Note:This report contains substantially new material. Subsequent reports will have changeshighlighted.
Reason for Report: 3Q06 earnings update. Previous Edition:October 3, 2006
Overview
Based in Austin, Texas, Freescale Semiconductor, Inc. (FSL or the Company) engages in the design, development, and manufacture of embedded semiconductors for automotive, consumer, industrial, networking, and wireless markets worldwide. It operates through three segments: Transportation and Standard Products Group (TSPG), Networking and Computing Systems Group (NCSG), and Wireless and Mobile Solutions Group (WMSG). The TSPG segment provides embedded systems components, such as microcontrollers, embedded microprocessors, digital signal processors, sensors, and analog and mixed-signal integrated circuits. These products are used in automotive, consumer devices, industrial, and computer peripherals applications. The NCSG segment offers embedded processors, related connectivity products, and semiconductor products for the wired and wireless networking, and computing markets. These products comprise communications processors, host processors, digital signal processors, radio frequency devices, and networked multimedia devices, which are used in wireless infrastructure, enterprise switching and routing, public network access, embedded computing, and small/home office networking applications. The WMSG segment provides semiconductors for wireless mobile devices, such as cellular phones, smart phones, personal data assistants, two-way messaging devices, global positioning systems, mobile gaming devices, and wireless consumer electronics. These products are used in cellular handsets, portable media players, personal digital assistants, handheld video game devices, audio devices and systems, and telematic devices and systems applications. Freescale Semiconductor was established in 1953. More information may be found at:
Key investment considerations as identified by analysts are as follows:
Key Positive Arguments / Key Negative Arguments- FSL is progressing well with restructuring and cost reduction efforts and analysts expect further margin improvements going forward.
- FSL has made significant headway regardingits distribution channels with a broad product line up, and has become a preferred supplier of microcontrollers for multiple distributors.
- Possible growthin the handset business in 4Q06, attributable to design wins for new models from Motorola and growth in emerging markets
- Cash flow from operations recently increased, improvingliquidity.
- Buyout offer resulted in large gains to current shareholders.
- FSL risks loss of sales to MOT, ability to secure handset design wins outside its former parent company, MOT, and pricing pressure in commodity and wireless products.
- FSL’s stock can be heavily influenced by changes in the general economic growth outlook.
- Analysts speculate the Companymay be failing to keep pace with technological advances in the industry.
- FSLis susceptible to changes in general economic growth and semiconductor fluctuations.
Note: FSL’s fiscal year ends on December 31; fiscal references coincide with the calendar year.
Recent News
On October 19, 2006, the Company reported 3Q06 results. Highlights are as follows:
- Net revenue was $1,619.0 million.
- Gross margin was 46.1%.
- Pro forma diluted earnings per share were $0.61 (including option expense of $0.03).
On September 15, 2006,FSL entered into a definitive merger agreement to be acquired by a private equity consortium in a transaction with a total equity value of $17.6 billion. The consortium is led by The Blackstone Group, and includes The Carlyle Group, Permira Funds and Texas Pacific Group. Further details are provided below.
Revenue
3Q06 total revenue compiled by Zacks Digest was $1,619.2 million, up 10.9% y/y and 1.3% q/q. The Company reported total revenue of $1,619.0 million as compared to $1,599.0 in 2Q06 and $1,460.0 million in 3Q05. The growth in revenue was attributed growth in the wireless business.
Revenue by Segment
TSPG revenue declined 2.0% q/q to $682 million in 3Q06, attributable to a steep US automotive production decline of 13.0% y/y and 23.0% q/q. This was seen as offset by strong sales growth in Japan(up 50.0% y/y) and Asia(up 20.0% y/y) and increased sales of analog/sensor products. Sales through distributors accounted for 15.0% of total sales, flat q/q and up from 13.0% in 3Q05.
In 4Q06, FSL expects the negative impact from the decline in auto production inthe US in 3Q06 to be partially mitigated by growth in the industrial and consumer electronics end-markets and distribution business.
NCSGrevenue in 3Q06 wasflat q/q butincreased3.0% y/y to $369 million with operating margin of 27.0%. Management said that ex-divestiture, NCSG sales would have increased 26.0% y/y, driven by strong demand in the wireline, wireless infrastructure, SoHo and set-top box markets. While Motorola noted 3Q06 weakness in its GSM base station business in EMEA, FSL is seeing strength in the GSM base station market moving into FY07.
