Investors Cash in Chips on Resurgent Semis –

After a long malaise, the semiconductor business has come back with a vengeance, promising hefty rewards for patient venture capitalists.

If there was any doubt, it was put to rest on March 17 when China’s Semiconductor Manufacturing International (SMIC) pulled off one of the largest IPOs this year. The chip fabrication company, which previously collected $390 million in venture backing, raised over $1.8 billion.

Just about every venture capital firm you can think of owns a chunk of SMIC, including DCM-Doll Capital Management, Goldman Sachs, H&Q Asia Pacific, New Enterprise Associates (NEA), Oak Investment Partners and Walden International. Venture firms’ holdings in SMIC were worth several hundred million at the time of the IPO.

The cheerful news from China just adds to what is shaping up to be the year that semiconductor investors have long been hoping for. Besides SMIC, one other venture-backed chip company has successfully gone public and 5 more are in registration (see Table 1). If that’s not enough, 15 semiconductor-related companies have been acquired, including eight that were venture- backed.

More than two dozen venture firms have cashed in on the surging interest in chips, but the biggest winners have been Alta, August, Battery, Foundation, Investar Capital, Carlyle NEA, Sierra, Walden, and USVP. Among the most successful VC exits have been Battery, making $75 million on SigmaTel’s secondary offering, Alta Partners which realized between two and three times its original investments in Synad, NEA, with exits in SMIC, Atheros, and 3Ware, and Carlyle, which is poised for a huge return on Jazz Semiconductor’s IPO.

Is this merely one of the semiconductor industry’s classic cyclical rebounds? It’s too early to know, but industry analysts say they expect the good news to continue for a while. “The buzz on semiconductors is very positive,” says Apjit Walia, a chip analyst at RBC Capital Markets. “Lead times for new orders are 10 to 12 weeks, typical of the peak of a cycle. The question is whether we have peaked now or whether the cycle will continue.”

While demand for microprocessors in PCs has slowed, other sectors like wireless and communications chips continue to grow, particularly because “China and India have become big consumers,” Walia says.

Wall Street’s hunger for anything chip-related waned a bit after the New Year, but it still has a strong appetite judging by the Philadelphia Semiconductor Index. It closed at 485.1 on March 12, up 67% from a year earlier.

Follow Through

Part of the reason for the continued demand that is due to the strong aftermarket performance of three new chip issues in the past six months: Atheros, which makes chips for wireless communication, priced at $14 in February and closed at $17.59 on March 12, up 26 percent; chip packaging maker Tessera priced at $13 in November and closed at $18.50 on March 12, up 43 percent; and SigmaTel, which makes mixed-signal chips for consumer devices, priced at $15 in September and closed at $23.31 on March 12, up 55 percent.

Analysts were also heartened by the warm reception given to SMIC, which priced at the top of its range on March 12. Its shares were scheduled to start trading as ADRs (American depository receipts) on March 17.

“Most [Wall Street] interest is in specialty semi companies selling into the hot consumer market that have a non-commodity product, however, now that some of the older areas such as telecom and SRAMs are perking up, there is interest in these sectors as well,” says John Michaelson, president of Needham Capital Partners.

“There is a definite window opening aggressively in 2004, driven by the macro dynamics of mutual funds,” says Chris Albinson, a principal at JPMorgan Partners (JPMP) who oversees his firm’s investments in semiconductor startups. “There is a ton of money coming into public equities. The flow has risen from $12 billion in 2002, to $144 billion in 2003, and the first month of 2004 saw a similar pace.”

While the demand for tech stocks has risen, mutual funds have found a shortage of tech companies with strong intellectual property and sales in the range of $50 million to $70 million, Albinson contends. And that, he says, has resulted in “a lot of water backed up behind the dam.”

At least part of that backed-up interest is finding its way into secondary offerings by a variety of public semiconductor companies seeking to raise additional operational funds or whose directors, investors and venture backers are seeking partial exits of their holdings. The most prominent examples are Battery Ventures, which sold more than 3 million shares in SigmaTel’s secondary offering at a price of $25.01 each for a total haul of $75 million, and Texas Pacific Group, which sold 17 million shares of On Semiconductor priced at $6.98 each for a total of $119 million.

The increase in the price of chip stocks has prompted semiconductor companies to use their shares as currency to purchase chip startups. “They have more money to make acquisitions so they’re looking,” says Rob Chaplinsky, a general partner at Mohr Davidow Ventures (MDV) whose portfolio company Accelerant Networks was just acquired by Synopsys in a deal valued at $22.5 million.

“For the first time in a long while they’re shifting from merely accretive acquisitions – companies that will add revenues to their bottom line – to strategic investments” that won’t payoff for three to four years, Chaplinsky says. That’s good news for venture backed startups which have developed strong IP assets in the past few years but which have been unable to reach other performance sales milestones.

Another factor driving M&A activity is the shift of the semiconductor industry to 90- and 65-nanometer manufacturing technologies. “We’re going through now what the industry experienced in the shift from .18 to .13 microns a couple of years ago,” says Nitin Deo, a vice president at Magma Designs, which recently bought startup Mojave for $115 million. The complexity of next-generation designs is sending companies like Magma on the acquisition trail to speed product development and to insure better quality in the design for manufacturing process, Deo explains. Six of the 11 recent M&A transactions have been among semiconductor electronic design automation and test companies.

As venture firms reap the rewards of long-anticipated exits, they continue their breakneck pace of investment into fabless startups. They poured nearly $500 million into 37 new or follow-on investments in January and February, according to original research by Venture Capital Journal.

Venture backers are increasingly motivated by the seemingly endless demand for new semiconductor products from the consumer electronics and information technology manufacturing sector in Asia. The best example at the moment is SMIC. John Paul Ho, founder of Crimson Ventures in Palo Alto who invests in Asian semiconductor startups, says that chip startups are on the rise, especially in Asia, because suppliers need to be close to manufacturers. Ho says that there are at least 500 semiconductor startups in Shanghai and probably as many in Taiwan that have been funded to supply systems or components to the computer and electronics builders of Asia.

While all of these factors add up to give a rosy outlook for almost anything related to semiconductors, there is reason to be cautious. If the industry’s growth rate, which has been accelerating, slows by mid-year, “interest in semiconductors will cool rapidly,” says Needham’s Michaelson.

MDV’s Chaplinsky quips that the upswing will continue until the “bad companies [go public] and investors are burned.”

For his part, Walia sees more upside ahead. Traditionally, “the first half is the weakest for semiconductor companies,” he says. Given the roaring start, if Walia is right, this is going to be a year most investors will be glad they were here to witness.

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