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As indicated in the table below, sales of the six Japanese companies which accounted for approximately 78 percent of total Japanese semiconductor sales in 1978 averaged slightly over $6 billion in 1979. The diversity of their operations is indicated by the fact that only seven percent of these companies' combined revenues were derived from semiconductor sales.
JAPANESE SEMICONDUCTOR COMPANIES
1979 net sales
to total sales (percent) 2
$1,838 10,725 9,846 3,896 3,292 7,096 6,115
6.7 4.1 2.3 3.8 17.8 5.5 6.7
Converted at 240 yen per $1, the approximate rate of exchange on December 31, 1979.
In contrast, of the nine U.S. companies which accounted for approximately 60 percent of total semiconductor sales by U.S. companies, only two had sales in excess of $1 billion. Sales of the typical U.S. semiconductor company (excluding Motorola and Texas Instruments) averaged only about $400 million.
U.S. SEMICONDUCTOR COMPANIES
1979 net sales
to total sales (percent)
Advanced Micro Devices, Inc. .
89 89 69 75 69 93 31 85 36 71
1 Based on 1978 sales. Source: Estimate by Dataquest Incorporated.
Since the size of a company is often an indicator of a proven track record, management depth, breadth of product lines, market share and position within its industry, larger companies usually command a higher credit rating than smaller companies with the same degree of leverage. Consequently, the relatively small size of most of the U.S. semiconductor companies places them at a disadvantage in raising capital at attractive rates. Japanese semiconductor companies employ significantly higher debt leverage than
U.S. semiconductor companies As is the case for Japanese industry in general, many Japanese semiconductor companies maintain debt-to-capital ratios as high as 60 to 70 percent (equivalent to a debt-to-equity ratio of 1.5 to 2.3).
By comparison, the U.S. semiconductor companies are fairly conservatively leveraged. During the past three years, the median debt-to-capital ratios of the nine U.S. companies reviewed were between 16 and 18 percent. At fiscal year-end 1979, the ratios of the nine individual companies ranged between 5 and 23 percent with a median of 18 percent (equivalent to a debt-to-equity ratio of 22 percent).
In our opinion, the typical U.S. semiconductor company could increase its debt-tocapital ratio to about 33 percent (50 percent debt-to-equity) without impairing its financing flexibility or incurring undue financial risk. Leverage of the two large companies could be increased to about 40 percent (67 percent debt-to-equity). However, these leverage ratios would still be well below those of the Japanese semiconductor companies. Japanese semiconductor companies are able to employ high leverage ratios because of
their affiliation with large industrial groups, Japanese lending practices and a
supportive government policy In Japan there is a high degree of concentration of ownership under large industrial and banking groups called “keiretsus.” These groups consist of large manufacturing, mining, trading and financial concerns that are controlled by a company or group of companies through cross ownership of shares and interlocking directorates. For examples, Hitachi, Matsushita Electric, and Toshiba each head up large industrial groups of their own while Fujitsu, Mitsubishi Electric, and Nippon Electric are each a member of a group which includes a major bank, i.e., Dai Ichi Kangyo Bank, Mitsubishi Bank and Sumitomo Bank, respectively.
To the extent that a keiretsu bank directly or indirectly own a significant interest in the shares of a borrower, it has a continuing voice in establishing corporate policy and direction. This control, coupled with the assurance of financial assistance or loan guarantees from the borrower's keiretsu, reduces the risk taken by lenders. The rates of return on capital of the U.S. semiconductor companies have been higher
than the rates of return of the Japanese semiconductor companies During the past three years, the typical U.S. semiconductor company earned 16.3 percent on capital employed and the two larger U.S. companies earned 15.0 percent. During this same period the Japanese semiconductor companies earned an average of only 7.5 percent on capital. (Rate of return on capital is defined as net operating profits after taxes as a percentage of average total debt and equity capital employed.)
Á more accurate measure of operating performance can be obtained by eliminating the effects of holding temporary short-term investments in money market securities from both earnings and total capital. During the past three years, the typical U.S. semiconductor company earned 18.1 percent on operating capital and the two larger U.S. companies earned 16.8 percent. Data was not available for calculating the rate of return on operating capital of the Japanese semiconductor companies.
