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Freescale: Motorola's Terrible Timing

By Olga Kharif and Spencer Ante, BusinessWeek, July 15, 2004

Just as the tech sector is going through its worst spell of the year, Motorola is spinning off its chip unit. Investors, beware On July 15, after the market closes, Motorola is expected to set a spin-off price for its $4.9 billion Freescale semiconductor business. The initial public offering would then follow on July 16. Just one problem: It would have been hard for Motorola to pick a freakier Friday to schedule this IPO.

Who knew? Certainly not Motorola (MOT ) when it announced in December that it would be spinning off Freescale. And certainly not the tech sector. Back then, chips sales were once again on the rise, buoying shares of semiconductor companies.

That was last winter, however. This week's news has been decidedly downbeat: On July 12, Merrill Lynch cut its semiconductor sector rating, citing concerns that the upturn had peaked (see BW Online, 7/15/04, "The Tech Sector Slips a Notch"). The next day, the world's largest chipmaker, Intel (INTC ), spooked the market even more when it reported rising inventories and forecast a decline in its gross margins (see BW Online, 7/15/04, "Intel's Rising Pile of Chips"). Even the overall climate for IPOs appears to have worsened. On July 13, the much-anticipated Domino's Pizza (DPZ ) offering fizzled, with shares soon trading below the opening price.

Freescale's IPO will probably price at the low end of an anticipated $17.50 to $19.50 per share, predicts Jeff Hirschkorn, co-founder of Current Offerings, which tracks IPOs. Yes, Motorola could try to delay the IPO. But if sentiment about the chip industry darkens any more, that strategy might backfire, leading to an even lower offering price or, in the worst case, a withdrawal of the offering. Investors might be better off considering Freescale's $1.25 billion bond offering, also expected to be priced on July 15, says Ren Zamora, an analyst with Loop Capital Markets in Chicago.

SLIM PROFITS. As if the news weren't bad enough, the IPO terms are enough to give some investors pause, many analysts believe. While Motorola is supposedly giving the public 30% in the new company, it's actually creating two classes of stock, with different voting rights. Under the arrangement, Motorola shareholders' stock has five times more voting power per share than Freescale's shares -- so that, after the IPO, Motorola will retain 92% voting control over the chip supplier.

The leash is so tight that Freescale has agreed it won't buy or sell any assets worth more than $100 million without Motorola's consent. As a result, it might make more sense to hold Motorola's shares than the Freescale stock, Hirschkorn argues.

Quality of earnings is another fear. Even in the first quarter of 2004, one of the industry's strongest in years, Motorola's chip unit turned a paltry $106 million profit on sales of $1.4 billion. Of that income, $41 million came from selling stock in the Chinese foundry Semiconductor Manufacturing Corp. An additional $8 million came from reversing charges from write-downs of assets.

And according to a asterisk note in small text on the bottom of Page 11 in Freescale's June 18, 2004 S-1 filing, the earnings include "$51 million of income relating to the reversal of liabilities previously accrued for the potential obligation to reimburse the Chinese government for various exemptions previously received on VAT (value-added tax) and duty on imported materials." Taken all together, these one-time shots of revenue mean 94% of Freescale's net income in the first quarter came from nonoperating sources. "[Motorola] has dumped a headache," contends Hirschkorn.

CHEAP DEALS. Prospects for future profitability look murky when you consider that Freescale's main customer, Motorola, will likely keep getting favorable pricing terms. Motorola already accounts for about 26% of the spin-off's sales and has likely been buying wireless components for its phones at below-market pricing, figures Paul Sagawa, an analyst with Bernstein Research in New York.

Here's his math: The wireless-components group's margins were a negative 20% during the industry's robust first quarter. Problem is, under current filings, Freescale will have to provide Motorola with parts through 2006, probably on the same below-market terms.

Motorola could also take some of its other business elsewhere. Although a change of suppliers would require significant reengineering of its phones, Motorola could potentially contract with another chipmaker for parts for new phone models, says Sagawa. Already, some of Motorola's internal divisions buy their chips elsewhere, says Eric Mantion, an analyst with market consultancy Cahners In-Stat in Scottsdale, Ariz.

To stay competitive, Freescale will need to up its ante on research and development, many analysts believe. But that will be more difficult without the deeper pockets of Motorola. Out of the cash it raises through its estimated $2.2 billion IPO and bond sale, Freescale will need to fork over $1.5 billion to Motorola's shareholders. Such compensation is common in spin-offs, say analysts.

NEW CHIPS. Freescale will likely use part of the remaining funds to restructure its manufacturing. Most of its plants have been underfunded for several years and are behind in technology, says Brian Matas, an analyst with chip consultancy IC Insights in Scottsdale, Ariz. Ultimately, Freescale plans to outsource more of its production to contract manufacturers.

It's not all bad news for Freescale. After years of weak financial performance, the unit seems to have stabilized and eked out an operating profit in the last two quarters. The utilization rate of its chip-fabrication facilities was 82% in the most recent quarter, up from 66% in the year-ago quarter. And its gross margins were 36%, up from 25.9% in the year-ago quarter. The latter metrics are signs of improving management.

More important, Freescale has some nifty technologies under development. The most promising is a new memory technology called magnetoresistive random access memory (MRAM), which could replace the dynamic random access memory (DRAM) that's common in PCs today as well as flash, which is used for storing data in mobile devices. "It has an R&D; lead in MRAM. It's very well positioned," says David Lytel, an analyst with consultancy Precursor Group in Washington, D.C.

WAIT AND SEE. As a truly independent company -- Freescale is supposed to be completely spun off within a year -- the chipmaker could have an easier time getting business from Motorola's competitors, such as cell-phone makers Nokia (NOK ) and Sony Ericsson, says Tom Smith, an analyst with rating service Standard & Poor's in New York. Neither Freescale nor Motorola could comment for this story because they're in a quiet period.

Still, investors with any interest in Freescale might want to sit on the sidelines until July 20, when Motorola announces second-quarter earnings, including for Freescale. Buying a stock right before an earnings announcement is always a risky proposition. With this IPO, scheduled during a time such as this, it almost seems foolhardy.