Is Big Blue the answer for Chartered Semi?

The stock rises 22% on the news of a deal, but will it solve Chartered Semi''s problems?

There are some people who might be wondering (yet again) just how market-savvy Chartered Semiconductor's senior management is. Having experienced the most savage rights issue in recent Asian history, it has now announced a key agreement with IBM that has seen its stock price jump 22% in a day to S$1.20.

Indeed, one may ask: surely these events are in the wrong order? If Chartered had concluded and announced its IBM agreement before it announced its massive rights issue, the reaction (and huge subsequent destruction of value) may have been somewhat more muted.

The market has clearly grabbed the IBM news in the hope it has given Chartered a strategic boost that may allow it to one day compete on equal terms with market leaders, TSMC and UMC. The deal allows Chartered access to IBM's new 300mm fab in East Fishkill and 90nm technology. This has gone some way to removing doubts over Chartered's future technology roadmap; it also defers capex on Chartered's own 300mm fab till the third quarter of next year.

However, is this a panacea for Chartered, which still operates at well under half the capacity of TSMC and has barely ever been profitable in its whole history? Does the deal solve Chartered's underlying problem of simply having too few customers?

UBS Warburg maintains a sell on the stock. It states: "We believe there should be limited impact on TSMC and UMC as gaining customers will likely remain a challenge for Chartered despite its alliance with IBM. IBM's foundry service is currently priced more expensively than its peers."

The top-ranked broker believes the move is defensive. It says Chartered is acting to protect existing customers who otherwise might have migrated to TSMC and UMC due to a fear of the Singapore company falling ever further behind in technological terms. It adds: "In our view, there may be a conflict of interest between Chartered and IBM as they would both be partners and competitors at the same time. Previously, UMC had a joint venture agreement with IBM. However, the agreement ended without extension. We believe this was partly due to the inability of the companies to achieve smooth technology transfer. Given the challenge of technology transfer, it remains to be seen whether the joint development between Chartered and IBM would have different results."

Much like other strategies Chartered has pursued for the past 18 months, the IBM strategy buys it time. "It delays capex", says one banker who knows the company well. "But this deal also caps the company's upside if demand does suddenly go up since IBM gets to use Chartered's 300mm fab when it ramps."

Thus, if there were a surge in demand in the next couple of years, Chartered's profits would see less of a boost than TSMC's or UMC's since IBM shares the upside by taking a share of the capacity. Since IBM is being paid a deposit by Chartered for using its existing capacity in East Fishkill, and yet gains massively from the use of Chartered's future 300mm fab in the event of a boom, you might describe IBM's position as akin to receiving a (fee-paying) option on the future of the foundry business.

Sharing the spoils with IBM in a booming semiconductor market is, of course, the best case scenario that Chartered can hope for. And management must hope that just this type of market occurs by 2005, so that the company starts to throw off free cashflow and profits. That's because in early 2006, Chartered's convertible bond is set to mature. Unless the company's stock is around four times where it stands today, the company will have to repay $664 million to bondholders. Of course, that will be less of a refinancing problem in a booming market where it could use positive cashflow to repay the sum or raise fresh debt.

In a really booming market, Chartered's stock may even perform so well that bondholders convert.

However, if conditions remain soft, and TSMC and UMC remain dominant, this situation will be more problematic since the stock is likely to remain low - as will the company's profitability. Meanwhile, some still wonder how China-based new entrant, SMIC will further disrupt the industry as a whole, and most particularly, Chartered.

As one tech banker put it: "I still feel that a merger between Chartered and SMIC may be the logical solution in the long run."

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