Barrons Touts ST Micro..Can ALU be far behind?

March 31, 2013

Terrapin Note- Barron's published a bullish feature article on STM (short 3) this weekend that is notable along several lines.  First off, as is somewhat typical accuracy is a challenge for Barron's in this case starting with the first sentence in which STM is described as a maker of smartphone chips.

Second, this description is applied even with the apparent knowledge that the company's main source of smart phone exposure, the ST-Ericsson JV, is in the process of being shut down after losing what should be over $2B during its existence and finding no buyers.  However this is all OK as the misadventure is "behind them" , sort of like say, Cyprus, Greece, Spain, Italy, the fiscal cliff, the debt ceiling, mortgage write offs and the budget deficit are all "behind us" from a macro standpoint.  We find the same question recurring in both cases:  Is it not at least somewhat relevant that the some crowd that created the issues that we needed to "get passed" is currently calling the shots.  Which is to say, as we have noted many times regarding CIEN, track record matters and in our view a poor one should be a multiple compressor not enhancer.  Recall it was only just over a  year ago that a new CEO  joined ST-E, from his post as COO of STM,  with much fanfare declaring "our company has tremendous potential"

Third, an improving economy along with a "widely anticipated" up cycle in semiconductors is cited as a key driver along with manageable European exposure at 25% of revenue.  Though we note that 25% is calculated on a "ship to" basis, meaning that 60% of revenue goes to Asia.  This is of course meaningless as those shipments are largely headed to CM's for shipment all over the world, with the company's actual European end market exposure likely far higher in the range of 40%.  Current estimates call for a move from revenues of around $2B to nearly $2.4B by year end and an improvement in EPS from losses to a run rate exceeding $0.70.  Even if that hockey stick were to happen, and the company's plan to reduced opex from $900M per quarter to $600-650M by year end were to come off without a hitch, an improvement t FY14 EPS of $0.60 plus is already priced in here around the $8 level.  The STE shutdown should deliver $125-150M of that quarterly opex savings, though at a $400M cash cost for the year

The question remains what warrants all of this optimism given the company's fairly consistent track record of share loss, against the nimbler likes of BRCM and INVN in set top boxes, networking infrastructure and mobile/gaming device sensors, and the difficulties in restructuring European companies.  This is especially the case in considering STM relative to its French peer ALU, which the market is currently valuing at $3B vs a $6B enterprise value at STM.  This despite expected revenues and EBITDA of $19B and $1.2B for ALU in 2013, compared to $8.6B and $700M for STM, with the EBITDA number representing a 100% increase for STM from 2012 levels.  That's right, ALU is trading at 2.4X EBITDA with nominal balance sheet risk, improving end markets and leading share positions in all key markets save wireless, compared to 8.2X for historical share donor STM. With 27% of actual revenues coming from Europe, ALU's exposure is lower and capex trends in key end markets in the US, China and Europe are clearly turning higher combined to the macro cycle hope that appears to be driving STM. The "French factor" in terms of management and restructuring execution is nullifed with this pair, and indeed revenue per employee at ALU stands at $263,000, not that far south of the $304K at the successfully turned around NSN, compared to $178,000 at STM.

In summary our "French Army Knife" which worked so well in the middle of  last year as both a fundamental short and selective hedge  has been malfunctioning of late.  We find the name very attractive up here on both fronts, with high conviction that the ALU and STM pair trade is likely to produce attractive returns over the next year.


Back in the Chips?


The turnaround story at STMicroelectronics, Europe's largest semiconductor maker, has been helped by management's focus on markets well beyond the euro zone.

STMicroelectronics, which manufactures chips for smartphones, is ringing in some changes of its own.

After several years of lackluster performance, Europe's largest semiconductor maker is getting its house in order. The company is narrowing its focus to fast-growing chip sectors, including sensors and car-infotainment systems, and exiting a joint venture that has hemorrhaged cash since it was created in 2009. STMicro's new target for profitability—lifting operating margins to 10% this year from minus 6.5% in 2012—is ambitious. But investors are so negative on the company now that even a near-miss could lift the stock.

