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Mr. VANIK. With respect to the west coast semiconductor industry, consisting primarily of small merchant firms that complain about the huge size of the Japanese firms and access to capital, are there a number of small U.S. firms merging with large U.S. technology firms and are not these mergers and consolidations rather traditional in a new industry? In other words, isn't your problem more of a small business problem than a trade problem with Japan?
Mr. SKORNIA. Mr. Vanik, I think you are right that there is what I would describe as an implosion going on in the industry which to some extent is inevitable. I think it has been accelerated by the kinds of foreign competition we have seen recently and by other macroshifts like thé exchange rates and the rest of it. I think to some extent it is inevitable. I think it is nevertheless contrary to the spirit of the antitrust laws. More importantly I think it will inhibit the kinds of entrepreneurship and innovation we have had and which has put the American industry at the forefront of the semiconductor industry worldwide.
If you describe the semiconductor business as a small business phenomenon, at the moment my company is running at a $300 million annual sales rate. I describe that as medium size business. Free from the pressure to merge, a number of other competitors will continue to grow as we have been growing without the anticompetitive effects of acquisitions.
I would prefer to see the industry shake out that way rather than through a wave of mergers which we have seen only the first part of.
Mr. VANIK. There have been reports that the Japanese supply customers with very high quality chips. The SIA says the standard of quality set by the Japanese are unnecessarily high and are not cost effective. Still, that is a decision that ought to be made by the customer. What is the industry position on quality vis-a-vis the Japanese? Can you make the same quality product that the Japanese do?
Mr. SKORNIA. We are committed by the end of our current fiscal year, which is March 1981, to establish and to comply with quality standards which will make our quality second to none. At the risk of wearing out my welcome let me read a brief excerpt from the annual address of the chairman of Advanced Micro Devices at our annual meeting a week ago Tuesday in Austin, Tex., because we think this is in response to the Japanese quality issue:
Sanders said that there is a perception that the Japanese offer integrated circuits with quality generally superior to U.S. manufacturers. The American response has generally been that this is merely an alternative market entry vehicle to cutting prices. We believe this evades the issue. Advance Micro Devices entered the market in 1970 by offering quality superior to the industry level in that every AMD device was manufactured in accord with military standard 883. In short we offered the customer more value. To criticize the employment of a strategy by foreign competitors which was in fact our market strategy would be unworthy.
AMD is committed to offering quality second to none. By the end of the current fiscal year we will guarantee an outgoing quality level from our factories equal to or better than any manufacturer in the world today. We will set the international quality standard. A tremendous amount of effort and frankly a significant sum of money must be expended over the balance of the current fiscal year to attain these quality improvements. This new international quality standard coupled with our demonstrated innovative skill in new product and technology introduction should enable us to offer customers superior value compared to our competition.
We think that the issue of quality like one of price is strictly a matter of competition. If you cannot meet the competition, in price and quality, you are going to be out of business. If you do meet it or better it, he is going to be out of business. This is a competitive matter on a company by company basis. We are not even sure that the industry association has much place in commenting on it because it is a matter of survival on a company basis.
Mr. VANIK. In my visit with the Japanese buying mission in my city on Tuesday we saw a lot of processes that I thought could be handled with the use of robots but the American producers said that because of the small orders and the variety of orders that the robot system would not lend itself, unless there was a massive, substantial production that was involved. So they have to go to nonrobotized production in order to be flexible and be able to produce the smaller demands that were made in the orders that were coming. The question that I would like to propound: Are the Japanese moving ahead of us in controlled machines, robot-controlled machines because they have more quantity production and bigger orders or are they doing it for some other reason? Are they really ahead of us in that area?
Mr. Austin. I don't feel that the Japanese are ahead of us in any area of robotic technology. Admittedly they are using the devices to a larger extent which means that they are probably producing more. We have a number of topnotch manufacturers here in the United States that produce these devices and we are applying them throughout industry in various manufacturing systems in any area where they are a distinct advantage over the prior methods.
We have no lack of robotic capacity in this country. The robotics that are getting all the publicity over the last few years are somewhat more sophisticated than many of the devices that we used in prior years. We did not always call them robots. We called them pick and place units or something like that and they were designed to do the job that was called for.
Mr. VANIK. We have a lot more questions and I have more questions of Mr. Willet that I would like to mail to you, which will be included in this record, because I want to pursue some of the questions we have.
If other members have questions of the individual panelists, we will get those questions to you, so that they can be included in the record before we close. [The information follows:)
QUESTIONS POSED BY THE SUBCOMMITTEE AND RESPONSES OF MR. WILLETT
1. What do you mean by equity capital? Are you using current or historical cost of the plant and equipment, current replacement cost of plant and equipment, or values of equity outstanding minus debt? What has been the rate of return on equity capital under these three measures?
