Spansion: Trouble on the Balance Sheet

After recently receiving a recommendation from a friend to buy into memory chip maker Qimonda AG (QI), I began doing a survey of many of the companies in the industry. It seems like there are certain industries that I am able to gain a very good understanding of in a short time, and other industries that I struggle to learn.

Semiconductors fit into the latter category, but I do know how to analyze cost and business structures, so I examined Spansion (SPSN) mostly from that perspective and will possibly take a look at some of the other semiconductor stocks in upcoming blogs.

It doesn’t take a market guru to tell you that SPSN’s recent performance has been weak. They lost 85 cents per share in Q1 of 2008 (see conference call transcript) and 63 cents per share in Q2 (see conference call transcript), meaning that FY 2008 is shaping up to be even worse than already bad FY 2007, when they lost roughly $1.90/share for the year.

Their margins are poor, but not completely terrible by industry standards; they had a 17.8% gross margin and a -12.6% operating margin (still better than some others I've seen). All the same, you can’t stay in business if you are losing money --- unless of course, you can outsurvive similarly situated competitors. Looking at SPSN’s situation, I’d surmise they would need to see prices rise to a level high enough so that they could achieve 30% operating margins before they could actually begin churning out any significant GAAP income. From their current revenue figures, I'd estimate that they would need to see around a 15% increase in prices to achieve that. Mind you, this would not necessarily put them in good shape; it should merely get them near a break-even point. That info alone suggests to me that this company might have some rough tredding ahead.

Spansion is also not helped by the fact that they have high R&D expenses and those expenses seem absolutely critical for their long-term survival. R&D has eaten up about 17-20% of revenues in recent times. Another interesting observation I take away from the income statement is that any time SPSN churns out higher revenues, they seem to have lower margins, emphasizing the inherent problem in the industry where continual oversupply is harming all the players in this sector.

One particularly noteworthy part of SPSN’s income statement that many might neglect to analyze is their “Interest Expense.” In fact, the trend of higher and higher interest expense (compared to interest and other income) really caught my eye! In Q3 of 2006, SPSN had interest income of 3.9 Million and expense of 13 Million, giving them a net expense of roughly $9 Million. By Q2 of 2008, they only brought in 2.5 Million in other income and had nearly $28 Million worth of interest expense, giving them a net expense of roughly $25 Million! That seems like a rather dramatic increase for a company that has not grown its revenues. In Q2, the net interest expense constituted roughly 4.5% of revenues, compared to 1.9% in Q3 of 2006. In other words, the longer they continue to incur huge losses, the more difficult it becomes to return to profitability because debt increasingly eats away at their earnings. On the bright side, they probably won’t have to pay taxes for awhile given how many tax benefits they’ve accumulated!

If the income statement looks bad, the balance sheet looks much, much worse! There are a few metrics I use to try to assess a company’s finances. First off, let’s look at Current Assets over Current Liabilities. I have analyzed four different quarters in order to try to understand the trends:

• Q4 – 2006: 2.57
• Q2 – 2007: 1.78
• Q4 – 2007: 1.69
• Q2 – 2008: 1.28

I find CA/CL to be an interesting metric, but taken by itself, it’s only so useful. All the same, we see a dramatic decrease over our 6 quarter time frame. Next, we look at a metric I have created called “Liquid” over Current Liabilities. “Liquid” is my term for current assets that could potentially be used to pay the bills, namely “cash and equivalents”, “marketable securities”, and “accounts receivable”; add the three together and you get what I will clumsily refer to as “Liquid”. The results of this metric are even more disturbing:

• Q4 – 2006: 1.86
• Q2 – 2007: 0.99
• Q4 – 2007: 0.92
• Q2 – 2008: 0.65

Our ending figure is only about a third of our beginning figure, which is scary. Of course, this metric can be flawed if a company is raking in high cash flows from operations. Indeed, SPSN has been making positive cash flows even if they have negative GAAP income. Based on this, we use another H.J. Huney specialty metric --- I take “Liquid” + Cash Flows from Operations and divide it by Current Liabilities. Unfortunately, SPSN does not include a complete cash flow statement in the quarterly reports available on their website for some strange reason. Therefore, I have to dig through the SEC filings. I cut out Q2 for 2007 and had to estimate for both the Q4's since the cash flow figures on the 10-K pertain to the yearly results. Based on this, I come up with the following info for (Liquid + CFO)/CL:

• Q4 - 2006 (est): 2.01
• Q4 - 2007 (est): 0.98
• Q2 - 2008 (act): 0.70

That’s a rather huge drop! I would think that any figure under 1.0 could be problematic, but it dips all the down to 0.7 for the latest quarter! More frightening to me is how quickly it is dropping! It suddenly makes a lot of sense as to why their "interest income" is increasing so rapidly!

While we’re discussing this whole liquidity issue, it might be worthwhile to mention that while the “cash and equivalents” number for SPSN has increased slightly over the past few quarters, the “marketable securities” number has dropped dramatically, so either SPSN is getting absolutely destroyed in the market or they're dipping into that stash to help stay alive. The bad news is that this is a company with a $4 Billion value and they only have $100 million worth of marketable securities left. Keep in mind that they lost $100 million in the last quarter.

Some have argued that despite the shortcomings of SPSN as a company, their assets alone justify the current price. That might be true. They are trading under $2.50/share right now and I came up with a book value of $9.7. Once you factor in that they seem to be losing about $2-$3/share per year, that certainly makes that look less attractive, but still a potentially attractive buy for a competitor. In fact, despite the bleak picture I paint for the company, that is one of the main reasons I would be afraid to short this or pick it to underperform.

