The Semiconductor Industry Desperately Needs to Go Private

With the announcement that Motorola (MOT) spinout Freescale Semiconductor (FSL) is being bought by private equity firms, the entire sector has rallied on hopes that any particular company will be the next to be taken private at a high premium. According to a recent Forbes article (that we found much more illuminating than most media stories):

The unexpected reports that Freescale might be a takeout candidate certainly benefited its current investors. Shares shot up 20% to $37 to start the week and are still holding those gains. The potential that other companies might also be targeted could result in similar pops. Intersil (ISIL) shares are up 13% to $26.25 since the week began.

Of course, we were quick to point out that those premium prices apply only when the price hasn’t already run up. By our logic, today’s Intersil buyer has already given 13% of the 20% premium to speculators.

But regardless of how much investors will gain from semiconductor consolidation, we believe the industry has a great deal to gain. The Forbes article also notes:

Chip companies’ cash piles are particularly attractive to private equity. It can help buyout firms pay off the debt that they take on to buy the company, and it’s also a prime reason why these target companies aren’t showing explosive growth or generating their market multiples of years past. If companies have a use for their cash they should put it into play, something that might be easier if they are not publicly traded and are out of the glare of investors focused exclusively on the short-term. With more flexibility, private companies can pursue other acquisitions and strategies that may not immediately add to earnings but will be beneficial only after several years.

“The willingness of sophisticated private market buyers to employ leverage in an industry where leverage has historically been a wretched idea is highly noteworthy–and likely to be of no small relevance to chip sector investors in the medium term,” wrote Arnie Berman, chief technology strategist for Cowen & Co. in a research note on Wednesday.

As we have noted frequently, semiconductor manufacturers are… well… manufacturing too many semiconductors. What’s worse, they continue to order equipment to manufacture even more semiconductors at a faster rate than the underlying demand can support. Although some companies are starting to get the hint (Intel said it would “avoid” $1 billion of new equipment purchases it had originally planned for next year) there are many who still don’t get it. Perhaps the only way to slap some sense into them is to buy their company and take away their cash hoard.

Again, Forbes gets to the heart of the matter:

“The problem here is that while the industry is gradually slowing down, the costs are not slowing down,” said Jim Tully, chief of semiconductor research at Gartner. “Something has got to give.”

Tully predicts that 350 of the roughly 1,000 companies making semiconductors will be either absorbed or disappear in the next ten years and that the number of companies able to build their own factories will fall by half.

For the sake of the industry, we hope so.

Comment on this article

Comments

[Amit Chokshi:]

Why not just have the semis pay out a massive cash dividend then or do their own leveraged recap rather than let a PE firm execute a buyout? ACS did that, they went to the leveraged loan market to do a big share repurchase.

I don't follow Freescale but I'd expect it has a good amount of capex and is highly cyclical, I have no idea why the PE firms would go after that company, I'm suspecting it's mostly because they actually believe in the "secular growth" in portable media and wireless consumer devices that FSL has a strong niche in. Plus they have more money than they know what to do with. A lot of LBO firms blew up from the 98-00 telecom deals they did, the same will probably happen again.

2006 Sep 19 05:16 PM

[William Trent:]

The semis won't pay out a massive cash dividend, or they already would have. The idea is that PE firms would come in and instill capital discipline. Yes, FSL is capital intensive. The PE firm can reduce Capex and use the additional cash flow to pay out more dividends. If they can consolidate several firms so the overall industry becomes more capital-rational, mission accomplished and they IPO them back.

I agree, though, that the LBO firms have more money than they know what to do with, and may likely not know what they are doing by going into something so capital-intensive and cyclical.

2006 Sep 19 05:23 PM

[Amit Chokshi:]

It's rare for a lot of companies to pay out massive cash dividends. The only one I know that really did an excellent job of it is FNF, they paid out $10 per share a year or so ago, and the stock adjusted ex dividend and then continued to ramp back up. If the right shareholders pressured the semis to do so, I'm sure they would have but I think most public shareholders are fine with status quo.

Also, how easy is it to reduce capex at FSL or other semis? Aren't these facilities multibillion dollar plants, I'm sure the maintenance capex is very high? Sure they don't need to build new plants but most semis don't do that until the top of chip cycles either way so I'm assuming (and maybe wrong) that a lot of that capex can't be shut off.

I think, having good familiarity with the LBO world from a prior life, that buying a cyclical business like semis is pretty risky for an LBO firm. You have massive fixed costs so when the cycle turns your cash flow will take a big hit, not to mention the capital intensive nature of the business. Oh well, these guys have billions so I'm pretty sure things will work out. As most LBO deals go, the PE firms are going to pay themselves an M&A fee up front which will prob be 0.5% to 1.0% of the deal so they're on their way to making money already.

2006 Sep 19 09:09 PM

[William Trent:]

Much of the capital could be replaced by increased reliance on the foundries. You don't want 3 companies building multi-billion dollar fabs when one will do. Instead, the three design firms should lease foundry capacity.

2006 Sep 19 10:31 PM