2. You use the average current yield on stocks as a measure of the minimum required return to keep equity capital in the industry—your “cost of equity financing.” Doesn't this obscure the importance of differences in expected rates of earnings growth in determining the attractiveness of alternative investments?
3. On page 2.3, your report states that “the tyical U.S. semiconductor company could increase its debt to capital ratio to about 33% without impairing its financial flexibility or incurring undue financial risk.” Why don't they, if it would be as beneficial as your report indicates?
4. Your report does not mention the effect of inflation on cost of capital and rate of return. Wasn't the Japanese rate of inflation much lower from 1977-79? Would that account for some of the differences in rate of return and cost of capital given in your report for U.S. and Japanese companies? How would differences in inflation rates in the U.S. and Japan affect the measures of the cost of capital and of the rate of return?
5. Your report compares the cost of capital on June 4, 1980 to the rate of return from 1977–79. On September 10 you wrote me that using a three-year average for the cost of capital would not affect the results.
Using figures in your report for the years 1977–79, the Committee staff has found that:
(a) for small U.S. semiconductor companies (called “typical” in your report), their cost of capital is higher than their rate of return;
(b) for large U.S. semiconductor companies, their cost of capital is much lower than their rate of return. Does this indicate that the smaller companies are less profitable or attractive than the large ones? Have the small companies been unable to borrow the capital they need? If so, how have they expanded so quickly over these years?
6. Haven't you inflated the cost of capital relative to the rate of return by picking a time when the “risk-free rate” was closed to an historic high? Why didn't you pick the rate on January 1, 1980 or some other date? Why June 4, 1980? How does it affect your results?
7. How did the difference between U.S. and Japanese risk-free interest rates on June 4, 1980 compare to the typical difference? If the difference was higher or lower than it normally is, how does that affect your results?
8. The figures for the 35 BBB-rated industrial companies on page 4.8 appear to come from Exhibit III, yet on page 4.8 they are listed as figures for 1977-79, while in Exhibit III they are “as of year-end 1978.” What are the correct periods?
The figure for Total Liabilities-TNW for the lower quartile companies are not the same on page 4.8 and in Exhibit III. What is the correct figure?
On the Table on the bottom of page 6.7 and for Table 7 on page 6.9, the figures also appear to be from Exhibit III, but the Table is a five-year average, while Exhibit III is for a three-year average. What are the correct years or figures?
Some of the figures in Exhibit III are for a three-year average. What are the three years? What are the dates or periods for the figures in Table 7?
If there have been mistakes, how do they affect the results? 9. Your report frequently compares the “Typical Japanese Semiconductor Firm” with the “Typical U.S. Semiconductor Firm.” Table 7 on page 6.9 is an example. The “Typical” Japanese grouping excludes the two companies with the smallest amount of semiconductor sales. The “Typical” U.S. grouping excludes the two companies with the largest amount of semiconductor sales. Thus, you are comparing the large diversified Japanese companies with the small specialized American companies. Doesn't this skew the results?
10. Why are the “Typical U.S. Semiconductor Firms” typical? For instance, they only account for about 30 percent of industry sales in 1978. The last paragraph on page 1.4 explains why they are a distinct group, but not why they are typical of the industry
11. What firms accounted for the other 40 percent of sales in 1978? Why aren't they included in your report?
1. Equity capital is defined simply as reported stockholder's equity, which is equal to total assets minus all liabilities. Therefore, equity capital is reported on a historical cost basis in accordance with generally accepted accounting principles. We did not attempt to estimate replacement cost of plant and equipment, and did not compute rates of return on equity capital under these measures.
2. Our “cost of equity financing” is not based on the average current yield on stocks. Instead, it is a measure of required return which uses a risk-free rate, a market risk premium, and a risk index, for estimating the required rate of return for a company or a group of companies. Since this number does not take into account differences in profitability among companies, it alone is not sufficient to place a value on the shares or to determine the attractiveness of an investment. It is precisely for this reason that we introduce in Chapter 3 and throughout the report the relationship between return on capital and cost of capital as the basis for assessing performance.
3. As stated in the report, we believe a capital structure of approximately 33 percent debt is prudent for the companies in the semiconductor industry. Although the U.S. companies, on average, have not reached this figure recently, individual companies have done so from time to time in the past; e.g., Advanced Micro Devices at 35 percent in 1976 and American Micro Devices at 45 percent in 1976. Additionally, both Intel, with its recent $150 million convertible issue, and National Semiconductor, have debt of approximately 25 percent of capital.
