By William Trent, CFA of Stock Market Beat
STMicroelectronics (STM), Intel (INTC – Annual Report) and Francisco Partners today announced they have entered into a definitive agreement to create a new independent semiconductor company from the key assets of businesses which last year generated approximately $3.6 billion in combined annual revenue. The new company’s strategic focus will be on supplying flash memory solutions for a variety of consumer and industrial devices, including cellular phones, MP3 players, digital cameras, computers and other high-tech equipment. The partners in the deal were gushing with superlatives, which you can read in the press release.
For my part, I don’t doubt that the new company exudes wonderfulness from a strategic standpoint, being “From the outset, the company will be a leading supplier of flash memory solutions for wireless communications,” with “the scale to benefit from the increasing demand for memory resulting from the growing amount of information and content that is becoming more mobile and is now based almost entirely on digital technology.” Instead, I was most interested in the structure of the deal itself:
Under the terms of the agreement, STMicroelectronics will sell its flash memory assets, including its NAND joint venture interest and other NOR resources, to the new company while Intel will sell its NOR assets and resources. In exchange, Intel will receive a 45.1 percent equity ownership stake and a $432 million cash payment at close. STMicroelectronics will receive a 48.6 percent equity ownership stake and a $468 million cash payment at close. Francisco Partners L.P., a Menlo Park, Calif.-based private equity firm, will invest $150 million in cash for convertible preferred stock representing a 6.3 percent ownership interest, subject to adjustment in certain circumstances. Concurrently, the parties have arranged for the new company to receive firm commitments for a $1.3 billion term loan and $250 million revolver. The term loan will be underwritten by a consortium of banks. Proceeds from the term loan will be used for working capital and payment to Intel and STMicroelectronics for the purchase price. The transaction is subject to regulatory approvals and customary closing conditions and is expected to occur in the second half of 2007.
This structure is interesting for a couple of reasons. First, Intel and STMicroelectronics will be receiving $900 million for the 6.3% stake they give up, but Francisco Partners will only pay $150 million for it. The rest will be provided by new debt held by the venture, with the risk presumably shared proportionately among the owners.
Second, the $900 total payments to Intel and STMicroelectronics for the 6.3% they will not own effectively values the total company at $14.3 billion, or roughly 4x revenues (though that valuation overstates things a bit because the convertible preferred shares offer a superior risk/reward than regular common shares would). Alternatively, the $150 million paid for the stake would assign a valuation of just 0.7x sales. Neither appears even close to Micron’s (MU – Annual Report) 1.5x sales, for example.
More interesting still is the fact that a partner was brought in for a 6.3% stake at all. One very important consequence is that the minority partner prevents either Intel or STMicro from owning 50% or more, which affects the way the joint venture’s results will flow through to the parent company financial statements.
Intel – the Equity Method
For Intel, the ownership stake of 45.1% suggests that the new company’s results will be reported using the equity method. This means, essentially, that only the JV’s net income and equity will appear on Intel’s financial statements. Assets, liabilities, sales, expenses and pretty much everything else stays off Intel’s financials. The obvious benefit is that net profit margin will be higher as it reflects the net income (numerator) but not sales (denominator) from the JV. In addition, other ratios such as return on assets and debt/equity could potentially appear more favorable.
STMicroelectronics – Equity or Proportionate Consolidation?
For STMicroelectronics, which adheres to International Accounting Standards (IAS) but also reconciles them to U.S. GAAP due to its U.S. exchange listing, the issue is a bit more complicated. IAS 31 states that “proportionate consolidation better reflects the substance and economic reality of a venturer’s interest in a jointly controlled entity, that is control over the venturer’s share of the future economic benefits.” Although the equity method is an allowed alternative under IAS 31, the clear preference is for STMicroelectronics to proportionately consolidate – that is, record its 48.6% share of assets, liabilities, revenue and expenses.
Yet the press release describes both STMicroelectronics and Intel’s ownership as “equity ownership stakes” which may imply that they both intend to use the equity method. That, in turn, suggests that STMicro’s 48.6% stake (making it the largest owner) somehow does not allow it to “jointly control” the entity. Perhaps Francisco Partners has an influence (such as Board membership) that is out of proportion to its 6.3% financial stake.
The Role of Francisco Partners
Without the third partner, Intel and STMicro would either have had to structure the deal to give STMicroelectronics control (which would require them to report all of the venture’s financials as their own) or to arrange a payment that would give them equal ownership. Intel would still be able to use the equity method in either situation, but perhaps would not want STMicroelectronics to be the controlling party. By bringing in the third partner, it knocks both of the primary owners into a more equal secondary status that both may consider more fair.
And of course, the more favorable financial reporting is a nice side effect.
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