The Wall Street Journal-20080214-Freescale a Test of Nitty-Gritty Reality

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Freescale a Test of Nitty-Gritty Reality

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It was a gutsy deal. Four of the world's largest private-equity firms paid $17.6 billion for the biggest technology buyout in history: Freescale Semiconductor Inc., a decades-old chip maker in a notoriously cyclical business.

Fourteen months since that December 2006 deal, Freescale is demanding more guts than ever from its new owners. The company is struggling with slackening demand from Motorola Inc. and auto makers. The loans used to finance the buyout are trading in the secondary market at 85 cents on the dollar, traditionally a sign of financial distress. Meanwhile, the industry's prospects have grown murky.

"We have encountered some rough weather," said Daniel Akerson, a Carlyle Group executive and Freescale board member. "Every company has challenges; the question is: Can you fight through them successfully?"

Freescale's four owners -- Carlyle, Blackstone Group, TPG and Permira -- are starting at the top. The company yesterday said that it has hired as its chief executive officer Rich Beyer, who resigned yesterday as CEO of chip maker Intersil Corp. He succeeds Michel Mayer, who announced last week that he was stepping down. Mr. Mayer earned as much as $50 million when Freescale went private.

Much has been made of the froth and overconfidence displayed at the top of the private-equity bubble in late 2006 and early 2007. Hardly any deals stumbled, and buyout firms booked big profits by accessing the debt markets for quick payouts.

Those days are gone. Now, owners must get to the nitty-gritty of managing businesses in tight economic times. The fate of Freescale will be one of the first tests of their mettle, but it may not be the last.

The loans on some of the biggest buyouts of the past two years are already under pressure. Claire's Stores, purchased by Apollo Management LP in May 2007 for about $3.1 billion, is trading at 78 cents on the dollar; Univision, bought in Sept. 2006 by a buyout group for $13.7 billion, is trading at 78 cents on the dollar.

Freescale's private-equity owners are counting on an advantage earned during the free-flowing days of cheap credit. Roughly $3.5 billion of Freescale's $9 billion borrowing package is "covenant- lite," meaning lenders won't hold the company to typically strict cash-flow requirements.

Also, about $1.5 billion of Freescale's debt effectively gives the company flexibility to turn the interest payments on and off. Known as payment-in-kind notes, this debt gives Freescale flexibility to suspend debt payments and instead issue lenders new securities at a higher interest rate.

Private-equity owners have more time on their side than do public- company chiefs driven by quarterly performance. Buyout firms historically have taken five to seven years to flip an investment back to public markets or corporate buyers, and economic cycles can shift dramatically. As long as they can pay down debt in the interim, they can typically make good returns for investors.

The past year has nonetheless been a challenging one for the semiconductor industry, and with recession fears heading into 2008, the demand from computer companies, wireless companies and other hardware makers is uncertain.

"Things were slow last year, they slowed even more toward the end of the year, and now we just don't know whether they're going to get worse from here," said Glen Yeung, a semiconductor analyst at Citigroup Inc.

And Freescale, a unit of Motorola until being spun out in 2004, is not without its specific issues. Sales were down 10% to $5.72 billion in 2007, and its sales of cellular chips totaled $1.22 billion, down nearly 18%. It recently painted a dim outlook for 2008, citing a slowing global economy and weakness in the North American car business, a source of company revenue.

Its largest potential problems rest with Motorola, which represents roughly a quarter of its revenue. Motorola recently announced that problems with its wireless business will "take longer than expected to fix" and said it's beginning to use Qualcomm Inc. for some handsets. This could cause Freescale a significant market-share loss beginning next year, according to debt-research company CreditSights Inc.

Freescale has implemented measures to shore up its finances. The company says it expects to receive about another $500 million in cash this quarter from a one-time Motorola payment and asset sales. It cut expenses by initiating layoffs of 700 people last spring. And to diversify its product line away from the wireless market, the company is seeking acquisitions.

Freescale has sufficient liquidity to service its debt, which amounts to roughly $800 million in annual interest payments, according to analysts. The company had roughly $1.5 billion in earnings before interest, taxes, depreciation and amortization during 2007; plus, about $750 million in cash on its balance sheet at year end.

But analysts say the company has high leverage and a relatively low ratio of Ebitda to its interest expense. Coupled with the macroeconomic picture, those factors make it a risky borrower, and investors are being compensated for that, with its bonds offering a total return of 13% to 17%.

"Even within the universe of high-yield bonds, we think that Freescale is one of the riskier credits," said Robert Lee, a credit analyst at KDP Investment Advisors Inc. Despite the risk, Mr. Lee is recommending Freescale bonds.