The semiconductor industry has always required a strong stomach and deep pockets. It's notoriously cyclical and, except for lucrative corners like PC processors, profit margins tend to be fairly low. Apparently, that's not a worry for top-tier private-equity firms Kohlberg Kravis Roberts, Silver Lake Partners, and Dutch firm AlpInvest, which late on Aug. 3 sealed a deal to acquire a majority stake in Philips Semiconductor from its Dutch parent company for an eye-popping €8.3 billion ($10.6 billion), including €4 billion in debt.
Question is, what draws KKR and company to this treacherous arena? And why have the private-equity firms gone to the mat to fend off two other investment consortiums—one reportedly including Blackstone Group, London's Permira Advisors, and Texas Pacific Group and the other including Apax Partners, Bain Capital, and Francisco Partners—to win this prize? Especially when KKR may be overpaying for Philips Semiconductor by as much as 15%, according to analyst estimates.
Announcing the deal, Egon Durban, a managing director of Silver Lake Partners, said that the consortium sees great untapped potential in the unit. "The business is well positioned to pursue and achieve significant expansion," Durban said in a press release. The group will continue "building value through a demonstrated commitment to innovative technologies."
Semiconductor industry experts figure the new owners aim to unlock hidden value in Europe's third-largest chipmaker by boosting profitability and selling off select assets. With €4.6 billion ($5.8 billion) in sales last year, Philips Semiconductor would be a top-10 maker on its own. But it is dwarfed inside sprawling Philips, which logged 2005 revenues of $38.6 billion.
The unit, which has swung between profits and losses in recent years, is among the most diversified chipmakers in the business. It supplies components used in everything from Dell (DELL) PCs to Mercedes (DCX) cars to Nokia (NOK) mobile phones. It also has a long tradition of innovation, having supplied other Philips divisions with the electronics that powered historic breakthroughs such as CD players and DVDs.
UP-AND-DOWN UNIT. More recent inventions include the Nexperia multimedia processors, which accounted for 17% of the unit's sales last year. Nexperia chips can be programmed to play TV on mobile phones or to stream audio and video signals into cars. Philips Semi has also played a pioneering role in so-called near-field communication, or short-range wireless communication of the sort used in contactless subway passes.
Such intellectual property might be more valuable if it were fully separated from the rest of Philips, analysts say. "The jewels are there; they just need to be polished up," says Malcolm Penn, director of semiconductor research at Future Horizons in Sevenoaks, England.
The new owners may have trouble finding immediate opportunities for polishing, though. After the tech downturn of 2000, Philips cut jobs and R&D spending at the money-losing chip unit and moved to more manufacturing outsourcing through partners such as Taiwan Semiconductor Manufacturing (TSM). Philips also sharpened its focus on growing markets where it had expertise, such as wireless and automotive.
The unit finally returned to profitability in 2004 after three years in the red and made €209 million ($265.4 million) in operating income on sales of €2.44 billion ($3.1 billion) in this year's first half. Even so, Philips announced in June its intention to cut the division loose for a possible sale or IPO.
FIRMS TEAM UP AGAIN. As a result of its efficiency drive, Philips Semi had first-half operating margins of 8.6%. That's higher than the 6.4% earned by Europe's largest chipmaker, Geneva-based STMicroelectronics (STM), which offers a similarly diversified product line to the same broad market segments. But it trails behind U.S. rivals such as National Semiconductor (NSM) and Freescale Semiconductor (FSL), which had a first-half operating margin of 14.7%. Bringing profitability up to the level of U.S. counterparts is likely a top priority for KKR.
New York-based KKR made its name in the late 1980s, popularizing the concept of the leveraged buyout with the record-setting $31.4 billion acquisition of RJR Nabisco, a deal that inspired the book Barbarians at the Gate. The legendary firm has resurfaced as a private-equity powerhouse in the past few years, recently teaming up with Bain Capital, Merrill Lynch (MER), and the family of Senate Majority Leader William Frist in a $33 billion bid for HCA (HCA), the largest hospital chain in the U.S. (Frist's father and brother founded HCA in 1968.)
For its part, Silver Lake, which is headquartered in Menlo Park, Calif., and New York, specializes in tech company investments and has developed a reputation for hitting it out of the ballpark on tech plays in its seven-year existence. It was part of a group that garnered a tenfold return on a $95 million investment in software maker Crystal Decisions.
KKR and Silver Lake have also teamed up before in semiconductors, buying Agilent Technologies' chip arm, SPG, for $2.66 billion in August, 2005. But SPG was a minnow with 6,600 employees. Philips Semi is in a different league: It has a staff of more than 35,600 and is the world's No. 8 chipmaker, according to Gartner.
POTENTIAL STRATEGIES. One of the most obvious ways to wring out value would be to sell assets. The new owners might split off the automotive segment to a company like U.S.-based Freescale, the former chip division of Motorola (MOT), which is strong in automotives, suggests Alan Brown, semiconductor research director at Gartner. The Philips unit already has a joint R&D production venture with Freescale and STMicroelectronics.
Another typical private-equity tack would be to hold onto the company for several years, rearrange the portfolio, and make R&D and manufacturing more efficient before selling it on. Again, the most likely candidate would be a U.S.-based firm such as Freescale or Broadcom (BRCM), which is now run by the former head of Philips' chip unit. By contrast, STMicroelectronics and Infineon (IFX)—the Nos. 1 and 2 European chipmakers—would probably turn down the chance to buy the former Philips unit, because there would be too much geographic and product overlap. They could also face EU antitrust concerns.
For all the ostensible merits of Philips' chip unit, there's no escaping the fact that the semiconductor industry remains highly volatile. Global chip sales are expected to grow an estimated 10.6% this year and 8.9% in 2007, according to Gartner Dataquest Research. While KKR and Silver Lake have obviously done their homework, the move is still a gamble.
"It's late in the up cycle to be buying, and they could be sitting there in 18 months wondering what to do," says Sean Murphy, an analyst with Nomura International in London. It might be time to stock up on the antacids.