Fitch: Consumer weakness drives negative outlook for semicon in 2009

Outlook 2009: Semiconductors

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Fitch: Consumer weakness drives negative semicon outlook

Fitch's 2009 Rating Outlook for semiconductor industry is negative due to a meaningfully weaker macroeconomic environment

Thursday, December 04, 2008

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CHICAGO, USA: Fitch's 2009 Rating Outlook for the semiconductor industry is negative due to a meaningfully weaker macroeconomic environment, resulting in lower revenues for all semiconductor markets and, in particular, PCs and mobile handsets, which represent nearly 60 percemt of the global semiconductor consumption.

While the overall market will be lower, Fitch expects developing economies will experience lower albeit still positive unit growth. Analog companies, typically less susceptible to industry cyclicality, will be negatively impacted by reduced global automotive production schedules and significant weakness expected for industrial products.

Overall, Fitch expects global semiconductor industry revenues, including memory makers, to decrease in the high single digits in 2009 from modestly higher revenue growth in 2008.

Excluding memory makers, which are more exposed to consumer electronics and experiencing severe pricing pressures, Fitch believes semiconductor industry revenues will decrease in the mid single digits. Fitch expects the more volatile semiconductor equipment industry will experience revenue declines in the high teens to low twenties.

While marking the industry's first revenue decline since 2001, Fitch does not expect decreases to be of the same magnitude as those of 2001 (~30 percent), although given the lack of visibility, Fitch believes there is more down- than up-side risk to current expectations. From a business and operating profile standpoint, Fitch believes semiconductor companies continue to be subject to the highest technology risk within the technology industry.

KEY INDUSTRY TRENDS: Several key trends impact Fitch's Outlook for the semiconductor industry in 2009:

Consumer electronics lead semiconductors lower in 2009:

Consumer electronics, particularly PCs and cell phone units, which have been the catalyst for semiconductor expansion over the past several years, will drive the overall semiconductor market lower in 2009. Fitch expects PC units to be flat to slightly lower and mobile phone units to decline in the mid single digits for the upcoming year. While the increasing mix of sales into developing economies should continue pressuring overall ASPs, Fitch also anticipates some ASP pressure to be mitigated by growth in higher priced smart phones in developed economies.

Additionally, Fitch continues to believe that, as the sales mix of consumer electronics increases, quickly bringing new products to market has become a competitive differentiator for original equipment manufacturers (OEM), supporting Fitch's expectations for increased use of outsourcing partners for research and development (R&D), manufacturing, and packaging and test.

More aggressive responses to evidence of slowdown:

Fitch believes the semiconductor supply chain has become more responsive to evidence of a slowdown, which should mitigate some of the impact of a weaker demand environment. Given the lack of visibility, along with concerns regarding the potential severity and duration of the current downturn, companies throughout the supply chain have announced restructuring initiatives, mostly headcount reductions but also shutting or transferring production to lower cost regions. Given the highly fixed cost nature of the semiconductor industry, Fitch expects there will be a lag in the impact of these actions and believes most programs, if successfully executed, will achieve targeted cost savings on an annual run rate basis by the end of 2009.

In addition, the semiconductor supply chain, including the equipment makers and distributors, have taken steps to reduce inventories, potentially resulting in cash generation from working capital and augmenting free cash flow. Investments into more advanced information systems, greater use of foundries and, as a result, less uneven in-house utilization rates, and increased inventory discipline by components distributors have enabled the supply chain to become more efficient in correcting pockets of excess inventory. While inventories remain at elevated levels, recent inventory imbalances have been corrected in one-to-two quarters, approximately half the historical time.

Outsourcing and restructuring improves free cash flow profiles:

Fitch believes outsourcing and business restructuring transactions planned for 2009 will strengthen the long-term free cash flow profiles of the companies involved, and potentially mitigate some expected profitability pressures for 2009. Both AMD and Spansion plan significant outsourcing partnerships, which Fitch believes will free capital to focus on design competencies and reduce cash burn rates from the associated R&D and capital spend. In addition, Fitch believes TI's and Freescale's planned divestitures of certain elements of their cellular handset chip businesses underscores the commoditization of this market and the increasing need for significant scale to support ongoing R&D investments. As a result of these transactions and cost reductions, Fitch expects intermediate term profit and free cash flow margins will improve.

These trends support Fitch's expectations for the increased use of foundries and partnerships, resulting in foundries expanding their share of semiconductor production over the longer-term. In Fitch's opinion, onerous R&D and capital spending requirements will prompt additional semiconductor makers to pursue hybrid or 'fab-lite' manufacturing strategies and partner with foundries in the development of next generation process technology. Importantly, Fitch continues to believe more use of foundries will result in a healthier supply and demand balance for the overall semiconductor industry, as foundries consolidate a significant amount of capital spending on leading-edge technology (required for cost effectively manufacturing high volume standardized products).

