DRAMeXchange wonders if DRAM prices will bottom out soon:

Current market observations show the DDR2 chip price possibly bottoming out. If this occurs, it should drive up the chip demand, and spur a rebound in the spot price.

Memory chips were the last domino to fall, so to speak, to the oversupply situation.  As such, I would expect them to be the last to recover. The quote above, that demand will rise because prices stop falling, appears counterintuitive at first. Perhaps the suggestion is that buyers were putting off purchases on the expectation that prices would be lower if they waited. I can’t really buy that argument, though, because I don’t think PC makers and other DRAM users would worry about the price if they had their own end demand - they would just buy what they needed and pass along the higher price to whatever extent possible.

In fact, quite the opposite likely occurred. For example, for several quarters Hewlett Packard (HPQ - Annual Report) has been making “strategic buys” of inventory they already thought was excessively cheap.

So while the “bottoming out” is not likely to spur demand, it may well spur a reduction in supply.  The same DRAMeXchange report hints at that as well:

Despite the fact that Taiwan DRAM makers posted a gross profit of nearly 50% in 4Q06, and 30% in 1Q07, DRAMeXchange believes the persisting DRAM price declines in May will cause them to post a loss in 2Q07.

Although DRAM makers must still ship their chips in May, they indicated no additional price cuts would be made, due to the continuing losses. Prices have thus started to increase for last week. Yet, the end market demand is not expected to pick up in May and June, and PC shipments have been performing worse than expected in May, in the wake of a weak seasonality. Furthermore, PC OEMs, major spot market buyers, and module houses still have inventory levels lasting for more than a month. DRAMeXchange believes that by only relying on buyers in purchasing cheaper chips, the DRAM price increase will be limited at least before June.

With prices already dangerously low, Hynix has already started to switch some of its DRAM production to NAND Flash instead.

With capacity being shifted to other products, and the profitability issues impacting the ability to invest in more capacity (as long as the companies heed the signs) the lower supply is what will allow demand to catch up and restore equilibrium to the market.

STMicroelectronics (STM), Intel (INTC - Annual Report) and Francisco Partners today announced they have entered into a definitive agreement to create a new independent semiconductor company from the key assets of businesses which last year generated approximately $3.6 billion in combined annual revenue. The new company’s strategic focus will be on supplying flash memory solutions for a variety of consumer and industrial devices, including cellular phones, MP3 players, digital cameras, computers and other high-tech equipment. The partners in the deal were gushing with superlatives, which you can read in the press release.

For my part, I don’t doubt that the new company exudes wonderfulness from a strategic standpoint, being “From the outset, the company will be a leading supplier of flash memory solutions for wireless communications,” with “the scale to benefit from the increasing demand for memory resulting from the growing amount of information and content that is becoming more mobile and is now based almost entirely on digital technology.” Instead, I was most interested in the structure of the deal itself:

Under the terms of the agreement, STMicroelectronics will sell its flash memory assets, including its NAND joint venture interest and other NOR resources, to the new company while Intel will sell its NOR assets and resources. In exchange, Intel will receive a 45.1 percent equity ownership stake and a $432 million cash payment at close. STMicroelectronics will receive a 48.6 percent equity ownership stake and a $468 million cash payment at close. Francisco Partners L.P., a Menlo Park, Calif.-based private equity firm, will invest $150 million in cash for convertible preferred stock representing a 6.3 percent ownership interest, subject to adjustment in certain circumstances. Concurrently, the parties have arranged for the new company to receive firm commitments for a $1.3 billion term loan and $250 million revolver. The term loan will be underwritten by a consortium of banks. Proceeds from the term loan will be used for working capital and payment to Intel and STMicroelectronics for the purchase price. The transaction is subject to regulatory approvals and customary closing conditions and is expected to occur in the second half of 2007.

This structure is interesting for a couple of reasons. First, Intel and STMicroelectronics will be receiving $900 million for the 6.3% stake they give up, but Francisco Partners will only pay $150 million for it. The rest will be provided by new debt held by the venture, with the risk presumably shared proportionately among the owners.
Second, the $900 total payments to Intel and STMicroelectronics for the 6.3% they will not own effectively values the total company at $14.3 billion, or roughly 4x revenues (though that valuation overstates things a bit because the convertible preferred shares offer a superior risk/reward than regular common shares would). Alternatively, the $150 million paid for the stake would assign a valuation of just 0.7x sales. The latter figure is similar to the 0.6x sales “enjoyed” by flash leader Spansion. However, neither appears even close to Micron’s (MU - Annual Report) 1.5x sales, or SanDisk’s 2.9x.

More interesting still is the fact that a partner was brought in for a 6.3% stake at all. One very important consequence is that the minority partner prevents either Intel or STMicro from owning 50% or more, which affects the way the joint venture’s results will flow through to the parent company financial statements.

Intel - the Equity Method

For Intel, the ownership stake of 45.1% suggests that the new company’s results will be reported using the equity method. This means, essentially, that only the JV’s net income and equity will appear on Intel’s financial statements. Assets, liabilities, sales, expenses and pretty much everything else stays off Intel’s financials. The obvious benefit is that net profit margin will be higher as it reflects the net income (numerator) but not sales (denominator) from the JV. In addition, other ratios such as return on assets and debt/equity could potentially appear more favorable.
STMicroelectronics - Equity or Proportionate Consolidation?

For STMicroelectronics, which adheres to International Accounting Standards (IAS) but also reconciles them to U.S. GAAP due to its U.S. exchange listing, the issue is a bit more complicated. IAS 31 states that “proportionate consolidation better reflects the substance and economic reality of a venturer’s interest in a jointly controlled entity, that is control over the venturer’s share of the future economic benefits.” Although the equity method is an allowed alternative under IAS 31, the clear preference is for STMicroelectronics to proportionately consolidate - that is, record its 48.6% share of assets, liabilities, revenue and expenses.

Yet the press release describes both STMicroelectronics and Intel’s ownership as “equity ownership stakes” which may imply that they both intend to use the equity method. That, in turn, suggests that STMicro’s 48.6% stake (making it the largest owner) somehow does not allow it to “jointly control” the entity. Perhaps Francisco Partners has an influence (such as Board membership) that is out of proportion to its 6.3% financial stake.

The Role of Francisco Partners

Without the third partner, Intel and STMicro would either have had to structure the deal to give STMicroelectronics control (which would require them to report all of the venture’s financials as their own) or to arrange a payment that would give them equal ownership. Intel would still be able to use the equity method in either situation, but perhaps would not want STMicroelectronics to be the controlling party. By bringing in the third partner, it knocks both of the primary owners into a more equal secondary status that both may consider more fair.

And of course, the more favorable financial reporting is a nice side effect.

Disclosure: William Trent has a long position in SMH.