According to analysts, 4Q06 has traditionally been seasonally weak for NCSG. In 2006, FSL believes the 4Q06 decline will be less pronounced as it is launching some new products (PowerQUICC3).
WMSGrevenue improved 5.0% q/q and 19.0% y/y to $540 million. Strong demand from Motorola/Qualcomm and ramp of i.MX processor shipment drove WMSG revenue. The Company has been recording an increase in power management and power amplifier revenue from Motorola, which has tripled since the past year. Motorola has incorporated digital baseband, power management, and power amplifier content in its latest 2.75G RIZR and KRZR handsetsvs. just digital baseband content in RAZR previously.Motorola's ASP for handsets in 3Q declined because of decreased shipment of 3G/UMTS and 2G/iDEN handsets and a 2x increase in its sale of low-end handsets in India (TXN is the supplier of content for low-end handsets instead of FSL). However, this did not negatively impact FSL’s wireless business in 3Q06, because of thestrong demand from Motorola, Qualcomm and Toshiba.
Motorola’s 3Q06 iDEN handset weakness may impact FSL in 4Q06. However, the Company’s 3G businesses could perform well in 4Q06 as it will launch a new 3G platform for Motorola’s RAZR XX, and RAZR Maxx phones. FSL has very modest expectations for the 3G market in 2007. It expects its 3G platform ramp to be quite gradual or linear in 2007 but a higher 3G mix could be incrementally beneficial to WMSG margins going forward.
Provided below is a summary of revenue as compiled by Zacks Digest:
$ in million / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008ETotal Revenue / $1,526.0 / $1,599.1 / $1,619.2 / $1,611.0 / $6,342.6 / $6,666.7 / $6,975.0
Digest High / $1,526.0 / $1,600.0 / $1,620.0 / $1,633.0 / $6,377.0 / $6,822.0 / $6,975.0
Digest Low / $1,526.0 / $1,599.0 / $1,619.0 / $1,585.0 / $6,284.8 / $6,513.0 / $6,975.0
Digest YoY Growth / 5.8% / 8.6% / 10.9% / 8.9% / 8.4% / 5.1% / 4.6%
Digest QoQ Growth / 3.2% / 4.8% / 1.3% / -0.5%
Highlights from the previous chart are as follows:
- 2006 forecasts (8 total) range from $6,284.8 million to $6,377.0million; the average is $6,342.6 million.
- 2007 forecasts (6total) range from $6,513.0 million to $6,822.0 million; the average is $6,666.7 million.
- 2008 forecast (1 total) is $6,975.0 million.
For more details on revenue by individual analysts, please refer to the ‘Consensus’ tab of the FSL spreadsheet.
Margins
3Q06 gross margin as compiled by Zacks Digest was46.1%, flat sequentially but an increase from 43.7% in 3Q05. 3Q06 gross margin reported by the Company wasalso 46.1%.
Operating margin provided by Zacks Digest was 16.7% as compared to 16.0% in 2Q06 and 11.2% in 3Q05. The Company reported operating margin of 16.4% for the reported quarter. Analysts expect an increase inthe operating margin in coming quarters.
SG&A expense, according to the Company, in the quarter was $181.0 million, andas compiled by Zacks Digestwas $179.4 million, down 10.7% y/y and 2.1% q/q. R&D expense, according to the Company, was $298.0 million, and as compiled byZacks Digest, was $295.0 million, up 7.7% y/y but down 0.8% q/q.
Barring a significant economic slowdown, FSL is seen as well on trackto achieve its 47%-48% gross margin goal over the next 12 months. The target isexpected to be driven by further operational efficiency gains, supply-chain improvements and a portfolio mix shift. Gross margin isexpected by a number of analysts to improve steadily through the next 6 quarters to approximately 47.5% in 4Q07.
Provided below is a summary of margins as compiled by Zacks Digest:
Margins / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008EGross Margin / 45.3% / 46.1% / 46.1% / 46.1% / 47.7% / 40.8% / 56.3%
Operating / 13.6% / 16.0% / 16.7% / 15.9% / 15.6% / 16.4% / 15.6%
Net / 14.3% / 16.4% / 16.9% / 16.1% / 16.0% / 16.8% / 16.3%
Pre-tax / 13.4% / 15.9% / 16.4% / 15.5% / 15.4% / 12.6% / 12.2%
For more details on margins by individual analysts, please refer to the ‘Consensus’ tab of the FSLspreadsheet.