The higher rates of return of the U.S. semiconductor companies have been achieved through a combination of better profit margins and a more productive use of capital (i.e., higher sales per dollar of capital employed). COMPARATIVE PROFIT MARGINS AND CAPITAL TURNOVER RATIOS OF UNITED STATES AND JAPANESE
SEMICONDUCTOR COMPANIES (1977-79 AVERAGES)
The Japanese semiconductor companies' cost of capital is significantly lower than
that of the U.S. semiconductor companies largely as a result of the higher debt ratios employed by the Japanese companies
Comparative weighted average costs of debt and equity capital of United States and Japanese semiconductor companies-June 4, 1980
Percent Typical U.S. Companies
17.5 Large U.S. Companies ...
15.2 Japanese Companies..
9.3 A company's weighted average cost of debt and equity capital (cost of capital) is the minimum rate of return necessary to compensate its debt and equity investors for bearing risks by investing in the company. It is, therefore, the standard by which profitability should be evaluated.
Because the after-tax cost of debt is lower than that of common equity capital, a company's cost of capital can be reduced by increasing leverage. Thus, the relatively high debt ratios of the Japanese semiconductor companies are largely responsible for their low cost of capital.
The lower cost of capital of the Japanese companies provides them with the advantage that their required rates of return on investment are lower than those of the U.S. semiconductor companies. As a result, the Japanese companies can accept lower profit margins and/or capital turnover ratios than their U.S. counterparts. While several of the U.S. semiconductor companies could reduce their cost of capital by increasing their debt-to-capital ratios up to 33 to 40 percent, the reduction in cost of capital would be marginal, i.e., approximately 17/2 percent, and would only slightly offset the Japanese financing advantage.
While the U.S. semiconductor companies have been earning rates of return approximately equal to their cost of capital, earnings of the Japanese semiconductor companies have fallen short of their cost of capital.
COMPARISON OF SEMICONDUCTOR COMPANIES' RATES OF RETURN WITH THEIR COST OF CAPITAL
If the Japanese semiconductor companies continue to accept rates of return lower than their cost of capital, competitive pressures could readily force U.S. semiconductor companies' rates of return below their cost of capital. If the investment community is led to believe that returns on new capital outlays will be less than adequate, U.S. semiconductor companies' share prices will be adversely affected and the industry's access to equity capital markets impaired.
Although the cost of capital of U.S. semiconductor companies would be markedly reduced if their leverage could be increased to that of the Japanese semiconductor industry, this reduction would still be inadequate to close the cost of capital gap. Furthermore, leverage of this magnitude would not be available from conventional banking or capital market sources in the United States.
An increase in leverage to approximately 67 percent debt-to-capital would enable the U.S. semiconductor industry to:
Increase debt on present equity base by approximately ninefold.
Raise capital at a lower cost, thereby allowing the industry to maintain technological leadership and to capitalize on additional investment opportunities in this fast developing and increasingly capital intensive industry.
Reduce the typical company's cost of capital from 17.5 to 12.7 percent and the larger companies' cost of capital from 15.2 to 11.1 percent. While reductions of this magnitude would be beneficial, the U.S. companies' cost of capital would still exceed materially the Japanese companies' cost of capital of approximately 9.3 percent.
Increase the spread between return on stockholders equity and the cost of equity capital, thereby facilitating the sale of equity capital if and when required. However, it is extremely unlikely that lenders would permit the U.S. semiconductor companies to increase their debt-to-capital ratios to anywhere near 67 percent. While specific companies within the industry could undoubtedly moderately exceed the 33 to 40 percent targets, it is unlikely they could do so on a sustained basis given the cyclicality of the industry and the moderate size of many of the companies.
In summary, the U.S. semiconductor industry is currently in a strong position as the result of its technological leadership, sound financial condition, and ability to earn an adequate rate of return on invested capital. However, the position of the U.S. semiconductor industry could be eroded by its shrinking share of the world market and its inability to raise capital as cheaply as Japanese competitors. Additionally, declining market share may adversely affect the U.S. companies' productivity and efficiency, thereby placing added pressure on profit margins and exacerbating the industry's ability to raise capital. A shrinkage in profit margins could threaten the viability of those companies within the industry that fail to earn their cost of capital over an extended period of time.
BIBLIOGRAPHY Comptroller General of the United States, United States-Japan Trade: Issues and Problems, Washington, D.C., September 21, 1979.
Finan, William F., The International Transfer of Semiconductor Technology through U.S.-Based Firms, University of Pennsylvania, 1975.
Haitani, Kanji, The Japanese Economic System, Lexington, Mass. Lexington Books, 1976.
Patrick, Hugh, and Rosovsky, Henry, Asia's New Giant, How the Japanese Economy Works, The Brookings Institution, Washington, D.C., 1976.
