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Merrill's Marriage of Inconvenience

By Bruce Einhorn As if New York Attorney General Eliot Spitzer's probes weren't enough, Merrill Lynch now finds itself in a bind with troubled Singapore chipmaker Chartered Semiconductor. Virtually overnight, Merrill has become a major shareholder in one of the weakest chipmakers in Asia, raising further questions about Chartered's long-term viability amid a rapidly changing environment for Asia's semiconductor industry.

Chartered tried to raise $620 million with a rights offering in early October, with Merrill as the lead underwriter. The offering got a tepid reception. No surprise there -- the government-backed Singapore-listed company, which has rarely turned a profit, has been a perennial No. 3 among Asian chipmakers. Chartered is a foundry, or made-to-order chipmaker, meaning it produces semiconductors not for itself but for companies that either don't have their own chip fabrication plants or do but want to cut costs by outsourcing some of their manufacturing.

Despite the latest woes in the chipmaking business, Chartered's longer-term strategy has merit. The foundry business is a promising industry, especially as the cost of a new, state-of-the-art chip fab soars beyond the billion-dollar mark. Many industry experts expect that foundries will be the fastest growing part of the chip industry in coming years.

FEW TAKERS. Chartered, however, may not be able to take advantage of that trend. The Singapore company trails its bigger Taiwanese rivals, Taiwan Semiconductor Manufacturing Co. and United Microelectronics Corp., in sales and technology. TSMC and UMC have already started production at cutting-edge fabs that produce wafers that are 12-inches in diameter, compared to the 8-inch ones that Chartered makes. The bigger wafers allow for more efficient production and will eventually lead to big savings for the Taiwanese chipmakers.

Chartered has been keen to close the gap, which may be why it decided to try to defy the brutal equity climate with its recent rights offering. But the U.S. investment bank found few takers for the Chartered shares. While a government-linked company bought a big stake, most other investors shunned the deal.

That left Merrill with no choice but to purchase most of the leftovers. The firm had made the unconventional promise to buy any shares that the public didn't snap up, agreeing to pay one Singapore dollar (about 55 U.S. cents) per share. People who follow the industry say Merrill now has to fork over as much as $250 million for those shares, leaving it with an 18% stake of Chartered. And selling that stake any time soon won't be easy.

SIGN OF DESPERATION. The chipmaker is looking on the bright side. "Chartered's strategy has always been to 'stay ahead of the curve' to ensure that we have maximum business flexibility and are able to respond to opportunities," Maggie Tan, a Chartered spokeswoman, wrote to me in an e-mail on Oct. 11. She declined to say what Chartered hopes will happen next with its new shareholder. "It is not appropriate for us to comment on behalf of our underwriter or to speculate as to what their intentions may or may not be with regard to these shares," she wrote. Merrill declined to comment.

However, its rivals have been happy to weigh in -- provided they can stay off-the-record. Predictably, competitors are shedding no tears. But not everybody is happy. The fact that Merrill was willing to agree to purchase the shares is "definitely a sign of how desperate things are" in the investment-banking business these days, says one banker in Hong Kong.

An executive at another competitor expressed puzzlement at the decision to proceed with the rights offering rather than a private placement. Given the poor business environment and Chartered's sluggish earnings record compared to its Taiwanese counterparts, a private placement might have been a better strategy, this executive says: "It's always going to be dangerous in a very public deal, having everything get out. If we had advised them, we would have encouraged the company to do something private. At least the process could have been done in a controlled way."

CHIPS GALORE. Where does all this leave Merrill and Chartered? With the U.S. firm now a big shareholder in the Singapore chipmaker, investors will likely watch and wait for Merrill to sell. Maybe the cash-rich Singapore government will decide it wants to relieve Merrill of its stake. Or maybe Merrill will elect to sit tight for a while, in the expectation that the foundry business can't get much worse and better times are ahead.

Still, with so many new foundries opening up in the region -- two in Malaysia and several more in China -- the competition is going to get only tougher for companies that aren't in the top tier. Chartered may have its work cut out trying to stay ahead of these up-and-coming rivals -- and that might make it even harder for Merrill to extricate itself. Einhorn covers technology from Hong Kong for BusinessWeek. Follow his weekly Online Asia column, only on BusinessWeek Online

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