Infineon Case Study_2 PDF

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Solution to the Mandatory Infineon Case Study...

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Case 4 - Business & Financial Analysis -

Infineon Technologies Corporate Finance

Section A | Team 5 Pirmin Affolter, Julian Kröger, Pedro Pereira, Charles Té, Simon Werner Master in Finance Class 2016/2017

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ESADE MSc in Finance | Section A – Team 5

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Business Analysis

1.1

Spotlight on Infineon’s business and industry environment

Infineon Technologies is a global player in the semiconductor industry based in Munich with market capitalization of around €6bn and €4bn in revenues (2011). Infineon develops, produces and markets products for a variety of microelectronic applications, focused on energy efficiency, mobility and security. The organizational structure is divided into three units in all of which Infineon is a global market leader. Automotive (ATV, 39% of Sales, 10% Market Share) -Vehicle electronics unit that provides microcontrollers, power chips and control sensors, chassis and comfort electronics as well as safety systems and battery control for electric cars -Microcontrollers one of Infineon’s core competencies and pervasive in many target markets Industrial & Multimarket (IMM, 45% of Sales, 12% Market Share) -Produces power chips involved in efficient generation, transmission and use of electricity in industrial applications or home appliances -Power chips from IMM (key product) were used in the ATV units as well, thus increasing IMM’s total contribution to revenue to around 60% -Mainly blue-chip customers promising stable revenues flows Chip Card & Security (CCS, 11% of Sales, 25% Market Share) -Delivers electronic security in chip cards and mobile devices, such as electronic IDs, SIM cards -Important growth market due to electronic systems integration and increased need for data security as well as energy efficiency Over the last years, Infineon was able to smoothen its top- and bottom-line performance by focusing on these three core units through divestures in commodity markets such as DRAMs. However, it still faces the main challenges of the semiconductor industry: cyclicality (dependence on economic growth), capital intensity, intense competition, government intervention, long lead times for technology and manufacturing capacity and innovative pressures. From an operational standpoint, Infineon was able to recover quickly in the years 2010 and 2011 after being hit hard by the financial crisis with sales growth of 50.9% and 21.3% and EBITDA margins of 20.8% and 27.5%, respectively. A deeper analysis of operational performance is shown in exhibit 1. Infineon was the market leader in the power chips market, in which scale is particularly important to cope with the industry’s challenges. In 2011, Infineon strategically divested its wireless chip unit (representing 30% of sales) due to a shift in the market, which simplified operations and reduced variability in returns, but also put more focus and dependence on further development of the remaining units. Additionally, it entered exclusive, long-term relationships with its customers and fixed prices contractually, thus mitigating some of the industry risk and facing only volume as contingency. However, although Infineon almost doubled its CAPEX to 22% of sales in 2011, if faced some capacity constraints due to a strong market upturn paired with long capacity expansion lead times. Therefore, Infineon might not be able to reap all the benefits of this upswing. Nevertheless, the company seems to have coped with the main challenges of the industry and successfully executed a turnaround focusing on promising growth segments, which leads us to predict a positive outlook. Going forward, in addition to the KPIs analyzed in exhibit, we would like to emphasize the following two measures to evaluate future performance: FCF: Reflects ability to run daily business and generate organic growth. In face of high cyclicality this ability is of vital importance ROCE: Reflects connection between profitability and resources needed to run the business. Highly important figure in this capital intensive industry

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To strengthen its current position from a business perspective Infineon has several options. Firstly, it should maintain high levels of CAPEX and R&D expenditures and could also use its re-established focus to integrate R&D activities and develop interdependent products, which would in turn further increase its power in the market. Further, Infineon might engage in M&A activity, which would further strengthen its market position and might hinder other larger players to enter particular markets, mitigate certain macroeconomic risks and utilize economies of scale. Although share prices are peaking one should not rule out this possibility for external growth.

