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China is more of a competitive threat than it was during the last boom. When U.S. chipmakers saw their prices fall as much as 90% post-2000, they did the smart thing: They closed down plants and laid off workers. The old equipment didn't disappear; it resurfaced in China. At the moment the technology at most Chinese plants is two generations, or three to five years, behind that of the newest U.S. plants. That means the lines etched in the chips are 500 nanometers wide in much of China, 90 nanometers in the most advanced U.S. factories. But the Beijing government has great plans to leap forward. More than 400 semiconductor design centers have sprung up across China, according to Isuppli, and the technology gap will close significantly by next year. As it has done in other businesses, China has shown it can expand despite worries over profitability or intellectual property rights. Digital circuits are in fact easier to reverse-engineer than analog circuits, which are part art and part science.

If U.S. chipmakers aren't quaking yet, that's because it can take two years to reverse-engineer a technology with a six-month life span. Perhaps they should be more worried, especially if they have big overseas sales, as many do. One prescient exception is Intel, which already sees China as a threat, says Howard High, the company's strategic communications manager. Reason: 72% of Intel's sales come from overseas. Most of the growth is coming from Asia, particularly China.

Even with old technology, a huge new entrant in the chipmaking sector can wreak havoc with prices. Until 2000 most of the chips produced in China went into domestically produced goods, and China was relatively isolated from the international market. But by 2002 Chinese foundries (plants that take in outside work) started competing for international business. And not all of their capacity is old. China has 7 plants under construction that can accommodate equipment capable of handling 12-inch wafers (the plants must be built a certain way to do this). By next year it will have 11. Right now China has 4% of the world's manufacturing capacity in chips. By 2007 it will have 9%, says Isuppli, while the U.S. share shrinks by five percentage points to 13%.

Morris Chang, the founder and chief executive of Taiwan Semiconductor Manufacturing Co., or TSMC, the leader in chip foundry work, told a Silicon Valley conference this fall that the good times for chipmakers will slow in 2005--and China will be the main reason. Especially hurt will be makers of second-tier chips Rohm and Episil Technologies, and memory makers such as Infineon Technologies of Germany, Micron Technology of the U.S. and Elpida Memory of Japan. The Semiconductor Industry Association tempered its usually bullish forecasts with a prediction that revenues for memory chips next year could fall by as much as 10%, after leaping 35% this year.

You can find U.S. chip firms that are likely to survive the coming bloodbath. Intel, master of microprocessors, is one. At 45 times trailing 12-month earnings, Intel isn't cheap. And it hasn't triumphed across the board. The shares fell in early December after the company announced a writeoff in its fledgling telecom business. But Intel enjoys a Microsoft-like near-monopoly in its core market; it sells 83% of microprocessors used in PCs and 86% of those in laptops.

Despite challenges to its overseas market from China and price-cutting in the domestic market from Advanced Micro Devices, Intel boasts an operating margin of 29%. With $9.4 billion of cash on hand and next to no debt, it can afford to construct the efficient factories that will help it stay a step ahead of price erosion and develop premium products that command high prices. Most other chipmakers have slid into the red in recent years; Intel hasn't had a loss year since 1986.

Among gearmakers the leader is Applied Materials, with an expected $7.3 billion in sales for 2004. The new Asian factories alone will keep the company busy for awhile. Applied--a solid company but no great bargain--also sells equipment to make liquid crystal displays, an industry growing far faster than its silicon cousins. At 45 times the earnings expectation for 2004, Applied's shares already incorporate the good news.

A third survivor is TSMC. Its orders are record-breaking and its operating margin in the third quarter jumped from 21% in 2002 to 30% in 2003. Up just 35% over the past 52 weeks to $10, these American Depositary Receipts are somewhat overlooked--in comparison with U.S. chipmakers. At this price TSMC goes for 44 times trailing earnings and 19 times estimated.

If you want to speculate, buy a put option on the semiconductor HOLDRs trust, a derivative that mimics the benchmark Philadelphia Semiconductor Index. The HOLDRs (ticker: SMH) recently closed at $40. A May put with a strike of $37.50, near the spot price, will cost you $255, or 6.4% of the value of the underlying HOLDR. The put (SMHQU) trades on the Amex and four other exchanges.

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