Description

Investment Summary

Buy Stock at $14.32 with a $20 target.  FSL’s free cash flow generation should increase dramatically over the next few quarters due to a revenue tailwind in their core sectors, gross margin expansion through the successful implementation of its operating restructuring and an extremely compelling refinancing/deleveraging opportunity.  At under 10x 2014 FCF, FSL is trading at a dramatic and undeserved discount to its peers

Company Description

FSL is a global leader in embedded processing solutions. Embedded processor products include microcontrollers (MCUs), single-and multi-core microprocessors (MPUs), digital signal controllers (DSCs), applications processors and digital signal processors (DSPs). These programmable devices, along with software, provide the core functionality of electronic systems, adding essential control and intelligence, enhancing performance and optimizing power usage while lowering system costs.

FSL offers complementary semiconductor products, including radio frequency (RF), power management, analog, mixed-signal devices and sensors. FSL combines its embedded processors, complementary semiconductor devices and software to offer highly integrated solutions that are increasingly sought by its customers to simplify their development efforts and shorten their time to market.

FSL’s products are used in some of the fastest growing applications within the industrial, networking, automotive and consumer markets. These applications include automotive safety, vehicle efficiency, next generation wireless infrastructure, cloud computing and data centers, smart energy, portable medical devices, consumer appliances and smart devices.

Capital Structure & Relevant Financial Metrics

Recent History & Current Situation

• In December 2006, FSL was bought in a LBO by Blackstone, Carlyle, Permira & TPG

-    The purchase was ill-timed, 2006, was a peak year for revenues and the LBO saddled FSL with a massive debt load

-    45% of FSL revenues are to the Auto Sector, which experienced a sharp decline in the years following the LBO

• Despite the massive debt burden, FSL was able to go public again in 2011 and used proceeds from the IPO to reduce debt
• Since the LBO in 2006, FSL has made some significant improvements to its business:

-    Refocused on growth areas and away from the more commoditized

• Targeting embedded processor solutions for the automotive, networking, industrial and consumer markets, which are expected to grow significantly over the next few years
• Despite some market share losses, 80% of revenues now come from segments in which FSL is the #1 or #2 global market share leader
• Making a stronger push into China and India, where they have already have been operating for years.  Recently added 75 sales people in China, up from 5-10 people over the past few years

-    Moved to a more “asset lite” model, where over 30% of front end and back end manufacturing are outsourced

-    Improved margins

-    Stabilized market share

Investment Thesis

• Earnings & Free cash flow are expected to increase dramatically over the next year due to FSL’s strong product portfolio, gross margin improvements and refinancing/deleveraging
• FSL has refocused the business to concentrate on growing sectors with long product cycles, providing both a tailwind and downside protection from stability in revenues

-    FSL supplies its products to 4 major high-growth end markets: Automotive, Industrial, Networking & Consumer

-    Automotive, (40% of revenues) is in a cyclical upswing in the US and is and more importantly, is in a secular upswing around the world with units expected to increase by 28% by 2017.  Additionally, the content per vehicle has increased dramatically, and is expected to increase by another 27% through 2018 mostly due to the government regulation of safety and emissions and the growth in telematics

-    Networking market (25% of revenues) sees growth from the increased focus on cloud computing & data center and the upgrades to wired and wireless infrastructure to take advantage of the higher speeds and the prolific growth of video on the internet

-    Industrial (15% of revenues), also has high growth potential due to focus on smart energy, portable medical devices and the need for smarter control systems and connectivity for appliances

-    Both Automotive and Industrial end-markets (over 50% of Revenues) have very long product cycles (5-7 years) which provides a solid recurring revenues and a stable base for FSL

• Despite the consistent improvement in gross margins since 2009, FSL’s gross margins are still well below its peers

-    2012 gross margins were 41.6%, well below the industry average of 47%

-    Management has target of achieving 53-55% gross margins

-    They feel that 50% gross margins is attainable in the near future just from

• Utilization of facilities – 89% in latest Q up from 79% in the first quarter and 86% in the 3^rd quarter – expect normal utilization around 90% which will result in 120 basis points of incremental margin gain.  Recent closure of Toulouse facility helped improve utilization in the 2^nd quarter
• Operational efficiency, improving test times, yields and improving mix of materials could improve gross margin by at least 50 bps a Quarter
• Procurement efficiencies – since 30% of business is outsourced they can leverage their scale and achieve cost reductions with partners and suppliers

-    Every 1% increase in GM’s results in a 5% increase in EBITDA

• Refinancing opportunity will be a strong near term driver of earnings and FCF

-    over $1.9 billion of high coupon debt becomes callable by April 2014

-    Recently refinanced $1.38 billion of 9.25% secured debt and $221 million of 10.125% secured for new debt averaging 5.66% resulting in an interest savings (including call premiums) of $54 million

-    Additionally, in the 1q of 2014, it is expected that FSL will call and pay-off its $264 million 10.125% subordinate debt, resulting in an additional $27 million of interest savings

• Large NOL and research tax credits will help shield earnings from taxes over the next few years
• Management Credibility – This is a management team that consistently under-promises and over-delivers.  They have beat street-consensus earnings expectations every quarter that they have been public and beat Revenues and EBITDA for the last 6 quarters

Valuation

• Since the primary thesis suggest a rapid increase earnings and free cash flow growth, most of which will come over the next 6 months, it is best to value FSL on 2014 & 2015 estimates

-    Most of the increases in cash flow are based on cost cuts and refinancing’s, which are primarily in the FSL’s control are therefore easily achievable

• Since the 2006 LBO (primarily because of the huge debt load), FSL has not produced meaningful positive FCF or positive Net Income, leaving investors with only EBITDA multiples for valuation

-    last year, the company finally starting producing some free cash flow and last quarter (3Q 2013) resulted in their first positive earnings since the LBO

-    As a result, in the coming quarters, FCF & P/E muiltiples will start to come into focus

-    On an EBITDA basis, FSL trades at a premium to its comps

-    However, when looking at Net Income and Free cash flow, which should always be the primary drivers of equity valuation, FSL trades at a steep discount to comps

-    Comp set includes: Texas Instruments, Intel, ST Microelectronics, Analog Devices, Maxim, Microchip, Infineon, & Cypress

• Below tables suggest (comp median highlighted in yellow) that FSL has upside to $29 (103% upside) and downside risk of $12.62 (-11.5% downside risk).
• I think that FSL should trade at $20, which would still be a discount to comps, that discount could be justified because of the high debt burden making cyclical swings more dramatic

Why Does This Opportunity Exist?

• FSL is one of the only semiconductor companies with a lot of debt which has scared many equity investors and as a result, FSL has not produced positive Net Income or any  meaningful free cash flow to give investors valuation metrics beyond EBITDA, on which metric FSL is not cheap
• Company still majority owned by the 2006 LBO investors

-    Investors fear their shares will remain an overhang on the stock

• Unfamiliarity with the huge increase in FCF and Net Income resulting from the refinancing opportunity

Risks – What Can Go Wrong? (Level of Impact – Small/Medium/Large; % Likelihood)

• Slow down in automotive sales (Medium; 25%)
• Loss of a significant customer (Large; 5%)

-         While FSL for the most part has a large diverse customer base, it has one very large customer, Continental AG, which makes up over 10% of revenues

-         customers in the automotive and industrial end-markets are generally very sticky since there are long product cycles and the overall cost of the semiconductors are very small relative to the item (probably not more than $100 of semiconductors and microcontrollers per average vehicle)

Catalyst