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Financial Analysis

2.1

Infineon’s financial policy and capital structure

The cyclicality of the industry in combination with the presence of intense rivalry and huge capital needs put a lot of pressure on the financial policy and capital structure of Infineon. With the burst of tech bubble in the early 2000s and the uproar of the financial crisis since 2007, it became evident that Infineon had to pursue an agile and flexible strategy to stay competitive. Conservatism with regard to huge provisions (amounting to a total of €810m in FY 2011) and extremely high cash reserves (€2.4bn, 40% of total assets) were the logical consequence. Having traditionally worked with internal measures, such as cost-saving plans, the German company used a number of different capital sources. In the early 2000s, they sold €1.5bn of equity, which in combination with existing credit lines (€2bn) and divestments (€700mn) avoided the hazard of bankruptcy during the dot-com crisis. Moreover, Infineon raised a total of €1.7bn equity through convertible bonds in 2002 in order to safeguard for potential litigations. Until the financial crisis, the company’s leverage stayed high while profits returned. In 2006, Infineon floated 14% of its wholly owned subsidiary Qimonda to raise capital. Unfavourable market conditions such as currency exposure and counter chip-related issues were the reason. Adverse to the previously positive developments of Infineon’s financials in the post dot-com period, the financial crisis had again severe consequence for the company’s financial policy and capital structure. In 2009 Qimonda went into liquidation. Apart from that, Infineon’s stock price dropped to a record low or €0.35 due to huge losses and €900mn of debt. As a consequence, Infineon raised €195.6m with a 5-year convertible and €725m in a 2.15 rights issue in 2009. Additionally, Infineon sold its wireless unit in 2011 to a PE for €250m. Synthesizing the above mentioned sources of capital for 2009 to 2011, we observe the following: in 2009, 55.03% of funds were source from “Assets held for Sale” reflecting the Qimonda liquidation. In 2010, the majority came from raises in equity, representing 35.09%. In 2011, the sale of Infineon’s wireless unit is represented in “Assets held for sale”, amounting for 27.15% of the fund’s sources. Additionally, provisions (14.24%) and equity (40.44%) are the main drivers. Looking at the use of funds, there is a more consistent picture. Cash reserves explode, while debt is repaid. In 2011, “cash and other liquid assets” amount for 53.46% of the total use of funds (see Exhibit 2). When the management reviewed its capital structure, a review of the cash reserves became inevitable. Compared to its peer, this position was extremely high, supplemented by a low leverage. The sustainable growth rate of Infineon represents the maximum growth rate that can be achieved without the use of increased financial leverage. The value increases from 20.95% in 2010 to 27.84% in 2011 (assuming equal payout ratios). These numbers are substantially higher than the net asset growth in the same period (2010: 14.4%; 2011: 17.6%). Therefore, Infineon’s growth potential has not yet been fully exhausted (see Exhibit 3). 2.2

Analysis of large cash holdings and the case of Infineon

Pros of large cash holdings x

Flexibility: Having large cash holdings allows company to be flexible in times of economic turmoil. This is a crucial factor as Infineon faced past challenges that strongly affected its financials.

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x x

Reactivity to opportunities (acquisitions, speculation): This is less relevant for Infineon as the company is already in a mature phase with little to no M&A activity. Strong company performance: Good signal to the market and investors that the company performs well. However, in the case of Infineon the stockpile of cash amount was raised to offset the effects of the cyclical nature of the industry which dragged Infineon down during economic recession.

Cons of large cash holdings x x x x

Opportunity cost: This large cash pile could be invested in new projects or used to expand the business. Given the company’s leadership in the 3 target markets, geographic advantage and complete product portfolio, the strategic need for acquisitions was unnecessary. Discipline: A high cash company may lose control regarding cash expenditure and spend it on inadequate matters Take-over risks: Large cash amount increases risk for takeover bidding from competitors. Considering the size of Infineon this scenario is very unlikely to happen. No or little use of tax shield: by increasing its leverage, Infineon could benefit from tax shield to create value.

