FROM A MARKET GROWTH perspective, Europe has come up short. Last year, the European semiconductor market was worth $40 billion, up 1.7 percent, whereas the world market grew 8.2 percent, according to U.K.-based semiconductor research firm Future Horizons. In 2006, Europe is expected to grow 17.9 percent, whereas the U.S. market is forecast to grow 21 percent and Asia 28 percent. The world chip market is expected to grow 20 percent, to $293 billion, according to Future Horizons.

Future Horizons, which has a track record of fairly accurate market predictions, has issued the most optimistic forecast among research firms. CEO Malcolm Penn argues that the three key variables for the worldwide semiconductor industry—the economy, unit demand and wafer fab capacity—have aligned to drive growth.

Worldwide capital expenditures are expected to see a 30 percent increase over those of 2005. According to Penn, vigorous, late-second-half spending will occur when companies realize that they are out of capacity. "It takes two quarters for equipment to come onstream," he says. "That's why this year will remain strong—companies haven't spent the money. Providing that the economy holds up, capacity will get tighter."

Deutsche Bank has issued more-modest predictions, forecasting an increase in semiconductor industry capex of 2.3 percent, to $48.4 billion in 2006. Three-hundred-millimeter capacity additions are projected to increase 1 percent in 2006—memory making up half of that—with 31 projects slated for start, expansion or upgrade.

Deutsche Bank forecasts global chip market growth at 11 to 13 percent. Europe's three chip makers—STMicroelectronics, Philips Semiconductor and Infineon Technologies—will converge around the lower end of this range, according to Nicolas Gaudois, director of semiconductor equity research at Deutsche Bank.

Europe's semiconductor companies are in the throes of fundamental change. STMicroelectronics last year changed CEOs and is busy reinventing itself to fit the realities of a consumer-oriented semiconductor industry, analysts say. "With the number of new-product launches, the realigned company should be coming close to the industry growth rate," Gaudois says. "In general, STMicro and Philips Semi underperformed industry growth for the past four years."

STMicro also hopes to benefit from its three-year-old NAND flash memory tie-up with Hynix Semiconductor. "STMicro will use these NANDs for stacked memories and will address the same market for NOR flash: wireless," Gaudois says. "From a technology standpoint, STMicro should also benefit from the fact that Hynix is going after the mass market on the side."

According to IC Insights, the joint venture, called Hynix ST Semiconductors, may pose a threat to Toshiba for the No. 2 NAND flash memory position in 2006.

Analysts previously questioned STMicro's concentration on key customer Nokia, which accounted for 17 percent of the chip maker's revenue in 2004. That has increased to 24 percent, Gaudois says. However, STMicro's revenues from Nokia are up 30 percent year-over-year, whereas the rest of the business is flat, according to Gaudois. "They've increased content at Nokia but also grown with the handset maker."

Philips Semiconductor (which specializes in making chips used in cell phones, TVs, autos and RFID) announced plans to split from parent company Philips Electronics. The idea is to get large. It has several options, including merging, being acquired, acquiring other businesses or launching an IPO. "Philips will be in better shape to look at M&A, particularly on the manufacturing side," Gaudois says. "Independence from the group is a good thing, but ties will remain for some time, because IP at the source is generated by the Philips group."

Europe's other chip maker, Infineon, is in a more difficult situation. After reporting a $376 million net loss for FY2005, management announced the spin-off of its memory division into a separate entity called Qimonda. "It came to terms with the fact that the logic business and the DRAM business have very few synergies with each other," Gaudois says.

Memory products contributed 44.4 percent of Infineon's FY2005 revenues. The remainder of the company will supply logic and system chips and will increase use of foundries, pursuing a fab-lite strategy.

The memory division, given a good flying wind, is expected to thrive. "The other part will have a tremendous set of problems," Future Horizons' Penn says. "If Infineon splits, it will drop out of the top 10 and be a second-tier player in a mishmash of other markets, apart from smart cards [where it is a leader]."

Moreover, the remaining part of Infineon will focus on the industrial, automotive and communications markets. Because it doesn't play in the consumer market space, which is widely considered to be the growth market, it is condemned to lose market share, he adds.

Jean-Philippe Dauvin, chief economist at STMicroelectronics, believes that the global chip market will be up 8 percent whereas Europe will grow by 2 percent. Europe's chip market drivers will be automotive electronics, communications and base stations. "These are soft drivers," Dauvin says. "Europe is moving—not very fast, but moving. We are ahead of Japan."

One strong industry sector in Europe has been automotive. Europe is leading the world in automotive electronics all the way down the chain. The center of excellence is in Germany, led by the firm Robert Bosch in Stuttgart. But automotive won't take Europe far in the near term. The sector, close to $16 billion in 2005, accounts for a mere 7 percent of the overall semiconductor market, according to research firm Strategy Analytics. Europe holds little more than one third of that 7 percent. Moreover, sluggish vehicle sales could slow the automotive electronics market in 2006.

A swing factor for Europe is economic recovery in Germany and France. In 2005, Germany, Europe's largest economy, recorded an unemployment rate of 12.6 percent, its highest since World War II. France has seen a spate of protests and strikes due to attempted modernization of its economy. Dauvin calculates that these two engines need 2.5 percent GDP growth on average in order to register upward movement in the overall electronics market in Europe. However, Germany and France are expected to show GDP growth of only 1.8 percent and 2.1 percent, respectively, according to the Organization for Economic Cooperation and Development (OECD).

