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Monday, September 18, 2006

The Semiconductor Industry Needs to Go Private

By William Trent, CFA of Stock Market Beat

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 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.

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