Infineon’s current capital structure: Before 2008, Infineon’s capital structure was composed of higher debt (with a D/E ratio of 2,23 in 2008). In the following years, the company has seen its capital structure rapidly change and decreased its D/E ratio to 0,75 in 2011. The decision stemmed essentially from a mixture of past events (financial crisis and preceding occurrences) and from the cyclical nature and the capital intensity of the industry. Record revenues and recent divestitures boosted the level of cash. The management’s decision to reduce leverage with a Debt/Asset ratio from 69% to 43% displays the actions taken to develop a more appropriate capital structure, based on more equity. In the meantime, the company’s liquidity highly increased with a skyrocketing cash coverage ratio of 0,24 to 1,34 between the same years. We believe these decisions were suitable considering the nature of industry. Nevertheless, some of the cash could be distributed to shareholders as the cash amount was higher than the total liabilities. Although the debt level does not alarmingly need to be readjusted, having more debt and decreasing cash can incentivize Infineon’s management to improve discipline. 2.3

Payout policy and the case of Infineon

A company might choose to pay out cash to shareholders for many reasons, including the following: x x x x x

Exhibit its financial performance to reassure current shareholders and potentially attract new ones. To prevent managers from “empire building” that may be unprofitable investments Reduce cost of capital by reducing assets, especially if company is out of positive NPV investments Allows room for unions to negotiate salaries and benefits as there is a high amount of available cash Reducing cash holding is a preventive measure to decrease risk of hostile takeovers

Infineon’s primary objective in paying out cash is to become” relatively predictable regarding dividend payments “. Particularly since 2000 dividends were not given to shareholders, it is a way to reward their trust and given that the firm is now able to do so. It will also stabilise share price and sends a clear message to the market about the firm’s stability and confidence. Some investors might however question Infineon’s investments opportunities and the management’s long-term vision for the firm. 2.4

Analysis of payout options We find that the main factors Infineon should consider choosing a payout method are the following: x x

Remain flexible in the future to react growth opportunities and economic downturns Increase predictability of Infineon’s shareholder returns

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x x

Calm concerns that Infineon has too much cash on its balance sheet or find a way to spend it that benefits its shareholders Account for differences in taxation of its shareholders

Î Considering Infineon’s situation, we find that in case Infineon decides to payout cash, it should do it via both, dividends and share repurchases. 2.5

Put warrants issues

Warrants are issued by companies (usually as part of a new-issue offering) to entice investors into buying the security. Put warrants are company-issued options that give the holder the right (but not the obligation) to sell the shares back to the company at a pre-determined date and (strike) price. In return, the company receives an upfront tax-free cash premium for the added security/flexibility. Through the issuance of warrants, companies can have equity financing in phases, which results in reduced issuing costs. The risks for the issuing company are potentially large and costly in case the share price drops below the strike price. First, it is important to note that put warrant issues give a positive signal to investors because it signals that the company does not expect its stock to fall below the strike price and is a useful tool to reassure investors in difficult times. Infineon used this ‘delayed share repurchase’ method in 2011 to return capital to shareholders after having successfully completed the much needed turnaround. Also, these put warrants enable Infineon to pocket sizeable premiums and reduce the cost of its share repurchase program. A positive capital market environment and company outlook, a solid credit rating of the company (issuer risk) and market liquidity/volatility are key factors that determine the success of put warrants issues. When we look at Infineon’s objective to be relatively predictable regarding their payout policy, put warrants do not appear to be the most suitable instrument to be scaled up. First of all, cash will only distributed if the price of the stock falls below the strike price. Moreover, this payout method is more risky due to the high volatility of Infineon’s stock (from 2007 to 2011 the stock price has went from €13 to less than 1€ and back up to around ESADE MSc in Finance | Section A – Team 5

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8€), which means the stock might drop significantly below the strike price causing warrants to be exercised (company would pay more than the stock is worth). This makes planning more difficult. Finally, it would cause additional cash inflows in the short term due to the premiums on the warrants while the company is actually thinking about how to best distribute their cash, even though the premiums would have a small impact on Infineon’s cash balance because of the size of this program. Therefore, put warrants should not be scaled up. 2.6