Memory makers remain the most volatile segment of semiconductors:

Fitch believes memory makers, mainly large integrated electronics companies who toggle between DRAM and NAND flash memory production based upon a dynamic demand environment, will continue to experience the greatest volatility. Despite curtailing capital spending in aggregate over the second half of 2008, the industry continues to suffer from excess supply that Fitch believes will be exacerbated by lower unit demand in 2009.

Capital spending in 2009 for memory makers is expected to be down sharply from 2008 levels, which should begin driving modestly improved pricing over the near-term. Nonetheless, because of significant competition in this highly commoditized market and that the vast majority of production is manufactured for use in consumer electronics devices, gross margins will remain thin, driving ongoing investments in leading-edge manufacturing capacity and ASP reductions for consumer electronics.

Key Company Outlooks

USA

Advanced Micro Devices Inc. (AMD): The Rating Outlook is Negative due to the company's currently weak liquidity and free cash flow trends and limited financial flexibility in conjunction with a challenging PC sales outlook. AMD ended the third calendar quarter with approximately $1.3 billion of cash and used approximately $225 million of cash during the quarter. At current cash burn rates, Fitch believes AMD's cash balances could fall below the $1 billion minimum cash requirement associated with the company's Fab 36 Term Loan Agreement over the next few quarters.

However, liquidity is expected to be meaningfully augmented by a $1 billion cash infusion in connection with AMD's proposed manufacturing JV, currently awaiting regulatory approval and expected to close in early 2009. Additionally, the company currently is negotiating with lenders to transfer approximately $1.2 billion of debt associated with the Fab 36 Term Loan Agreement to the JV. Assuming the transaction is consummated, Fitch believes the ratings could be stabilized. Longer term, the JV could have a positive impact on AMD's ratings due to an improved operating and financial profile, particularly if meaningfully lower capital spending results in stronger free cash flow.

Fitch believes a challenging PC market outlook of flat to down units for 2009 could cause a negative impact on AMD due to the company's greater exposure to consumers and the SMB market via the distribution channel. Additionally, AMD's recent product launches have stemmed rather than reversed additional market share to Intel Corp. (Intel).

Furthermore, Fitch expects Intel to continue using its manufacturing process technology lead to maintain meaningful pricing pressures on AMD. Positively, AMD should benefit from cost savings resulting from further aggressive restructuring actions to lower the company's break-even point to $1.5 billion of quarterly revenue. Assuming the aforementioned outsourcing transaction is consummated, AMD will gain additional savings from transferring employees and reduced R&D investments, which will be partially offset by higher wafer costs associated with a standard foundry model.

Freescale Semiconductor Inc. (Freescale): The Negative Rating Outlook reflects Fitch's expectation that the weaker macroeconomic environment should negatively impact Freescale across all business segments, including its historically more stable microcontrollers and radio frequency (RF), analog, and sensors segments. Sharper-than-anticipated production cuts for Freescale's automotive customers, particularly the big three U.S. automakers, should exacerbate top line and profitability pressures.

Finally, Motorola's cancellation of its remaining contractual purchase obligations from Freescale will result in a precipitous decline in quarterly cellular segment sales to below $100 million beginning in the fourth calendar quarter of 2008, compared to more than $350 million in the year ago quarter. However, Freescale's divestiture of the cellular business, which constitutes a significant amount of the company's R&D spend, should result in higher consolidated profit margins. The ratings also reflect Fitch's expectations that Freescale's credit protection measures will weaken over the near term, driven by a combination of lower profitability anticipated for 2009 and the company's recent draw down on its RCF.

As a follow up on to its 2008 restructuring activities, Freescale recently announced additional restructuring plans for 2009, which are expected to reduce annual fixed costs by up to $400 million by the end of next year. Cash restructuring costs should be offset by a $150 million of cash payment from Motorola, in exchange for the aforementioned cancelled purchase agreement throughout 2009. Although Fitch does not believe cost reductions will offset revenue declines in 2009, potentially resulting in negative free cash flow of more than $250 million, Freescale's liquidity position is more than sufficient to absorb negative free cash flow over the near-term.

Spansion Inc. (Spansion): The Negative Rating Outlook is driven primarily by Spansion's weak liquidity position and strained financial flexibility, which Fitch believes is likely to worsen in 2009 and potentially require the company to obtain external financing. It remains to be seen as to whether Spansion's aggressive capital and discretionary spending cuts are sufficient to offset expectations for meaningfully lower revenues and profitability over the near-term.

