, all the major OEMs, including Alphabet, the parent company of Google, have been active in the mergers and acquisition market, buying rivals, suppliers and start-ups still in the “garage” product design phase, especially those developing technologies that have the potential to threaten their dominance. These acquisitions complement other massive investments in products and R&D centers in the world’s leading educational institutions and in Silicon Valley-style corridors of China, India and in Europe.

Apple Inc. designs microprocessors for its smartphones and employs a team of seasoned semiconductor engineers that have been churning out advanced integrated circuits. The group rivals any at leading chipmakers; the company’s custom-designed A11 ARM-based system-on-a-chip is touted by some as one of the fastest processors in the smartphone market. But Apple is not done. It is moving deeper into the design of other chips by developing components for connectivity, artificial intelligence, graphics and video. The world’s biggest consumer electronics company wants to deliver devices that work hitch-free, seamlessly merging hardware and software “designed from the ground up to be compatible,” according to an industry source.

But what Apple wants, other OEMs also desire, and they have been actively pursuing the development of integrated-products, which means deeper foray into not just software development but also semiconductor ICs and other components on the printed circuit board. This push has significant implications for semiconductor suppliers, distributors, software developers and others involved in electronics design and production. Moving core components such as processors and graphics ICs off the procurement shelves results directly in a reduction of the total available market (TAM) served by others in the supply chain.

To counter the trend, safeguard and expand revenue streams, chipmakers, distributors and others in the industry must accelerate new product development initiatives, foster the creation of fresh market opportunities and bring up a new breed of OEMs. Interviews with industry leaders indicate this is an urgent objective for many in the industry but it’s a project very much in its infancy, they said.

Samsung might have inadvertently initiated the process of forcing some OEMs to bring IC design work back in-house. The South Korean giant is a major consumer electronics OEM as well as a supplier of semiconductors to many of its competitors. The arrangement worked well for as long as the company was focused on devices of limited concern to its customers. However, its foray into and strong success in the mobile handset market amidst a fractious dispute with Apple forced the American PC and iPhone maker to hasten efforts to wean its supply chain off Samsung.

But the re-verticalization process extends well beyond the mobile phone market. Networking equipment vendor Cisco Systems Inc. has a battery of chip designers working for it. Last year, it acquired Leaba Semiconductor Ltd., “an Israeli-based fabless semiconductor provider whose semiconductor expertise is expected to be leveraged to accelerate the company’s next-generation production portfolio,” Cisco said in its latest annual filing with the Securities and Exchange Commission. “This acquisition is a component of the company’s strategy to enhance its product offerings in the networking chipset market.”

Huge Numbers

If the stealthy reintroduction of verticalization is good for these OEMs, it comes with enormous challenges for many suppliers and supply chain partners. It has accelerated a process that has lopped huge chunks off distribution TAM, driving the companies into a frenzy of consolidation years ago that has taken many rivals off the market but not quite solved their problems.

With each semiconductor design conducted by an OEM – typically farmed out to foundries such as TSMC and GlobalFoundries for production – chipmakers lose another design socket and distributors lose a sourcing contract. The insourcing of IC development work has attracted a copycat move by rivals seeking to gain the same competitive advantage or neutralize a rival’s edge. What these OEMs gain in sourcing advantages and production edge is a major loss rippling through the rest of the supply chain.

These are not small numbers. Apple is the extreme example because it barely uses a distributor for any of its component needs. This means very little of the company’s annual COGs is available to distribution. Apple’s cost of goods sold is usually about 61 percent of its revenue, which is projected to top $227 billion in fiscal 2017, according to Yahoo Finance estimates. Even a fraction of the $138 billion in Apple’s fiscal 2017 projected COGS would make a huge difference in the outlook for the component distribution market.

Alas, Apple’s component sourcing business is not a part of distribution’s TAM. As more OEMs make moves like this, though, the traditional market for distribution shrinks further, forcing these companies to explore innovative ways to re-grow the pie. Companies like Arrow Electronics Inc. are targeting new opportunities in IoT and the digital market. The American distributor has increased engineers on its team to pull in new businesses at start-ups and small to medium-tier enterprises and has partnered with crowd-fund site Indiegogo to connect with makers and inventors. CEO Michael Long said while presenting the company’s latest quarterly results that it has also been deepening existing ties with OEMs and contract manufacturers.

Michael Long, Chairman, President & CEO, Arrow Electronics Inc.

“We've been getting ahead of the changes we've seen coming in our industry in the broader technology environment. We've invested in our digital platform, we've invested in our cloud capabilities, we've invested in sustainable technology solutions, we've invested in engineers and technical salespeople, and we've invested in our IoT capabilities and our ability to sell solutions across the entire enterprise,” Long said. “These investments are bearing fruit. We are providing solutions that encompass the full life cycle of our customers' products from sensor-to-sunset. The investments we've made are rapidly expanding our customer base and deepening our relationships with existing customers.”

Partners and Rivals

The top OEMs are not intentionally locking chipmakers and distributors out of their huge COGS but it is happening nevertheless. What these company don’t design and make themselves, nowadays, they source directly from component manufacturers or hand over to contract manufacturers, unless distributors can offer compelling gains.

Foundries and contract manufacturers, meanwhile, are experiencing a boon as OEMs turn to IC designs. Apple’s patronage, for example, turned Foxconn International into a behemoth with sales running into more than $100 billion. Since it operates a low-margin business, Foxconn has in turn jacked up its own efforts to bring more sourcing in-house, establishing a vertical operating structure that has put further pressure on its component suppliers and distributors.

In fact, the verticalization of Foxconn’s operation has shifted to such an advanced stage that the company has itself been exploring the option of buying a semiconductor vendor. It is participating with Apple and others in the acquisition of Toshiba Corp.’s semiconductor business and has looked at similar opportunities at other companies. Earlier this year, the company was reported to have looked into establishing a U.S. display factory in conjunction with Apple (See: Foxconn may team with Apple to build $7 billion manufacturing facility in U.S.).

The semiconductor merger and acquisition market has also not been immune to OEM meddling. Semiconductor industry consolidation accelerated in recent years partly in response to OEM demand for one-stop offerings and because of efforts by chipmakers to build up product portfolios, acquire emerging technologies and stave off the competition.

Top OEMs have been active here, too. They compete directly with chipmakers for new technologies and exert so much power over M&A transactions that prospective buyers lacking their support may end up on the losing side. This happened this year to Western Digital when Apple successfully blocked its efforts to purchase Toshiba’s semiconductor business. The storage drive maker should have been the preferred buyer because of its existing relationship with Toshiba but Apple reportedly made it clear it would not patronize the new enterprise if Western Digital’s offer was accepted. A consortium led by Bain Capital Private Equity won although Western Digital is contesting the transaction in court.

Their acrimonious rivalry notwithstanding, Apple Inc. and Samsung share one significant trait: They have evolved into super OEMs. They are leveraging their enormous size, revenues, purchasing power and influence to redefine and shape the roles and fortunes of other players in the electronics industry. They are also sucking a lot of the industry’s sales into their corner, hogging its profits and essentially establishing dominant roles that other companies must respond to one way or the other.

This is the first in a series of articles exploring ongoing changes in the electronics industry design chain and supply chain. In the next article in this series, we will explore how two segments of the industry – distribution and semiconductor vendors – are responding to this trend; detail outlook for the industry; and offer some suggestions for assuring success at the individual enterprise level.