Earnings per Share
3Q06 proforma EPS as provided by Zacks Digest was$0.63, up 80.0% y/y and 4.8% q/q. GAAP EPS as provided by Zacks Digest was $0.61, up 60.5% y/y and 1.7% q/q. FSL reported 3Q06 EPS of $0.61, which included stock based compensation expense (stock options) of $0.03 per diluted share. This comparedto $0.61 per diluted share in 2Q06, including stock option expense, and $0.38 per diluted share, without stock option expense in 3Q05.
Also included in the third quarter EPSwas $15 million of expense associated with the redemption of $400 million of the Company's floating rate notes and $7 million of expense related to the definitive merger agreement.
According to analysts, EPS benefited from better operating cost control and a $0.03 one-time tax benefit. EPS upside was also attributable to an increase in sales and operating margins.
Provided below is a summary of EPS as compiled by Zacks Digest Research:
FY ends December / 1Q06A / 2Q06A / 3Q06A / 4Q06E / 2006E / 2007E / 2008EZacks Consensus / $0.48 / $0.58 / $0.64 / $0.57 / $2.25 / $1.96
Digest High / $0.48 / $0.66 / $0.67 / $0.64 / $2.41 / $2.12 / $2.21
Digest Low / $0.48 / $0.55 / $0.60 / $0.55 / $2.21 / $1.85 / $2.00
Digest Avg. / $0.48 / $0.60 / $0.63 / $0.58 / $2.31 / $1.99 / $2.11
Mgmt Guidance
Digest YoY Growth / 100.0% / 100.3% / 80.0% / 32.8% / 72.5% / -14.0% / 5.9%
Quarterly Growth / 9.1% / 25.2% / 4.8% / -7.3%
Highlights from the above chart are as follows:
- 2006 forecasts (8total) range from $2.21to $2.41; the average is $2.31.
- 2007 forecasts (7total) range from $1.85 to $2.12; the average is $1.99.
- 2008 forecasts (2 total) range from $2.00 to $2.21; the average is $2.11.
For more details on EPS by individual analyst, please refer to the ‘EPS’ tab of the FSL spreadsheet.
Guidance
For the fourth quarter of 2006, the Company expects to report revenue of $1.535 billion to $1.635 billion. Gross margin in the fourth quarter of 2006 in expected to be essentially inline with the third quarter of 2006.
Target Price/Valuation
All7 analysts covering the stockprovided neutral ratings. Price targets for FSL range from $36.00 (BMO Capital)to $41.00 (Kintisheff) with an average of $39.50( from the previous Zacks Digest report).One analyst (Deutsche Bank)believes that FSL should trade at a relative discount to its faster growing semiconductor peers.
Provided below is a summary of valuation and ratings as compiled by Zacks Research Digest:
Rating DistributionPositive / 0.0%
Neutral / 100.0%
Negative / 0.0%
Avg. Target Price / $39.50
Metrics detailing current management effectiveness are as follows:
Metric (TTM) / Company / Industry / S&P500Return on Assets (ROA) / 12.48% / 11.52% / 8.22%
Return on Equity (ROE) / 19.06% / 15.26% / 20.19%
Return on Invested Capital (ROIC) / 14.87% / 14.13% / 12.23%
For more details on target price by individual analysts, please refer to the ‘Valuation’ tab of the FSL spreadsheet.
Capital Structure/Solvency/Cash Flow/Governance/Other
Balance Sheet
Cash, cash equivalents, short-term investments, and marketable securities totaled $3,000.0million in 3Q06as compared to $1,380.0 million in 2Q06.
Capital expenditure in the third quarter was $193.0 million, up from $145.0 million in 2Q06.
Merger Update
Under terms of the merger agreement, the above-mentioned consortium will acquire all of the outstanding Class A and Class B shares of FSL for $40.00 per share in cash, representing a premium of approximately 36.0% over FSL's average closing share price during the 30 trading days ended September 8, 2006.
