Can ST Become Fabless?

Yesterday, Vijay Nagarajan completed his in-depth of analysis of ST Microelectronics . I will review his analysis as well as STM’s recent financials in this post.

As per a recent iSuppli report, STM jumped from the fifth place to be the third largest wireless semiconductor supplier thanks to its design wins from Nokia and Ericsson. STM has about 5.1% of the $29.5 billion market. And with the recent joint venture with NXP, STM has strengthened its No.3 position. For 80% stake in the JV, STM will be paying NXP $1.55 billion. This JV equips STM to take on the convergence device movement.

Though STM’s wireless performance has been commendable, Vijay’s review of its 2007 financials shows that its overall semiconductor business is struggling to keep pace with the industry. Its gross margin in 2007 was 35.36% compared to the industry average of 50.5%. In the day of the fabless model, STM’s integrated device manufacturing model is holding it back from better profitability despite its restructuring plans.

Let us now review STM’s Q1 results reported on April 28. Revenue increased 9% to $2.5 billion and excluding FMG increased 11.6% to $2.2 billion led by growth in automotive, industrial and wireless segments. Net loss, affected significantly by the declining US dollar, was $84 million or $0.09 per share versus net income of $74 million last year or $0.08 per share. Excluding restructuring and impairment charges, diluted EPS was $0.13 compared to $0.09 last year. Analysts estimated revenue of $2.52 billion and earnings of $0.18 per share.

In the quarter, it completed the spin off of its FMG into a new company, Numonyx and the acquisition of Genesis Microchip. Excluding FMG the gross margin was 37.6%, up about 60 basis points from last year mainly due to improved product mix and volumes, despite the negative impact of currency fluctuations.

Segment-wise, Application Specific Product Groups (ASG) revenue grew 14.2% y-o-y and declined 8.4% q-o-q to $1.4 billion or 56.2% of net revenue. Industrial and Multisegment Sector (IMS) revenue grew 7.1% y-o-y and declined 8.7% q-o-q to $772 million or 31% of revenue. FMG accounting for 12% of revenue declined 7.4% y-o-y and 16.5% q-o-q.

Despite the economic uncertainty, STM expects revenue (excluding FMG) in Q2 to increase by 5 to 11% sequentially and 10 to 16% y-o-y. Q2 gross margin is expected to about 37%. It is currently trading around $13 as against Vijay’s valuation of $15. Its market cap is around $11.5 billion.

The big question that ST will have to wrestle with over the next few years, is whether or not to abandon its status as an IDM, and join the prevalent fabless manufacturing movement. This is not going to be an easy transition at all, given that in Europe, this sort of large-scale restructuring is very difficult to pull off due to labor law challenges. Manufacturing in Europe is somewhat of an anachronism, and remaining competitive with that structure is a proposition that is almost flawed by design.

On the other hand, if it wants to leapfrog competition as a manufacturing powerhouse, that would require investment that may not be within its current reach either.

STM, the IDM, is thus caught in a bit of a no-man’s land. Not a stock I would bet on, despite other attributes.