A Powerful Chip Off the Old Block?
By Thomas W. Smith, CFA
Few things could excite semiconductor investors and analysts more than the prospect of a new, large, American pure play in the market. And it looks like they'll get one with Motorola's Oct. 6 announcement of its intention to spin-off its Semiconductor Products Sector (SPS) division.
Motorola (MOT, ranked 3 STARS, or hold, by Standard & Poor's), announced few details about the spin-off, dodging for the moment questions about timing, whether it would occur all at once or bit by bit, and how much of the parent's debt would be foisted upon the offspring. These are all critical issues, judging by Lucent's (LU; 2 STARS, or avoid) rough-and-tumble experience spinning off its semiconductor operations into Agere Systems (AGR.A ).
As Agere's spin-off date was delayed, its potential offering price slid lower. Its shares were eventually sold in April, 2001, and distributed to Lucent shareholders in stages. The inherited debt from Lucent -- roughly $2.5 billion -- put the newborn Agere at a considerable disadvantage to its peers, in our view.
However, we think Motorola's timing is much better than that of the Lucent-Agere deal, which occurred as the semiconductor industry was near the lowest point of the sharpest downturn ever. Investors certainly like the news: Motorola shares have climbed 12%, to roughly $13.80, since it revealed the plan.
Here's what's known so far: Motorola is considering an initial public offering of part of SPS, followed by a distribution of the remaining stake to shareholders in a tax-free manner (subject to Motorola board approval, favorable market conditions, and customary regulatory approvals). Motorola told analysts on a conference call that the rest of the details will be in the yet-to-be-released S-1 filing that will officially describe the transaction.
Outgoing Motorola Chairman and CEO Christopher Galvin did say the independent SPS operations would have its own focused strategy, pursue acquisitions, and be valued at "semiconductor-equity valuations instead of the blended-equity valuation of Motorola." Presumably, the valuations on a stand-alone chipmaker would be higher than those of a conglomerate telecommunications equipment outfit, but we at S&P think the figure would vary significantly depending on how much debt Motorola transfers to the spin-off.
CHEAP CHIP STOCK.
Motorola trades at about 1.3 times trailing 12-month sales, vs. 1.5 times and higher for chipmakers. The two American chipmakers larger than Motorola are Intel (INTC; 5 STARS, or buy), which trades at almost 7.2 times sales, and Texas Instruments (TXN; 5 STARS), which trades near 4.8 times sales. We think Texas Instruments is the better comparison for Motorola's chip business, since they both focus on chips for wireless-phone handsets.
Agere Systems trades at around 2.9 times sales. Microchip Technology (MCHP; 5 STARS), which we think is doing well in its narrowly focused quest to overtake Motorola in market share in so-called 8-bit microcontrollers, trades near 8.2 times sales.
At the lower end of the valuation spectrum for chipmakers are outfits such as Fairchild Semiconductor (FCS; 4 STARS, or accumulate) and Vishay Intertechnology (VSH; 5 STARS), which change hands at about 1.6 times sales. Semiconductor makers sporting price-to-sales ratios at the high end are Linear Technology (LLTC; 4 STARS), at 20.6, and Maxim Integrated Products (MXIM; 4 STARS), at 12.4.
POTENTIAL FOR GAINS.
S&P thinks it's reasonable for the independent Motorola semiconductor business to trade near 2 to 3 times sales in its early years. After adding and shedding operations to reshape the company, we believe its valuation would eventually change to reflect the type of chips it makes (commodity or proprietary, low-margin or high-margin), its ability to execute its plans, and its debt position.
Motorola SPS makes a broad line of chips for wireless, networking, automotive, and other markets. Offerings include network and communications processors, digital signal processors, microcontrollers, memories, radio frequency chips, analog chips, and sensors.
According to researcher Strategy Analytics, Motorola commands the leading market share -- nearly 14% -- in chips for the automotive industry. That market is estimated to grow at an average annual rate of 12% from 2001 to 2005, says market-researcher Gartner Dataquest. Motorola SPS also claims a leading share of 15% of the total microcontroller market, which was a $10.8 billion market in 2002, says Gartner. By Thomas W. Smith, CFA
PART OF A TREND.
Indeed, a spun-off Motorola SPS would be a relatively big name. Motorola's semiconductor sales in 2002 were $4.82 billion (about 17% of its total revenue), making it the world's No. 9 chipmaker last January, as tracked by market researcher IC Insights. It believes that Motorola has been among the world's top 10 chip suppliers since 1959, when the industry was born. However, IC Insights' rankings for the first half of 2003 showed Motorola falling to No. 11. As recently as 1985, it was ranked No. 3 in the world and was No. 5 in 1995.
Interestingly, one of the semiconductor operations jumping above Motorola on the list (partly because of favorable European currency fluctuations) was Philips Semiconductor, a unit of Koninklijke Philips Electronics (PHG; 3 STARS), which now stands as one of the few remaining electronics conglomerates that have chosen not to spin off its chipmaking segment.
Motorola is following the trend among electronics conglomerates. Rockwell (ROK ) spun out Conexant (CNXT ) in January, 1999. Siemens spun out Infineon (IFX ) in April, 1999, which became publicly traded in March, 2000. AT&T (T ) spun off Lucent (LU ), which later hived off Agere in March, 2001. Hynix Semiconductor was spun out of the Hyundai Group in 2001. And in April, 2003, the Hitachi (HIT ) and Mitsubishi spin-offs together created Renesas.
These newly independent companies can change a lot within their first few years. Conexant has evolved into three separate outfits to focus on different markets, after merging with Alpha Industries. Agere has shed significant operations to pay down debt and focus on its preferred markets.
On 2002 sales of $4.8 billion, Motorola SPS lost $1.5 billion on a GAAP basis, an improvement from a $1.9 billion loss on sales of $4.9 billion in 2001. As with many restructuring semiconductor concerns, the losses look better after excluding special items: $283 million in 2002 and $1 billion in 2001.
Nevertheless, we can see why Motorola execs might want to shed the corporate segment that was responsible for $1.5 billion of the $1.8 billion loss for the whole company in 2002. Severe cyclicality remains a hallmark of the semiconductor industry, as does the need for heavy spending on plants and research and development. To some extent, Motorola SPS was already moving toward an "asset-light" model -- what's known in semiconductor circles as "fab-lite" -- a middle stance between being "fabbed" (owning all your own wafer-fabrication plants) and being "fabless" (outsourcing all production to foundry operations such as Taiwan Semiconductor [TSM]).
SPS gets about 20% to 25% of its sales from other divisions of Motorola. We expect that those units might shop around more after the spin-off, reducing SPS's business somewhat. On the other hand, some communications-equipment rivals of the parent Motorola might be more inclined to buy chips from an independent SPS. In our view, the new business should somewhat offset any sales loss from the Motorola divisions.
In addition, we believe that Motorola SPS, as a stand-alone chipmaker that can use its own shares as currency to make acquisitions, would have a lot of expertise to mix and match with acquired properties. It will be interesting to see which direction SPS takes. Given that it's already well established in automotive and wireless chips, we think Motorola's offspring should be able to grow as the semiconductor industry enters an upturn.
Analyst Smith follows semiconductor stocks for Standard & Poor's
Edited by Karyn McCormack