Can ST Become Fabless?

| About: STMicroelectronics NV (STM)

On Tuesday, Vijay Nagarajan completed his in-depth of analysis of STMicroelectronics  (NYSE:STM). I will review his analysis as well as STM’s recent financials in this post.

As per a recent iSuppli report, STM jumped from the fifth place to be the third largest wireless semiconductor supplier thanks to its design wins from Nokia (NYSE:NOK) and Ericsson. STM has about 5.1% of the $29.5 billion market. And with the recent joint venture with NXP, STM has strengthened its No.3 position. For an 80% stake in the joint venture [JV], STM will be paying NXP Semiconductor $1.55 billion. This JV equips STM to take on the convergence device movement.

Although STM’s wireless performance has been commendable, Vijay’s review of its 2007 financials shows that its overall semiconductor business is struggling to keep pace with the industry. Its gross margin in 2007 was 35.36% compared to the industry average of 50.5%. In the day of the fabless model, STM’s integrated device manufacturing model is holding it back from better profitability despite its restructuring plans.

Let us now review STM’s Q1 results that were reported on April 28. Revenue increased 9% to $2.5 billion, and excluding FMG, increased 11.6% to $2.2 billion led by growth in automotive, industrial and wireless segments. Net loss, which was affected significantly by the declining U.S. dollar, was $84 million or $0.09 per share versus net income of $74 million last year or $0.08 per share. Excluding restructuring and impairment charges, diluted EPS was $0.13 compared to $0.09 last year. Analysts estimated revenue of $2.52 billion and earnings of $0.18 per share.

In the quarter, it completed the spin off of its FMG into a new company, Numonyx and the acquisition of Genesis Microchip. Despite the negative impact of currency fluctuations, excluding FMG, the gross margin was 37.6%, up about 60-basis points from last year mainly due to improved product mix and volumes.

Segment-wise, Application Specific Product Groups [ASG] revenue grew 14.2% y-o-y and declined 8.4% q-o-q to $1.4 billion or 56.2% of net revenue. Industrial and Multisegment Sector [IMS] revenue grew 7.1% y-o-y and declined 8.7% q-o-q to $772 million or 31% of revenue. FMG accounting for 12% of revenue declined 7.4% y-o-y and 16.5% q-o-q.

Despite the economic uncertainty, STM expects revenue [excluding FMG] in Q2 to increase by 5% to 11% sequentially ,and 10% to 16% y-o-y. Q2 gross margin is expected to about 37%. It is currently trading around $13 as against Vijay’s valuation of $15. Its market cap is around $11.5 billion.

The big question that ST will have to wrestle with over the next few years, is whether or not to abandon its status as an IDM, and join the prevalent fabless manufacturing movement. This is not going to be an easy transition at all, given that in Europe, this sort of large-scale restructuring is very difficult to pull off due to labor law challenges. Manufacturing in Europe is somewhat of an anachronism, and remaining competitive with that structure is a proposition that is almost flawed by design.

On the other hand, if it wants to leapfrog competition as a manufacturing powerhouse, that would require investment that may not be within its current reach either.

Therefore, STM, the IDM, is caught in a bit of a no-man’s land. This is not a stock I would bet on, despite other attributes.

Chart for STMicroelectronics NV (<a href='' title='STMicroelectronics NV'>STM</a>)

Disclosure: None