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A Dicey Win For Blackstone


It was a quick but brutal skirmish between private-equity titans, but it said a lot about the state of the buyout business. On Sunday, Sept. 10, a team of four firms led by the Blackstone Group was putting the final touches on a $38-per-share bid for a major industrial company. All of a sudden, a rival quartet led by Kohlberg Kravis Roberts & Co. swooped in and suggested they might be willing to pay up to $42. Flush with cash, buyout firms have begun gobbling up companies everywhere in sight, often busting in on each other's deals. The surprising thing about this bidding war was the spoils: Austin (Tex.)-based Freescale Semiconductor Inc. (FSL), one of the world's largest players in the semiconductor industry, hardly a province for buyout barons.

On Nov. 13 the Blackstone crowd prevailed when Freescale shareholders signed off on its $17.6 billion offer, paving the way for the largest tech buyout ever. The $40 per share that Freescale ultimately accepted was a steep premium for a company that traded at $30 before the deal and just $13 after being spun off from Motorola Inc. (MOT) two years before. "The deal was a shock," says veteran semiconductor analyst William I. Strauss at research firm Forward Concepts Co. in Tempe, Ariz.

The semiconductor industry is unstable and demands lots of capital spending to keep up with rapid technological changes. In that kind of an environment, debt--the lifeblood of buyout firms--can be dangerous. Someday Blackstone, Texas Pacific, the Carlyle Group, and Permira Advisers might look wise for paying up for one of the few chipmakers large and strong enough to be a survivor, and a potential acquirer, in an industry ripe for consolidation. But there are many risks, and the deal could just as easily turn out to be a bust.

The most pressing question for the buyout firms is whether Freescale can thrive despite the $9.5 billion in debt it must take on for its owners to pay for the deal. Freescale's interest expense payments are expected to zoom to more than $750 million, vs. $105 million paid in the 12 months ended in September. "Because this is funded with so much debt, it is one of the riskier deals in tech land," says Jason Pompeii, an analyst at Fitch Ratings. When the buyout was confirmed, Fitch downgraded Freescale's existing debt from investment grade to junk status.

Freescale's management team and Blackstone's group declined to comment for this story, citing regulatory restrictions. When asked if the deal was risky, Freescale board member Stephen P. Kaufman said: "That's an issue for the buyers." The board, he says, was focused on getting a good price for shareholders.

Right now it looks as though the buyers have some breathing room; Freescale generated $780 million in cash last year. But the firms are expected to cart off all but $600 million of the $3 billion of cash on the balance sheet to pay for the deal. Moody's Investors Service estimates that Freescale will generate only $350 million in free cash in 2007. Value Line reckons net income will shrink to $860 million, from $930 million. "The company will have less flexibility to fund growth plans," says Moody's analyst Gregory A. Fraser.

The debt load also leaves precious little room for error in the event of an industry downturn. In the semiconductor industry's last severe bust, in 2001, Freescale, then Motorola's chip division, lost $2.2 billion. It began to slash its workforce by one-third and shuttered more than half of its manufacturing facilities to reduce fixed costs. When the red ink kept flowing, Motorola spun off the business and brought in Michel Mayer, a general manager at IBM Microelectronics (IBM), to be the new company's chief executive. He quickly set about making Freescale lean and mean. Profit margins rose by 10% in two years, and it regularly beat analysts' quarterly earnings estimates. "Had the private-equity firms leapt in right after Freescale went public, I could see where they would have recognized the value in the turnaround story," says Doug Freedman, an analyst at American Technology Research Inc. "But they're stepping in after the company has been raising its numbers many quarters in a row."

UNDERAPPRECIATED PLAYER

Cost-cutting alone can't work forever. Freescale's sales increased by only 2.4% in 2005 as the revenues of chipmakers overall rose by 5.7%, according to tech industry researcher Gartner Dataquest (IT). In early 2006, executives began to examine their strategic options, which included buying the semiconductor business of Amsterdam-based Royal Philips Electronics (PHG) and merging with another company, according to company filings with the Securities & Exchange Commission. In May, Blackstone contacted Mayer to see if Freescale would be interested in a deal, and going private was added to the list of possibilities.

The buyout firms led by Blackstone were interested in Freescale because they perceived it to be a crucial player in an industry growing faster than the overall economy. They also believed public investors weren't recognizing the improvements it had made or appreciating its position as a leading supplier of chips to a wide variety of products in the electronics industry, from cell phones to cars.

And the group thinks the chip industry itself is changing in a fundamental way. According to sources close to the deal, they expect it to experience slower growth and less volatility as chips become incorporated into a wider range of products. As a result, they reason, Freescale won't have to burn through cash to fund rapid expansion, and will be able to handle more debt on its books. That assumption makes the deal seem more like a classic leveraged buyout, in which a firm seeks out steady cash flow.

But Freescale needs to do more than stabilize its cash flow to make the buyout work for its new owners--it needs to grow. One way to do that is through acquisitions. Citigroup (C) analyst Glen Yeung recently issued a report speculating that Freescale might buy other chipmakers or chipmaking units like STMicroelectronics (STM) to transform itself into a Texas Instruments Inc. (TXN)-like business with scale.

Buyout firms do know a thing or two about rollup strategies. Still, bidding wars often push buyers to make offers they later regret. Consider that in July Blackstone offered just $35.50 to $37 per share for Freescale while it was pursuing the semiconductor business of Philips Electronics, according to filings. By the time the KKR group pounced on the possibility of buying Freescale on Sept. 10, Blackstone's group was about to nab it for $38 a share. On Sept. 14, Blackstone's crowd put in a "best and final" offer of $40 that would expire the next day at 10 p.m. The offer permitted Freescale to seek higher bids for the following 50 days. None emerged.


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