Spansion should be negatively impacted by a weaker cellular handset growth, which is underscored by the company's largest customer providing unseasonably weak sales guidance for current quarter. Spansion's embedded flash memory businesses should suffer from weaker spending on consumer electronics and declining automotive production levels through 2009. As a result, free cash flow should be negative for fourth quarter-2008 and all of 2009.

While Spansion's leading-edge manufacturing capacity and deepening relationships with foundry partners should enable the company to achieve sustainable operating profitability through a normalized pricing environment, Fitch remains concerned with the company's inability to command premium pricing, despite consolidating additional market share and increasing penetration of its higher density products. Positively, Spansion continues to reduce costs and is in the process of outsourcing its test and assembly operations, which should modestly reduce capital spending. Fitch believes Spansion's leading competitors, Samsung Electronics Co. (Samsung) and, to a lesser extent, Numonyx, also benefit from greater financial flexibility and, therefore, have been better able to withstand the currently challenging operating environment.

Texas Instruments (TI): The Rating Outlook is Stable and reflects TI's diversified end-market, customer and product portfolios, hybrid manufacturing strategy and leading market positions, particularly in applications processors and analog and mixed-signal markets. TI's strong annual free cash flow should continue to exceed $1 billion, augmenting the company's already strong financial flexibility. TI also has no debt in its capital structure. The company's operating profile may be strengthened by the planned divestiture of the company's less profitable baseband business, which Fitch believes will result in higher pro forma profit margins. While lower R&D spending also should boost profit margins, Fitch expects TI to shift these resources to its higher-margin applications processor and analog and mixed-signal businesses.

TI's operating performance should be pressured in 2009, driven by the aforementioned lower cell phone units and weaker demand for the company's analog and mixed-signal business, which represents approximately 40 percent of the company's semiconductor sales. TI's outsourcing relationships, including the development of next-generation process technologies with TSMC, should enable the company to maintain below industry average capital expenditures and R&D as a percentage of revenues and bolstering free cash flow. However, Fitch believes meaningfully lower than anticipated profitability or share repurchase activity in excess of annual free cash flow (beyond excess cash) could result in negative rating actions in 2009.

KLA-Tencor Corp. (KLAC): The Stable Outlook reflects KLA-Tencor's strong share within semiconductor process control markets, consistently solid annual free cash flow, which Fitch expects will be pressured but positive in 2009, increasing recurring revenues associated with a significant installed base, and solid liquidity and credit protection measures. Fitch expects the semiconductor equipment market will decline nearly 20 percent in 2009, driven by a weak outlook across all semiconductor maker end markets, although Fitch believes KLAC's end markets are slightly less volatile than the broader semiconductor equipment market due to the critical role process technology evolution plays in semiconductor manufacturing.

Nonetheless, Fitch expects KLAC will experience significant gross margin contraction over the near-term, possibly decreasing into the mid-twenties range from the mid-to-high 50 percent in fiscal year 2008, which the company aims to counter with a recently announced restructuring program. Despite expectations for positive free cash flow in 2009, Fitch believes KLAC has more than sufficient liquidity to support even moderate cash burn for 2009, in a stress case. While the potential for more aggressive stock repurchases and further acquisitions remain a longer-term concern, Fitch believes the company will focus on preserving cash balances in 2009.

Europe

STMicroelectronics NV (STM): The Rating Outlook is Stable, driven by STM's strong market positions in a number of segments and solid liquidity position. While Fitch anticipates operating performance will decline in line with the broader semiconductor market in 2009, Fitch nonetheless expects STM to continue to generate positive free cash flow, supported by the company's strengthened operating profile following its ongoing business restructuring activities and increased scale in certain key markets. Going forward, Fitch believes STM will benefit from its increased partnering with Ericsson via its ST-NXP Wireless JV, as well as the contribution of its capital-intensive NOR flash memory business to a JV with Intel, Numonyx. As a result of the former, STM increases its scale, which Fitch believes is increasingly critical in the wireless market, and provides opportunities for a growing share of higher margin royalty type revenues.

The significant portfolio restructuring accomplished in 2008, should continue to drive down capital intensity (capex/sales), build margins and further improve cash flow over the medium term. Fitch recognizes that results will be impacted by industry conditions through 2009 (including a meaningful slowdown in the auto sector and a weakening wireless market). The recent strengthening of the USD should provide some margin support given a relatively high euro denominated cost base, while the cash payment from Ericsson following its participation in the wireless JV will return STM to a net cash position earlier than previously envisaged, providing rating support despite economic conditions.