The Board of Directors of FSL has unanimously approved the merger agreement, and has resolved to recommend FSL's stockholders to adopt the agreement.There is no financing condition to the obligations of the private equity consortium to consummate the transaction, and equity and debt commitments for the full amount of the merger consideration have been received. It is currently anticipated that substantially all of the Company's outstanding Notes will either be tendered or repaid.
The merger is subject to customary conditions to closing, including the affirmative vote of FSL’s stockholders and requisite antitrust approvals. The merger agreement contains a provision under which FSL may solicit alternative proposals from third parties during the next 50 calendar days. In addition, the Company may, at any time, subject to the terms of the merger agreement, respond to unsolicited proposals. If the Company accepts a superior proposal, a break-up fee would be payable by the Company. There is no assurance of any alternative proposal.
On November 13, 2006, shareholders will vote on the sale to the Blackstone-led investor group. If the vote passes, the Company will start seeking investors for the debt financing package. In the meantime, FSL needs to obtain anti-trust approval from the various countries that it operates in. Management is planning to close the transaction in 4Q06.
Potentially Severe Problems
A cyclical slowdown in the automotive and networking end markets and the timing of WCDMA network launches are key variables behind analyst price targets. If growth rates are slower than expectations, the shares may not reach analyst price projections.
Long-Term Growth
The long-term growth rate for FSL is 8%.
Analysts state positive announcements regarding 3GSM could benefit FSL’s wireless technology but 3GSM is just the beginning of its foray into the wireless business. They opine that3GSM is likely to aid HSDPA based products and RF transceiver wins. Success may come in the form of a large ODM win later in the year that supports a large tier one OEM, according to analysts.
FSL will ship into both high-end and low-end 3G platforms for Motorola. The low-end, high-volume market is consideredthe most attractive market for suppliers. Therefore, Qualcomm is expected to try to gain share in this market butthe Qualcomm solution is seen as more attractive at the high-end of the 3G market. According to most analysts,FSL will concentrate on the low-end, high-volumemarket to grow revenue in late 2007 and beyond.
FSL is expanding operations in India with the acquisition of a 300,000 square foot campus in Noida. The Company plans to expand its presence to 1,500 engineers in India over the next four years to support global research and development efforts.
Growth initiatives highlighted by the Company include:
- Investment in high growth initiatives such as consumer applications and merchant wireless chipset.
- Plans to dedicate more resources to grow the high-margin distribution business.
- Increase sales in Asia-Pacific and Japan, especially in automotive and networking segments.
- Expand the addressable market in other fast growing areas, such as ZigBee, IP media gateway, and personal media player.
Upcoming Event
January 19, 2007: Expected 4Q06 Earnings Announcement
Individual Analyst Opinions
POSITIVE RATINGS (0.0%)
None at this time.
NEUTRAL RATINGS (100.0%)
Pacific Crest – Sector perform (no target price) - 10/20/06: The analyst has reiterated a Sector perform rating and believes that the growth prospects of the Company is low. INVESTMENT SUMMARY: According to the analyst,FSL shareholders are receiving a healthy option premium for new business initiatives, such as MRAM, as well as strong margin improvement in the wireless andmobile systems group.
Citigroup – Hold ($40.00 - target price) - 10/20/06: The analyst has reiterated a Hold rating along with a target price of $40.00. INVESTMENT SUMMARY: The analyst doesnot care to suggest anything to investors until the Blackstone merger is completed.
Deutsche Bank - Hold ($40.00 - target price) - 10/19/06: The brokerage firm has maintained a Hold rating with a target price of $40.00. INVESTMENT SUMMARY: According to the firm, the Company will face risks if the merger is not completed.
Piper Jaffray – Market perform ($40.00 - target price): 10/20/06: The firm has downgraded the stock from Outperform to Market perform as the stock trades close to the acquisition bid of $40.00/share. INVESTMENT SUMMARY: In spite of downgrading the stock the firm is encouraged by strong wireless revenue, which was mainly attributable to increased sales to Motorola.
NEGATIVE RATINGS (0.0%)
None at this time.
RATING SUSPENDED
Cathay Financial –10/20/06:The analyst has suspended the rating and target price on the Company based on the pending buyout by a private equity consortium.
DROPPED COVERAGE
American Technology – 09/18/06: The analyst has dropped coverage on the Company based on the pending private equity acquisition.
Merrill – 09/11/06: The analyst has terminated coverage on the stock based on the private equity acquisition.
Copy Editor: Joyoti D.