National Semiconductor (NSM)

National Semiconductor Corporation (NSM) is an OEM of analog and mixed signal integrated circuits. Although the company continues to manufacture a number of other products as well, corporate restructurings over the last few years have increased its focus in the high-performance analog area. According to data submitted by the World Semiconductor Trade Statistics (WSTS), semiconductor sales were $255.6 billion in 2007, up 3.2% from 2006 levels. The SIA has lowered its growth expectations for 2008. It now expects semiconductor sales growth of around 4.3% in 2008, down from its previous forecast of 7.7%. The lower expectations for 2008 were attributed to the continued pricing pressure in the memory chip category, excluding which, sales are expected to be up 7.4%.

Semiconductor devices are generally divided into three categories analog, digital and radio frequency (RF). Analog semiconductors condition and regulate real world information such as light, temperature, speed, pressure, power and electrical currents. Digital logic semiconductors process information in only two states. Mixed-signal semiconductors combine both analog and digital technology into a single device. Typically, an analog sensor samples real world information, and then converts the input into an electronic analog signal, which is converted into a digital format for further digital processing. The analog and mixed-signal markets tend to be more varied and specialized, with customized products that have longer life cycles than the digital industry segment. There is an ongoing drive to decrease the number of discrete devices, lessen power requirements and shrink the size of the existing devices, which correspondingly increase performance and reliability. Consequently, a greater amount of functionality is being consolidated into increasingly smaller devices.

National has design centers all over the world sixteen in the U.S., eight in Europe and five in Asia. The company currently has 3,000 patents to its credit. Most of the manufacturing, including wafer fabrication, wafer sorting, product assembly, final testing and coating is done in-house. The three wafer fabrication facilities are are located in Arlington (Texas), South Portland (Maine) and Greencock (Scotland). Chip testing and assembly are done at its facilities in Melaka (Malaysia), and Suzhou (China).

The World Semiconductor Trade Statistics define standard linear products as amplifiers, data converters, power management regulators and references, and interface products. The company has been shifting most of the product mix to these categories, although it continues to generate a small percentage of revenue from application specific products. In fiscal 2008, analog products generated 90% of the company's sales. Power management products comprised the largest percentage of the total analog business at 47%, amplifiers comprised 25%, interface products 8%, data converters 5% and other analog 5%. The remaining 10% was derived from other non-analog products, including microcontrollers, connectivity processors and embedded Bluetooth TM solutions. Most of the products are targeted at the handset market, although the company also serves the communications infrastructure, consumer, computing, industrial, automotive and other markets.

Operations are categorized into two power management and analog signal path. The power management group is made up of products such as switching and voltage regulators, controllers, low drop-out voltage regulators, white LED drivers, voltage references and battery management ICs. The company is expanding the power mangement group to include LCD display, device connectivity, telecom and application specific products. The analog signal path group consists of high-speed precision operational amplifiers, high-fidelity low-power audio amplifiers, high-performance analog-to-digital and digital-to-analog converters, precision timing products, high-speed serial digital interface products and thermal management products.

Products are sold directly to OEMs and ODMs such as Motorola, Nokia, Sony Ericsson Mobile Communications, L.M. Ericsson, LG Electronics, Panasonic, Samsung, Sharp, Seagate, Apple, Matsushita Electric, Robert Bosch, Siemens and Tektronix. Around 54% of fiscal 2008 sales were made directly to OEMs, while the balance came from distributors. The top three customers in 2008 were distributors Avnet and Arrow generating 15% and 12% of total revenue, respectively and OEM Nokia accounting for another 11%. The top competitors are Analog Devices, Linear Technology, Maxim Integrated Products and Texas Instruments. The revenue contribution by geography in fiscal 2008 was the U.S. 20.4%, China 30.4%, Singapore 16.4%, Japan 10.6%, Germany 10.8% and the U.K. 11.2%.

Strategic restructurings have increased focus on high-performance analog and reduced the cost structure

It is the intention of management to continue only those non-analog products that are able to generate good margins for the company. Over the last two years, National has been engaged in strategic restructurings that have streamlined operations and lowered the cost of operation. As part of its restructuring activities, the cellular baseband IC business was shut down at the end of the May 2003 quarter, and the Geode business was sold to AMD at the end of the August 2003 quarter. Both units were suffering from increased competition and low profitability. Recently the company sold the Advanced PC unit to Winbond and entered into an agreement to sell the cordless telephony chipset business.