STMicro's New York–listed shares (ticker: STM) fell 17% in the past three years, to $7.71. They could rise as much as 50% in the next 12 months if the company can deliver on its plan.


STMicroelectronics specializes in sensors and automotive electronics. Above, a clean room at its fabrication plant in Crolles, France.

The company's history dates back to the 1987 merger of Italy's SGS Microelettronica and Thomson Semiconducteurs of France. The company, now based in Geneva, long served European manufacturers, from auto makers to cellphone producers such as Nokia (NOK) and Ericsson (ERIC)—once world beaters, now also-rans.


Today STMicro focuses mainly on areas like audio systems and power-conversion chips, where it is the market leader or has competitive advantages. Europe contributed only 25% of last year's $8.49 billion in revenue, while 60% came from Asia. Top customers include Apple (AAPL), Samsung Electronics (005930.Korea), Cisco Systems (CSCO), and Western Digital (WDC).


STMicro is expected to earn $85 million, or 12 cents a share, this year on revenue of $8.7 billion, up from a loss of 33 cents in 2012. Analysts think the company could earn as much as 59 cents in 2014.

Shares have risen 15% since STMicro disclosed its new strategic plan in December. They carry a fat dividend yield of 4.4%. The payout is backed by solid free cash flow and $1.2 billion in net cash on the company's balance sheet.


JUST FOUR YEARS AGO, STMicro and Ericsson, after much fanfare, were into the process of merging their wireless chip businesses, to gain manufacturing synergies and develop a more integrated and efficient product strategy. It didn't work out that way. The two companies pumped an estimated $1.7 billion into ST-Ericsson, which never made a profit, largely due to intense competition in the market for basic cellphones, and troubles at Nokia. Last month, the companies announced that they would terminate ST-Ericsson by the third quarter.


Peter Knox, an analyst at Société Générale, reckons investors don't fully appreciate the fact that STMicro has drawn a line under its investment in ST-Ericsson. "I think the majority of the market sees ST-Ericsson as a continuing part of the group and a burden going forward," says Knox, who rates STMicro a Buy with a $10 price target. Other analysts think the shares could go as high as $12.



STMicro is exiting the venture on favorable terms. It is taking on 950 of ST-Ericsson's 4,350 employees and getting all the businesses other than Long-Term Evolution multimode thin-modem products, which go to Ericsson. The LTE-modem business has exciting potential but requires a huge amount of research-and-development investment.

The move "maximizes our future prospects and growth plan," CEO Carlo Bozotti told Barron's in an e-mail exchange. It will reduce costs, strengthen STMicro's financial position, and eliminate a major distraction.


WITH ST-ERICSSON BEHIND IT, STMicro will be in a stronger position to exploit an upturn in the semiconductor market, which is widely expected this year, given an improving economic outlook. It says the markets it is targeting—sensors and power, automotive products, and embedded processing solutions like set-top boxes and TVs–will be worth $140 billion in 2013, according to the company.


STMicro generated 38% of its revenue last year from the division that produces microelectromechanical sensors such as smartphone microphones, digital compasses, and gyroscopes. With an operating profit margin of 13%, the division is STMicro's most profitable.

The Bottom Line


Now that STMicro is putting a disastrous joint venture behind it, management can focus on markets where it has an edge. Shares could rise 25% to 50% in the next year.


Its automotive unit, which accounted for 18% of revenue in 2012 and had a profit margin of more than 8%, is an industry leader in car-door electronics. It has established partnerships with car makers Audi, part of the sprawling Volkswagen(VOW3.Germany) group, and Hyundai Motor (005380.Korea).


With revenue spread across a variety of sectors and customers, STMicro is less vulnerable to pockets of instability. Its new strategy, focus on costs, and exit from ST-Ericsson mean it is well placed to prosper in 2013, and beyond. "These decisions will drive our growth and enable us to become stronger and much less sensitive to the market variation," says Bozotti.

Investors might want to put a few chips of their own on STMicro.