Convertible bond repurchases

Convertible bonds are a type of debt security that can be converted into a predetermined amount of the underlying company's equity at certain times during the bond's life, usually defined by the conversion ratio (i.e. the number of shares in exchange for one bond). They offer lower coupon rates than straight bonds, reflecting the option value they contain (participation in the upside movement of the underlying stock). Most convertible bonds are callable, meaning the issuer can buy back the bond before expiration and in doing so distribute cash back to investors. If a company is interested in repurchasing their convertible bonds, they have various methods to do so. The most common are: x x x

Open market purchases: retirement of convertibles for cash through open market or privately negotiated transactions. Common stock exchanges: opportunistic retirement of convertibles through stock exchange. Public tender offers: engaging in tender offers may involve payment of cash, registered issuance of shares or debt in exchange for the convertible bonds or temporary increases in the conversion rate.

The repurchase of convertible bonds might be an appealing strategy if the company seeks to reduce debt, streamline its debt-to-equity ratio or optimize its borrowing cost in the case of falling interest rates. As the bonds were issued after the crisis, its coupons were considerably high, which makes a repurchase attractive. Furthermore, the loss of the buyback would be tax deductible for Infineon. Consequently, this is a method that could be scaled up to distribute further cash. However, before making such a decision Infineon should consider the effect on its capital structure and share price development. As the convertible is deep in the money, this can be seen as very similar to a regular share buyback. Given the substantial cash balance of the semiconductor manufacturer in 2011, it can indeed be interesting for them to use the liquidity to buyback a part of its outstanding convertible debt. However, it is important to keep in mind that this would not benefit current shareholders at all. 2.7

Conclusion

Based on Infineon’s objective of becoming predictable in its payout policy and rewarding shareholders, a steadily-growing regular dividend seems to be the most appropriate method. Given its substantial cash balance, we recommend combining this with a share buyback (Dutch tender offer 1) to make use of a more flexible and short-term oriented payout method. At the same time, Infineon should retain sufficient cash to cope with the industry’s challenges, such as cyclicality, intense rivalry, high R&D and capital intensity.

1 A Dutch tender offer operates like an auction; a company offers to repurchase a specific number of shares within a given price range. Shareholders are invited to tender shares over a 35 calendar day period, and do so by specifying the lowest price within the range that they will accept. The company collects investor offers, and purchases the tendered shares up to the specified share limit at the lowest price possible. If the company receives more offers at the accepted price than the specified share number, all shareholders who tendered at or below the accepted price will receive a pro-rata allocation. This would also consider the differences in taxations of capital gains and dividend revenues of its shareholders.

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Appendix

Exhibit 1: Operational Performance Indicators Operational Performance Indicators 2008

2009

2010

2011

CAGR 08-11

EBITDA margin Cash Conversion Cycle Asset Turnover Return on Assets Return on Equity COGS margin as % of sales R&D expenses margin as % of sales SG&A margin as % of sales D&A margin as % of sales

12.4% 98 38.5% -14.3% -29.9% 56.5% 14.6% 15.2% 20.7%

20.8% 38 70.4% 13.2% 25.1% 52.3% 12.1% 11.7% 10.2%

27.5% 7 73.6% 19.1% 33.4% 49.5% 11.0% 11.2% 9.1%

28.5% -58.7% n/a 176.8% 162.6% -1.6 -10.9% -5.3% -13.6%

13.0% 103 n/a. -42.0% -135.8% 52.0% 15.5% 13.2% 14.1%

Exhibit 2: Sources and Uses of Funds 2009-2011

Exhibit 3: Sustainable Growth Rate 185

2011: 33.35% ∙ (1 − 1,119) = 27.84%

ESADE MSc in Finance | Section A – Team 5

2010: 25.10% ∙ (1 −

109 ) 659

= 20.95%

i...