I have a few more thoughts on this stock. I’ve done a bit of research into both the flash memory makers and DRAM, and one thing I’ve concluded that is even if I don’t completely understand the trends, it seems like no one else does either. Even those with great expertise in the memory sector seem to have heated disagreements about what the future may bring. There is no consensus at all if and when pricing will improve. That said, it’s fair to say that if you believe there is a positive trend in the pricing of flash memory right around the corner and believe Spansion has a competitive advantage in the industry that can utilized in a short period of time (i.e. about a year or so), then perhaps you look at this as an opportunity to buy a good company at a very discounted price since the overall market has fears about this company’s ability to produce a profit or even survive.

As for me, I’m staying away from this one (both long and short) for reasons mentioned above, but if I had to bet, I’d bet against it due to a poor record of performance, a weak balance sheet, and no real indication that the market for flash memory will dramatically improve in the very near-term. Sure, it’s possible that this thing has bottomed out and is ready to turn the corner with an upswing in prices, but it’s also entirely possible that the worst is yet to come. In fact, the latter seems much more likely.

Disclosure: none

Comments

[User 234787:]

Fantastic article! Well written in understandable terms. My wife works within they semiconductor / memory sector. I have been reading, learning, following trends, company growth, etc. for ten years. You missed one interesting point: “Behind the scenes“ during the most problematic times many tax breaks are provided by local economies/gov. in utilities and water, expansion plans, re-tooling, operation costs, etc. Monies are also pouring in from overseas whereas foreign gov. has been most generous with Euros‘.
No one wants to see these companies collapse, or layoffs. We need the jobs. The forth quarter of 2009 will be bottom. Good job on the article.

2008 Jul 30 12:02 PM

[armstp:]

You miss the entire story... the company just spend $1.8 bn on a new mftg plant in Japan.... the result has been higher leverage, weaker margins and cashflows... the plant puts the company head and shoulders above the competition from a cost base perspective... the spending has now stopped and the company is improving financial results and credit metrics as it ramps up production on that new plant... just looking at the numbers during the last two years while it was building this plant is not 100% fair... you have to look at the numbers on a more normalized basis....

2008 Jul 30 06:45 PM

[H.J. Huneycutt:]

The margins have progressively gotten worse and need very significant improvement before this company can do much of anything. Do you think their gross margin is going to improve 20-30% in the next year or two? Even if the margins do improve to that level, can they sustain those margins over a significant period of time? How much longer can they sustain themselves via debt financing? As it is, they're losing a substantial amount of money each quarter and with every loss, they incur higher interest expense, thus making it more difficult to be profitable in the future and hence requiring even higher margins.

I'm not saying you're wrong. I even left room for that possibility at the end of this article. If you're correct, then maybe this is a great beaten-down investment to hop aboard. I only know so much about the industry and don't feel as if I can predict future trends in a year or two. However, I do know those future trends have to be fairly dramatic to make SPSN a worthwhile long-term investment (barring a takeover). And I'm not so sure they are better positioned than competitors with more flexibility.

Right now, the entire memory sector looks like a war of attrition between several companies and it's not a war that I'm overly confident Spansion is well-position to win that war.

2008 Jul 30 08:02 PM

[H.J. Huneycutt:]

Another thing to think about: right now analyst estimates for FY 2009 range from a loss of $1.70 to 0.60/share. Analysts are, of course, wrong sometimes, but when a company has as poor of a balance sheet as SPSN and even the most optimistic of analysts believes they will continue seeing loses for at least another 12-18 months, that doesn't exactly scream out "BUY BUY BUY" to me. Sure, they'll have some cash flows and that will certainly help, but will it be enough? Are they going to go to 65-70% debt, have a few profitable quarters and then need to "upgrade" again in order to compete? Given the history of the industry, that would not seem like a bad prognostication.

2008 Jul 30 08:16 PM

[Jobu37:]

Spansion has potentially hit bottom in regards to overall cashflow due to the afore mentioned new plant builit in Japan. And as the author mentioned they have consistently been cash flow positive operationally throughout this downturn. The new plant along with less pricing pressure in the market due to the consolidation of Intel's NOR business with another competitor will lead to the higher margins.
Besides at these prices this stock is a perfect speculative play due to the fact that they have already provided a roadmap to undercut the entire DRAM industry on price and performance. This is a market they are not currently in and it is many times larger than either the NAND or NOR markets they currently compete in. They have vast upside potential.

2008 Jul 31 01:40 PM

[Rock Johny:]

great points Jobu, i'm wondering if IBM has included Spansions' EcoRAM on their new 'green' servers they're advertising now. IBM took a $5mn Equity stake in SPSN in liew of payment with another $10mn due IBM in a couple years.......but for what. I don't think it's really been made clear. It was a 'patent cross-license agreement' but what technology was shared? At least it does prove they're in cahootz on something.

2008 Sep 02 05:13 AM

[Jobu37:]

It is my understanding that their mirrorbit technology is much more efficient than the floating gate technology that all of it's competitors use. And since their new plant will start producing chips at much smaller nanometers they appear set to increase margins beginning in the next quarter or so. The fact that IBM sees positive attributes in this company certainly implies that SPSN has a strong future. One would think that IBM knows more about the technical side of this company than any of us. RockJohny, you have a good theory on the eco-ram tie up with IBM. I was thinking that eco-ram was further down the road but if I recall correctly it was contingent on getting production down to 45 nanometers and it appears with the new plant in production that SPSN may be further along than even I had anticipated.

2008 Sep 02 11:43 AM