On the end product side, the picture is a bit brighter. Consumer electronics and information and communications technology (ICT) are showing clear growth, despite the slowdown in Europe's largest economies.

Europe's total consumer electronics market in 2005 was $65.7 billion, up a record 10 percent, according to the European Information Technology Observatory (EITO), in Frankfurt. In 2006, the market is expected to grow 7.2 percent, to $70.4 billion, according to the EITO. Growth is strong but concentrated in a few sectors: flat TVs (both LCD and plasma, as digital television rapidly replaces traditional TV), MP3 players, DVD players and game consoles.

In ICT spending, Europe leads the world (see chart ), accounting for more than one third. The ICT market, slated to grow 3.2 percent, to $816 billion, in 2006, serves as a benchmark for Europe's market health. "You cannot separate ICT any longer from other industries, because it has a lot of impact on other areas," says Carola Peter, EITO's managing director.

IT security, regulatory compliance that involves business infrastructure upgrading, the shift from the desktop to a mobile environment and e-government have all been growth drivers for ICT.

The countries that entered the EU in 2004 are showing the highest ICT growth as they continue to upgrade their IT and telecom frameworks. "There's still a boom going on there," Peter says. "The markets are not saturated, and they have higher demand in more basic areas." However, ICT market growth is expected to decline until 2007, when it will reach 2.9 percent growth.

Perhaps Europe's biggest opportunity lies in the accelerated growth of broadband penetration, both wireline and wireless. Europe's broadband buildout is the most robust in the world, according to the EITO. The compound annual growth rate (CAGR) is 29 percent from 2004 to 2008, compared to 16.6 percent in the United States and 8.1 percent in Japan.

The contract manufacturing landscape underscores the continuing shift of production from West to East. High-volume manufacturing seems to be reviving on Europe's periphery, away from the comparatively high taxes and labor costs in the West, according to Scotland-based MHM Business Development Services.

Michael Hannon, MHM consultant, says the Western Ukraine area, including Romania and Bulgaria—both expected to enter the EU in 2007—are pulling in production. Flextronics runs a plant in Western Ukraine, and Foxconn is rumored to be looking there, he says. Celestica followed Solectron into Romania. In Bulgaria, Videoton and Epiq are running plants. "Eastern Europe is giving China a run for its money," Hannon says.

MHM sees a three-tier Europe evolving, with R&D and high-mix/blow-volume in the West and low-cost assembly work in the East. Central Europe—Hungary, the Czech Republic and Poland—sits between the two regions and may act as a systems integration center.

Semiconductor manufacturing is another issue altogether. Future Horizons' Penn says Europe's share of the world market has been eroding. Europe represented 17.4 percent of worldwide market share in 2005; 17.1 percent is expected in 2006 and 16.9 percent in 2007, he says.

Europe's population grew 20 percent, to about 450 million, when the Union added 10 new countries in 2004. The raw measure of a larger population would make Europe appear to be increasing its semiconductor market share. However, the far more accurate per-capita figures are unknown. "Even if Europe's growth looks good on its face, Europe is actually showing declining share," Penn says.

His position reflects a debate in Europe about the direction of its semiconductor industry.

Europe imports more chips than it produces, according to the European Semiconductor Industry Association (ESIA) in Brussels. Europe's chip market is close to 20 percent of the world market, but semiconductor production is 12 percent of the world's wafer fab capacity.

The ESIA's concern is that Europe will host fewer wafer fabs than other world regions, resulting in diminished potential for semiconductor innovation, according to Hans-Friedrich Buhner, senior director of relations management at Infineon and chairman of a task force that wrote a competitiveness report. He argues that R&D is tightly connected to the leading-edge process technologies in the fab.

Yet Europe attracts less than 10 percent of capacity investments worldwide, he says. A fab in China, Korea or Malaysia will generate net income 220 percent higher over a given period than the same fab in Germany, with little difference across European countries, according to the report. The main difference is that Asia has attractive investment incentives that Europe lacks.

The conventional wisdom that as long as the intellectual property stays in Europe, the flight of manufacturing is tolerable is mistaken, sources say. "IP goes where the product is, if for no other reason than shortened design cycles," Penn says. "Chinese and Indian talent is just as good as European talent, and it is only a matter of time before R&D goes there. Then what is Europe left with? Theoretical scientists and philosophers?"

Deutsche Bank's Gaudois disagrees, adding that system and process design can remain separate without sapping Europe's innovation. "The real issue for European companies is whether they retain the market presence and relationships they need in order to drive innovation and hold margins in the long run," Gaudois says. "For many of them, the answer is to use fabs in Asia to avoid the cost issue in Europe or to go fab-lite."

STMicro's Dauvin also believes that Europe is not in danger of losing some vital strengths and becoming a follower in semiconductors. He asserts that it has held a leading position in dedicated (that is, non-DRAM) ICs over the past five years and that this is not under threat. Dauvin argues that all regions have seen a shift of chip manufacturing to Asia while the global chip industry's annual growth has dramatically slowed. His calculations show that, on average, the market grew 14 percent annually from 1995 to 2005. Going forward, he puts the best-case scenario for annual growth over the next 10 years at 8.5 percent.

The semiconductor business is also becoming more consumer-oriented, increasing price pressure throughout the supply chain and shaking up traditional models.

Drew Wilson is a freelance writer based in Berlin.