Solid State Technology - <center>January 2008 Exclusive Feature #2:<br>Revenue management key in the quest for better gross margins</center>

Many semiconductor companies are managed by professionals with technical backgrounds that believe prices can only fall and that the road to profitability heavily depends on reducing manufacturing and operational costs. While there are many proven strategies for reducing costs through faster design cycles and improving manufacturing efficiencies, fabless investments, and supply-chain efficiencies, most have reached the point of diminishing returns. Semiconductor CEOs and CFOs need to stop thinking of their organizations as manufacturers and adopt a seller's mentality in order to boost gross margin

With a natural tendency to view their company as a product manufacturer rather than a seller of the product they build, senior semiconductor and component manufacturing managers continue to focus much of their attention on reducing costs and improving efficiencies. Adopting a seller's mentality requires a significant shift in self-perception that many companies find extremely difficult to do.

As companies continue to under-invest in sales processes, support tools, and financial systems; their buyers, end customers, OEMs, distributors, manufacturing and stocking reps, and contract manufacturers have armed themselves with sophisticated global procurement systems designed to exploit any and every weakness in pricing policies and transactional processes. This dramatically increases pricing pressures and makes it difficult to manage margin throughout the revenue life cycle.

A late 2006 Yankee Group survey of 59 semiconductor and component manufacturing companies revealed that 85% of companies use the rudimentary functionality of ERP and/or legacy or homegrown systems to manage their revenue life cycle. Deploying such commodity or patchwork systems for critical business processes almost always results in significant price erosion.

Companies are finding themselves in a Catch-22; investing millions of dollars to reduce costs so that they can drop their prices further or saving 3% in cost so they can offer a 5% discount. A McKinsey Research survey of more than 2,000 companies has demonstrated that a 1% improvement to cost structure delivers a 4% increase in gross margin while a 1% improvement to pricing delivers an 11% increase in gross margin.

Pricing pressures and IP: debunking the myth
Some companies feel they are immune to pricing pressure thanks to highly proprietary product lines and or "sole-source" solutions. However, this is a false assumption. Pricing pressures are always present, whether they result from design target price commitments or competition. Based upon interactions with more than 50 semiconductor companies over the past two years, it is this author's experience that a quick sanity check helps assess whether price pressures exist and what their impact may be.

It is a simple fact that unless a company is winning 100% of the business it is bidding on, there is some business it is not winning. Lost business either was cancelled or won by another company. If the answer is the latter, then there is competition and pricing pressure is a factor.

Price erosion is not an immutable law
A big challenge for marketers and pricing managers in adopting a seller's mentality is internally communicating that price can be improved, which seems to contradict the common wisdom that price is always market driven. True, the laws of supply and demand do have an impact on price. However, price pressures are also driven by other players in the value chain that wish to increase their margins at the expense of their suppliers. This type of pressure can be better controlled.

What managers must internalize is that price improvement does not automatically equal price increase — it just means that prices don't have to drop so low, so quickly. Controlling this process has a material impact on margin.

Case Study: ON Semiconductor. Arizona-based ON Semiconductor is a $1.6B company that was spun-off from Motorola and taken public in the late 1990s. The company has a product line mix of 70% commodity and 30% proprietary. ON Semiconductor was experiencing difficulties in tracking demand, allocating resources to the most lucrative opportunities, and managing its pricing effectively. Often, pricing negotiations started from the lowest possible point. The company invested in processes and tools that allowed its sales and field application engineers to focus on qualified opportunities early in the sales cycle, increasing their design wins. At the same time, ON Semiconductor recognized that opportunities and design registrations are the gateway to transactions. Through its investment in the Model N Revenue Management suite, the company was able to increase quote-to-order conversion by 15% and reduce price erosion, resulting in an annual savings of more than $20 million.

By deploying an integrated revenue management solution, ON Semiconductor was able to focus its resources on better qualified opportunities and then transact effectively on those deals. The company's gross margin has more than doubled since it went public, going from 18% to more than 40% — no small achievement for a company with a product mix that leans toward commodity parts.

The nonlinear relationship between GM and market cap
Gross margin is a pivotal indicator of a semiconductor company's health and prospects. A recent analysis of 70 U.S.-based, publicly traded semiconductor and component manufacturers demonstrates that the market is clearly favoring companies with 40% gross margin and above, rewarding them with 4 to 8× multipliers on revenue to determine their market cap (Fig. 1). Companies operating below 40% gross margin are typically given 1 to 3× multipliers on their revenue.

Meeting or crossing this 40% demarcation has a direct impact on a company's ability to increase shareholder value. This phenomenon, in part, has been driving the wave of multibillion dollar semiconductor equity buy-outs engineered by private equity firms such as Bain Capital, Texas Pacific Group, and KKR. These firms are investing in these companies to improve their financials and no doubt will take them public again once they pass the 40% gross margin line.

As Table 1 below clearly demonstrates, there is a nonlinear relationship between gross margin and market cap. Even a small movement in 2-4% in gross margin in one direction or the other can move a company from having a 6× market cap multiplier to a 4× multiplier. Only companies that have been able to optimize costs and simultaneously manage their revenue life cycle have been able to drive margins higher and truly increase shareholder value.