Suzuki, Yoshio, Money and Banking in Contemporary Japan, New Haven, Conn., Yale University Press, 1980.
United States Department of Commerce, Industry and Trade Administration, Office of Producer Goods, A Report on the U.S. Semiconductor Industry, Washington, D.C., September 1979.
United States International Trade Commission, Competitive Factors Influencing World Trade in Integrated Circuits, Washington, D.C., November 1979.
Mr. WILLET. We found first of all that the Japanese companies have an immediate financial advantage in that they are much larger than the U.S. companies, as you know. The average company engaged in semiconductor manufacturing in Japan has roughly $6 billion in sales which compares with an average level of sales of about $400 million for the typical U.S. semiconductor firms—$3 billion for the two large U.S. firms. In addition there are institutional differences and structural differences in the way the two economies function which allow the Japanese much higher use of relatively cheap debt financing in their capital structure.
Debt financing is cheaper than equity financing for the simple reason that interest payments on debt are tax deductible. To give you some idea of the magnitude of this advantage, the average company in Japan in semiconductors has a level of debt as a percentage of total assets of something like four times what the average U.S. company has. The effect of this is a much lower cost of capital for the Japanese companies relative to the U.S. companies.
To illustrate that I would like to turn to the graph, which is behind me, which looks at, on the vertical axis, the percentage rate of return or percentage cost of capital, and on the horizontal axis, the dollars of invested capital. The health of any business, and I think this point was borne out by Mr. Ingersoll's testimony this morning, is determined by the relationship of that company's rate of return relative to its cost of capital and the cost of capital in the competitive capital market is going to be determined largely by the level of inflation which determines the level of interest rates, the risk associated with the company's operation, and the composition of the capital structure between debt and equity.
Those two forms of capital have radically different costs. Not only the health of the business but also that business's ability to access the capital market in the future is largely determined by the relationship between the rate of return which we have plotted on the graph and the cost of capital. Now our findings from the study are that the average U.S. company engaged in the semiconductor business has a weighted average cost of debt and equity
capital of about 16 to 17 percent. To provide some perspective for that number, long-term Government bonds traded every day currently have a yield at maturity of about 11 percent which means investors in long-term government bonds can get an 11 percent return for what is effectively a riskless investment in the sense that there is no risk of default.
The risks of a high technology, rapidly growing business result in a cost of capital in the neighborhood of 17 percent in today's capital market. That number has not changed substantially in the last 3 to 5 years.
Correspondingly the Japanese companies, largely because of their much greater reliance on the relatively cheaper debt financing, have a cost of capital of approximately 9 to 10 percent, roughly half of the cost of capital of the U.S. companies.
Now the profitability position of the U.S. firms today is that they are earning rates of return which are just about equal to their cost of capital. The rate of return average for the past 3 years was approximately 17 percent for these companies. That is the rate of return that is really required given the risks of being in the semiconductor business.
Mr. JONES. Is that only the semiconductor industry you are talking about?
Mr. WILLETT. Yes, it is. Now the potential danger to this what we might call cost of capital gap between the U.S. firms and the Japanese firms is that it provides the Japanese with a competitive advantage with respect to access to capital. The ultimate impact of this competitive advantage might be to make it difficult for the U.S. firms to earn rates of return which are commensurate with the risk, and equal to, the cost of capital.
Typically, we find that firms that do not earn rates of return equal to the cost of capital find it more difficult to compete and find it more difficult to raise capital in the debt and equity markets to finance growth in the business. It is a particular problem for companies such as those in the semiconductor industry which do have larger requirements for funds because of the rapid growth of the business.
Just to summarize, I think that the rates of return and cost of capital for the semiconductor industry today indicate a business which in most respects is quite healthy. The potential problem is down the road in that the industry's position could be eroded if the Japanese are able to take advantage of much greater access to funds at lower cost.
Mr. SKORNIA. We see the choice here between lowering our cost of capital or increasing our rate of return. We think that consistent with the American free enterprise system that increasing the rate of return is the way to go and that some of the tax relief measures and other structural reforms which I previously indicated we support will help us to do that. It won't get us all the way; we will have another package of proposals to present to the next Congress.
We think that improving the tax and regulatory environment in which we exist is the tack that we want to take. I also want to reiterate that we are congenitally free traders, although we have been accused of being protectionists. One of the reasons for that accusation is that 3/2 years ago when we were founded we were