Description
Freescale is a recent spinoff of Motorola which I believe management has timed to increase the probability of success for the stock and to maximize the value of options they received in the intial spin off. Freescale is an established leader in numerous semiconductor markets with good prospects for both margin improvement and organic growth. Freescale is the third largest semiconductor company in the united states which operates its business through three primary segments: the Transportation and Standard Products Group (TSPG)(49% of sales), the Networking and Computing Systems Group (NCSG)(27% of sales) and the Wireless and Mobile Solutions Group (WMSG)(23% of sales). TSPG provides products for the automotive electronics, industrial and other markets. NCSG supplies products to the wired and wireless infrastructure and computing markets. WMSG provides products for wireless mobile devices. In addition to these three segments, they have an Other business segment that includes all of their other operations, including their Metrowerks software business.
Motorola over invested in Freescale in the late 1990's believing their growth would continue for some time but when the industry downturn cycled in Motorola experienced substantial losses. Motorola dramatically restructured Freescale prior to the spinoff selling off and closing numerous plants, cutting substantial numbers of workers and implementing an asset light strategy. The asset light strategy which is early in its implementation is designed to improve return on equity and decrease capital expenditures by outsourcing manufacturing and entering joint ventures. The result of the restructuring has been improving profitability. In addition new CEO Michel Mayer has moved aggressively to reduce SG&A expenses and cut an additional 5% of Freescales workforce to improve prospects for profitability further.
I believe Freescales growth prospects look good. In addition to participating in high growth industrys Freescales spin off allows managment to pursue a number of new prospects which were not available to it as a subsidiary of Motorola as these customers competed with Motorola. Furthermore the spinoff provides management focused on Freescales prospects. Though competition is great in all Freescales industries Freescale has tremendous research and development infrastructure with 14,000 of its 22,000 employees devoted to research and development which has allowed it to continually produce design wins which lead to expanding sales for a number of years. Since its intial spin off Freescale has strengthened its lead position in the auto market with a design win with General Motors which will lead to its chips controlling all GM motors from 2008-2012. Year to date sales for the nine months are up 22% from last year.
Freescales balance sheet is very strong with 2.17 billion in cash and long term debt of only 1.25 billion for net cash of 900 million. With approximately 400 million shares outstanding this equates to approximately $2.25 of cash per share.
Looking at the valuation Freescale is cheap relative to its peers. Taking into account its net cash Freescale sells at approximately 1.1 times sales while the industry sells on average at approximately 3.0 times sales. In additions a numbers of these companies trading at higher multiples do not have Freescales broad sales base, long term relationships with major companies, and portfolio of 4900 patents with licensing revenue of 3% of sales.
It looks cheap based on other metrics also. I estimate next years earnings at 400 million and consequently currently trades at approximately 15 times next years earnings which is not overly cheap; however on a cash flow basis Freescales depreciation is high relative to capital expenditures due to past investments and managements relatively new asset light strategy. I estimate this adds another 100 million to free cash flow or free cash flow next year of approximately 500 million thus stock trades at 12 times free cash flow. In addition Freescale has research and development expenses it is deducting which provide future benefits which equate to approximately 17% of sales or an estimated 1 billion. I believe the 500 million in free cash flow should be able to grow at 10% for the near term and consequently I did a discounted cashflow with 10% growth for 10 years and 2% growth thereafter and came up with a price over $30 a share.
On the negitive side Motorola accounts for 26% of sales which provides a significant risk given that Freescale has fixed costs with its plants which would more than likely cause significant losses should Freescale loose this business. Currently there is an agreement in place through 2006 which protects Freescale but after that the tranistion could be difficult. I believe with Freescales relationships with Motorola and research and development expertise they should be able to maintain this business going forward but it remains a significant risk. In addition the asset light strategy is relatively new and Freescales ability to manage production and quality outsourcing business is not proven; however this strategy intuitively makes sense and if they are able to manage the process it should provide big dividends for Freescale. In addition the price has already run up from 13 to its current price or an approximate 34% increase; however I believe there is plenty of room for it to continue to increase.
Catalyst
Recent spin off and timing by management to provide incentives to themselves and increased chance of success. Management received 18 million of stock options which vest in 4 years priced at $13 and 6 million shares in restricted stock which vest in 3 years.
Increased growth due to focused managment and availablity of new customers who were competitors of Motorola and would not deal with a subsidiary.
Restructuring completed increasing margins and profits