Table 1 presents a comparison of two comparable companies with competing product lines selling into the same markets. Even though Company B has over $500M more in sales than Company A and operates in the same markets with competing products, its market cap is over $5B lower than its smaller competitor. This example reinforces the non-linear relationship between gross margin and market cap. While some of the issues plaguing Company B are related to cost structure, many revolve around revenue management processes, such as those described below.

No sales operations. Without a function designed to support and manage sales operations including process and tools, performance cannot be measured and improved.

No clear ownership over pricing. Without clear ownership over pricing, the result is regionally-driven pricing with no central control, guidance, and tools other than rudimentary ERP capabilities.

Manual design registration processes. If a company uses manual design registration processes, it makes it difficult for with suppliers to enforce margin agreements on transactions automatically, which leads to incorrect prices, longer cycles and unhappy distributors

Weak opportunity tracking. Inability to effectively understand where to focus resources and what opportunities across the channel are for the same end customer, leads to internal bidding wars costing hundreds of thousands per transaction.

Ineffectual global price management. Poor ability to consistently execute pricing globally and across all channels leads to price and margin erosion.

Manual quoting. Having no automated quoting processes negatively impacts quote-to-order conversions as well as the ability to tie quotes automatically back to opportunities and registrations. Without automated systems, there is limited visibility into where wins and losses are occurring, and why.

Weak POS (point-of-sale) and debit reconciliation. A combination of a partially manual process and partially homegrown solutions that are bolted onto the ERP system, which is not effectively capturing data inconsistencies, can lead to channel incentive overpayment and financial reporting issues.

Stuck in neutral: How to get out
Some companies that have enjoyed high margins (>60%) have been faced with a different, but related, challenge — they have stopped growing. Being stuck in neutral with little or no growth is a problem that affects companies of all sizes, ranging from <$100M up to $2B. Many of these stagnating companies have been able to build a successful and often profitable business mainly due to high quality and highly differentiated products. These companies are aware of the non-linear relationship between gross margin and market cap and have been concerned that if they attempt to grow through product line diversification, gross margins and subsequently, market cap, will suffer.

Companies that decide they must grow and maintain their margins have to take into account that as the business grows, so will transaction volume and channel complexity. Therefore, they must have processes and systems in place that will allow them to effectively protect margin on each transaction.

Common causes for margin and price erosion
The causes for margin and price erosion include impaired visibility into demand that leads to bidding wars across channels and regions, inconsistent price execution, high volume of special price requests, poor contract compliance and overpayment of channel incentives.

Visibility into demand. The global nature of the industry makes it extremely difficult for a manufacturer to track all opportunities and registrations across the globe and across all channels. Companies may find different regions competing against each other within the company or through different channels for the same business. Apart from reduced efficiency, the measurable impact of this internal competition is price erosion.

Inconsistent price execution. Pricing can be driven by different factors including volume, territory, direct contracts, market price programs, channel contracts, step pricing, future pricing, and margin agreements based on registrations. Without dedicated tools, it is virtually impossible to consistently resolve correct pricing for 100% of worldwide transactions.

High volume of special price requests. According to two independent surveys conducted in the last 12 months by Yankee Group and Accenture that covered close to 100 companies, at least 50-60% of all deals are done outside standard pricing guidelines through "special pricing" processes that prolong the quote cycle and/or introduce a huge workload on a small group of people. These processes make it almost impossible to consistently deliver optimized pricing designed to win the deal while protecting as much margin as possible.

Weak contract compliance tracking. In many cases, companies agree to give up-front discounts against future fulfillment of a high-volume deal. As much as 10-15% of a contract's value is never realized as customers don't always meet their commitments. Nevertheless, they get away with the discount, which represents pure value loss to the manufacturer.

Channel incentive overpayment. For companies conducting business through channels, reconciling POS with debits to manage channel credit claims and incentive payments is painstakingly manual. Since POS data, even if delivered via EDI or RosettaNet, often does not match up to the information the manufacturer has, manual adjudication is required, which prolongs the pay cycle for the channel partners and increases the risk of error. Several companies that hired third-party auditors found they typically overpay channels as much as 10%. The issue is further complicated for companies that recognize revenue based on POS data as inaccurate reconciliation data puts the integrity of their revenue statements into question.

Conclusion
An increasing number of forward-thinking CEOs and CFOs have made revenue management an integral part of their plans around growing their businesses more profitably. Close to 15% of the semiconductor and component manufacturing industry, including companies such as Microchip, ON Semiconductor, Micron, Linear Technology, PMC-Sierra, Cypress Semiconductor, and IDT, have already deployed the processes and systems required to manage their entire revenue life cycle in a holistic fashion. These innovative companies have, on average, experienced 2-3% in gross margin growth year after year while improving quote-to-order conversion by 10-15% and reducing risks related to financial reporting regulations. By the end of 2008, it is expected that 20-25% of semiconductor and component manufacturers in the U.S. will have made similar investments in revenue management to help set them apart from their competitors.

Chanan Greenberg has worked closely with more than 50 semiconductor companies over the past two years. Prior to his role at Model N, Chanan filled EVP and CEO positions for 12 years, selling technology solutions to high-tech OEMs and large defense and government contractors. He is the Senior Director of Business Development and Marketing in the High Tech division of Model N, 1800 Bridge Parkway, Redwood Shores, CA 94065; e-mail CGreenberg@modeln.com.

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