Historically, two factors have tended to keep leverage at low levels—the newness and relatively small size of most companies in the industry and the modest amount of capital needs. With increasing capital requirements for the industry, leverage will probably increase. However, each company's management must determine its own leverage policy. While we believe generally that increases in leverage are beneficial, such decisions must be made by the individual companies involved.
4. As shown below, the Japanese inflation rate was higher than the U.S. rate for 1977 and lower for 1978 and 1979:
These differences in the inflation rate between the U.S. and Japan could account for some of the differences in rate of return and cost of capital between U.S. and Japanese companies. For this reason, on page 7.7 of the report, we present the translation into U.S. dollars of the yen costs of capital for the Japanese. For the six Japanese companies, doing so increases the cost of capital by eight tenths of one percentage point, as of June 1980.
5. While the reading of the numbers by the committee staff is correct, my interpretation of the results is slightly different:
For the typical U.S. semiconductor company, profitability from 1977-1979 was just about equal to the cost of capital and superior to the returns of the larger companies. However, because of the low risk of the larger, more diversified U.S. firms, their costs of capital are lower and returns have therefore exceeded the cost of capital. I would not intepret these results to mean that the smaller companies are in some sense “less attractive” than the larger companies, and to my knowledge, none of these companies has had problems raising capital in the recent past.
6. The cost of capital was measured as of June 4. 1980, because that was the approximate date of the report's publication. In the body of the report (pages 5.8, 5.9 and 7.1) we have presented costs of capital for U.S. and Japanese firms from 1975 to 1979. The average cost of capital for this five-year peirod is in fact higher for our sample than at June 4, 1980.
Furthermore, while the risk-free rate of 10.2 percent at June 4, 1980 may seem high at historical standards, I should point out that the corresponding rate was 10.1 percent at year-end 1979 and exceeded 12 percent during the second quarter of 1980. Presently, September 23, the risk free rate is 11.5 percent.
7. The U.S. and Japanese risk-free rates from 1975-1980 are shown below:
(a) On page 4.8 the three-year averages 1977-1979 refer to the nine U.S. seimconductor companies while the data for the 35 Triple B-Rated companies is as of yearend 1978 (Exhibit III), our latest survey available at the time of our study.
(b) The figure for Total Liabilities/Tangible Net Worth for the lower quartile Triple B companies is 1.5 on both page 4.8 and in Exhibit III.
(c) The numbers for the Japanese and U.S., semiconductor companies on pages 6.7 and 6.9 are for the periods indicated for the respective ratios. Again, the data for the Triple-B survey is as of year-end 1978. Those figures in Exhibit III identified as three-year averages are ratios which have earnings in the calculation and the averages cover the period 1976–1978. (We have found that over the years the data for all rated industrial companies does not change materially and, as a result, the 1978 survey accurately reflects the period under review.)
9. Although we examined six Japanese companies, our analysis focused primarily on the four companies which published financial statements in accordance with U.S. generally accepted accounted principles (see page 6.1). The data for the Japanese firms in Table 7 on page 6.9 are. for these four companies. The choice was determined by availability of information, not on the level of semiconductor sales. The "typical” U.S. company was used in this table in order to compare the Japanese companies to the American firms which have a majority of their business in semiconductors.
10. The word "typical” was used to describe those seven companies for which semiconductors accounted for a majority of their total sales. Nothing further should be read into its meaning.
11. There were over 40 companies which accounted for the remaining 40 percent of U.S. semiconductor sales (source: Dataquest, Inc.) They consisted of relatively small, independent companies as well as in-house semiconductor operations of large companies whose primary businesses are not semiconductors. These companies were not included in our sample either because detailed financial information was not available, sales were made in-house and not at arms-length transactions or the firms were too small to make their results statistically meaningful.
Mr. VANIK. I would like to announce plans by the subcommittee to hold a hearing in California on October 14 on the issue of the quality of production and American industrial competitiveness. This hearing will concentrate on the status of a GAO report being done for the subcommittee on the operation of certain Japaneseowned plants in the United States and the ability of these plants to use American workers to produce high-quality products.
In many cases the products of these plants are better than those made in plants of the same company in Japan, or better than the same products previously made in the same plant under American managers. The phenomena of very high quality production under foreign ownership may point to some important lessons for American management and labor.
Our hearing will explore these issues. Persons who are interested in testifying should contact the subcommittee. A normal press release will be issued soon.
Because of the unique nature of this hearing, I ask unanimous consent that certain foreign nationals be permitted to testify at this one hearing. Hearing no objection, I will go forward with the invitations in that regard.
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