Gross margin expansion has been consistent over the last three years

Many of the lower-margin businesses have been disposed off and the company is now focused on the higher-ASP analog business. Management stated that the fab utilization rate was 70% in the last quarter, flat compared to the May quarter. The company continues to introduce higher-margin higher-ASP products, which are improving the overall mix of business. It has also implemented cost reduction initiatives. The Texas fab transition to 8-inch is expected to add another $1-2 million to gross profit dollars in the next two quarters. This will be followed by an upgrade of the UK fab.

The handset market will continue to grow

Handsets are the most important market for National. The company has a roster of top-shelf customers, including Nokia, Motorola, Samsung and other emerging Asian ODMs/OEMs. The top five players typically cater to around 80% of the global handset market and bring in around 70% of the company's total revenue. Nokia already employs National's power management, audio amplifier lighting and display management products and the company's flash lighting chips have been designed into cell phones at all of the top five handset manufacturers. The fiscal second quarter is usually a strong one for NSM, and management stated that the current state of backlog indicated that the sales pickup would be just slightly short of normal seasonality. The company has been increasing its components in 2.5G and 3G handsets, and most of the growth in the last quarter was driven by smart phones. As a result, the dollar content has been rising gradually to around $2-3 per unit in some high-end phones. We note however, that according to a recent report by Gartner Dataquest, smart phone shipments grew a mere 16% in the June 2008 quarter compared to the year-ago quarter. This was much slower than the 55% growth witnessed in the June 2007 quarter. Nokia expects mobile device volumes to grow 10% in 2008 from the 1.14 billion units shipped in 2007, although the cell phone giant is expected to sacrifice market share to protect margins. iSuppli expects handset sales by Chinese OEMs to increase 19.7% in 2008. According to the IMS Research Online Cellular Database, shipments of new handsets are forecast to hit 1.19 billion in 2008, up from 1.12 billion in 2007. Asia is projected to grow at 10.7% in 2008 over 2007 levels, with particular strength in China and India, the Americas are expected to grow 7%, while the over-penetrated European market is expected to decline -1.2%. The company should benefit from growth in both high-end and low-end phones.

The handset business in Asia, particularly China, remains strong

China has 400 million new consumers of cell phones and other handheld devices these are being replaced more frequently than in prior cycles. The company has had some success in this market with handsets supporting the 450mg CDMA and TD-SCDMA standards. NSM devices have also been designed into handsets marketed by the largest local brand in China. Significant opportunities are also expected in other developing markets such as India, Russia and Africa.

There is opportunity in several other markets, especially solar

Management strategy appears to be focused on energy. To date, it has relied on its core strength in power management products, which are likely to remain a major driver in not just developing but developed countries as well. The company is now extending its capabilities in power management to alternative energy areas, such as powering for solar panels and LED lighting products. In June this year, management announced a solar product, which it refers to as SolarMagic. The product will incorporate the company's new PowerWise power management technology, and will significantly increase the efficiency of solar panels, even in shady areas. With only 0.04% of North American rooftops covered with solar panels, compared to 8% of rooftops in Germany (which is more focused on solar), the opportunity for growth could be significant. However, the payback period is lengthy, and management does not expect any revenue from the product line in fiscal 2009. Other areas of management focus include sensing and detection (security), medical and infrastructure. Management is redirecting R&D spending into these areas.

The balance sheet is highly leveraged

National has a net debt of $704.9 million and a debt-to-total capital ratio of 87.4%. The debt was incurred with the objective of enabling the accelerated share repurchase. Interest payments were 18.1% of profits and reduced the EPS by -$0.08 in the last quarter. The company generates sufficient cash from operations and should not have trouble servicing the debt.

In summary

National's strong IP has enabled the company to build a position for itself in the wireless handset space. Although the consumer nature of this market usually has a negative impact on margins, management has successfully expanded the product range, progressively introducing higher-margin, higher-ASP products and increasing the dollar content per device. As a result, gross margins improved consistently over the last three years. With high-margin wireless infrastructure demand strengthening in parts of Europe and Asia, the product mix is expected to improve further. Management intends to devote R&D dollars into several new markets, which are the likely areas of growth over the next few years. We agree that this is a solid strategy, and believe that this is the right time to be bringing the products into the marketplace. The near-term prospects for the company are also good, as distributor inventories are very low, and current lead times are at around 6 weeks. Therefore, any increase in demand should push up order rates. On the manufacturing side, even after the decommissioning and sale of a couple of its facilities, manufacturing is shifting to 8-inch wafers. However, the industry is in the process of moving to 12-inch wafers. This makes the company's manufacturing capabilities relatively less efficient. The other side of the story is that National should enjoy better operating leverage as utilization picks up and manufacturing shifts to larger wafer sizes and smaller geometries.

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