ASML Holdings NV (ASML): The Rating Outlook is Positive, driven by ASML's dominant market position in lithography equipment manufacturing, free cash flow profile, flexible cost structure, and solid liquidity position. While Fitch expects meaningfully lower sales for ASML over the near-term, driven by customers' postponement of non-critical lithography investments, lower foundry orders for high-end lithography tools, and weaker capacity-related expansion spending across the industry, the ratings incorporate Fitch's expectations that ASML will post mid-teen operating margins in 2008 and positive earnings and free cash flow through the business cycle. Further assurances are provided by the company's commitment to a gross cash balance of EUR 1 billion-1.5 billion.

Fitch recognizes the inherent volatility in ASML's revenue visibility, relatively small scale, lack of diversification and somewhat high customer concentration. Given recent declines in orders and a current lack of visibility throughout the semiconductor supply chain, Fitch will focus on ASML's order intake over the next one-to-two quarters, as the order backlog at that stage should provide some base line assurances for the following six-to-nine months. While demand for high-end immersion tools will, in Fitch's view, provides an underlying level of sales, the revenue environment is extremely uncertain at present. While Fitch believes the company's cost structure and sound liquidity, will help protect the rating through the downturn, the severity or potential length of the down cycle, could prompt a further review and potentially lead to a stabilization of the Rating Outlook.

Asia

Taiwan Semiconductor Manufacturing Co. Ltd (TSMC): Fitch's Rating Outlook on TSMC is Stable, driven by the company's broad product range, technology leadership, and integrated services for IC design and manufacture resulting in a dominant market position and deepening customer relationships. Fitch believes the foundries' long-term growth prospects, TSMC's strong financial flexibility, consistent free cash flow, and conservative capital structure and financial policies mitigates Fitch's concern regarding the company's reliance on outsourcing orders, significant ongoing capital spending requirements and operating volatility due to the semiconductor industry's cyclical nature.

Fitch believes negative semiconductor unit growth in 2009 will be exacerbated by continued ASP pressures related to order reduction and slow technology migration by customers. Following declines in 2008, Fitch expects continued capital spending prudence in 2009, supporting TSMC's capacity utilization and profitability. For 2009, Fitch believes TSMC's share buyback plans to offset EPS dilution will have negligible negative implications on TSMC's credit metrics due to expectations for positive free cash flow and the maintenance of a net cash position through 2009.

United Microelectronics Corp. (UMC): Fitch's Stable Rating Outlook on UMC is supported by the company's full range of production capabilities, solid relationships with a diversified and growing client base, and strong market position as the second-largest dedicated foundry in the world. The increasing outsourcing of wafer fabrication by semiconductor suppliers and UMC's sound financial profile, characterized by solid liquidity, conservative capital structure, and steady annual free cash flow, mitigates Fitch's concern on its reliance on outsourcing orders, capital intensity resulting from significant requirement in capital spending and R&D, and operating volatility related to the cyclical nature of the semiconductor industry.

While Fitch believes declining semiconductor unit growth in 2009 will be exacerbated by continued ASP pressures related to order reduction, slow technology migration by customers, and UMC's narrowed technology edge against competitors, Fitch expects the evolution of the outsourcing manufacturing model will result in solid longer-term growth. Given a weaker near-term semiconductor outlook, Fitch expects UMC to focus on maximizing capacity utilization and generating positive free cash flow, driven in part by significantly reduced capital spending for the year. Fitch does not expect significant shareholder-friendly actions during 2009, particularly in light of the investment requirements related to the company's research and development of advanced process technologies and continued expansion of manufacturing capacity, including a second 300 mm wafer fabrication plant.

Hynix Semiconductor Inc. (Hynix): The Rating Outlook for Hynix is Stable, reflecting Fitch's expectations that memory prices are likely to remain pressured but begin improving from currently depressed levels within the near-term, driven by capital spending reductions in the second half of 2008. As a result, supply and demand imbalances should ease somewhat for the industry, although weaker PC, cell phone, and other consumer electronics demand in 2009 could mitigate industry supply rationalizations.

Nevertheless, incorporated into the Stable Rating Outlook is Fitch's expectation that the company will return to operating profitability, resulting in the stabilization of credit protection measures, which have weakened since the end of 2006. Fitch notes that credit protection measure remain solid for the current rating category. Fitch may downgrade Hynix further if the current weak DRAM pricing environment is protracted and Hynix continues to report negative EBIT margins on a quarterly basis, and/or its adjusted net debt/EBITDAR leverage exceeds 3x.

©CIOL Bureau

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