MagnaChip Semiconductor Corporation (MX) has a major problem. Before investors jump in, they should understand MagnaChip’s enormous debt and limited customer base. Since December 2016, long-term debt has soared 36% to $300 million. In addition, they only have ten major customers, accounting for 64% of their total net sales. Two of those customers (Samsung Display Corp. and LG Display) account for 34.9% of total sales. If either company decides to pull out, as Apple did with Imagination Technologies, MagnaChip would lose at least $78 million in revenue. With their two largest customers losing market share in MagnaChips predominant customer region, decreasing revenue, it will become harder to pay off their enormous debt.
The semiconductor industry is rapidly changing and evolving. Manufacturers that cant stay up-to-date with the newest technology will suffer. That is why over the last five years, MagnaChip has spent an average of 51 % of gross profits on research and development, creating a shortage of cash and the reasoning behind issuing $86 million in senior notes in January 2017. The notes issued improved liquidity, boosting their quick ratio from 1.21 to 1.82.
Moody’s Investors Service upgraded MagnaChips credit rating to B3 from Caa1 in May. Their rationale is that MagnaChip has improved their liquidity and has had an operational turnaround. However, Moodys said they would downgrade the company if they return to reporting negative EBIT (EBIT is earnings before interest and taxes), negative funds from operations or cash on hand below $70 million.
If Moodys lowers the credit rating it would drop below B3, and be considered a speculative investment. This would cause MagnaChip to pay higher interest rates, making it more difficult to retain cash and pay off their debt.
It is highly likely that they will report a negative EBIT. I will get into more detail about their reven ue stream later on in this article. Essentially their two main customers, which account for 34.9% of revenue, are losing market share in MagnaChips main customer region, resulting in lower revenue, causing lower EBIT.
*All numbers are in millions
Besides issuing notes, another way to lower liabilities is through the use of free cash flow. Free cash flow is exactly what it sounds like. Companies can use their cash freely, either to grow the business, pay off debt, or return to shareholders through dividends. The only problem is MagnaChips free cash flow is nonexistent. Over the last 10 quarters it has been negative seven times, and negative for the past three years on an annual basis.
*All numbers are in millions
MagnaChip cant issue more notes due to fear of over leveraging themselves. They also dont have the ability to use free cash flow. Another way to reduce their debt is through a cost-cutting program. At the beginning of 2017, MagnaChip initiated the Headcount Reduction Plan. It will save them $23-$27 million annually, and only cost $29-$33 million. This program will get them on the right track, however, is it enough? Over the past four quarters (June 2016-March 2017) theyve averaged a negative free cash flow of $31.9 million. Even saving $27 million from the program, they would still be in the red $4.9 million. It appears they are out of options. Issuing more notes to boost the reduction program will only cause shareholders to become nervous. Without extra cash there is no way to cut costs. Their debt will continue to pile on interest, eventually growing too large, triggering a snowball effect that could lead to bankruptcy.
Weake ning Revenue:
The more urgent issue is relying only on two customers. They account for 34.9% of total sales and 85.2% of Display Solutions revenue. Samsung Display Corp. (OTC:SSNLF) represents 23.5% of total net sales and LG Display (LPL) represents 11.4%. If either company lowers its purchase orders, or pulls out, it would be detrimental to MagnaChip.
In 2016 mobile AMOLED display driver sales helped boost their revenue (AMOLED is a bright, thin, flexible and efficient display that is used in phones, tablets, TVs, laptops and smart watches). It gave a 36% increase (Dec 2015 Dec 2016) in net sales to the Display Solutions division, which accounts for 41% of total revenue, making it appear that revenue was increasing. However, Power Solutions sales dropped 16% in the same period, and Foundry Services Group dropped 6%.
A recent study was done by Strategy Analytics. It found that Samsung is drastically losing market share in China. In the first quarter of 2 016 it sold 7 million phones, year over year, dropping to 3.4 million units. LG Electronics didnt even make the list of top smartphone brands in China because Chinese companies have been increasing their online presence hurting LG sales. This will mean Samsung and LG will not require as many AMOLED display drivers from MagnaChip, reducing their revenue stream.
Total revenue rose 9.2% in their recent quarter thanks to an increase in the global power management IC foundry product and an increase in sales from source drivers for ultra-high definition TVs. Mobile AMOLED display driver ICs however did drop in revenue. Even though they only declined 4.3%, I believe its the beginning of the end to LG. LG didnt even make the list of top smartphone brands in China, meaning they are losing brand recognition. Generally, people only buy what they trust. People are not trusting LG’s phone, which will likely cause a ripple effect into their TVs. Similarly, since the Galaxy Note 7 started catching fire, their brand has diminished. In March of 2016 they had 6.7% of Chinas phone market. Year over year, it is down to 3.1%. Over time this will reduce MagnaChips AMOLED display driver revenue and their source drivers for ultra-high definition TVs revenue.
MagnaChip has stated two approaches on how they plan to improve revenue. The first approach is through increasing business with existing customers. In order to strengthen their relationships, they are working with their customers on critical design and product development, aligning their product roadmap with key customers in order to expand customer relations and sell more products. I believe this will backfire. Its important to keep your key customers happy, however, molding your company around only a few customers will alienate the rest.
Their second approach is to broaden their customer base. In order to generate new accounts, they are expanding their global design centers , local application engineering support and sales presence. They plan on introducing new products and variations of existing products to appeal to a broader customer base.
MagnaChip has created a vast amount of products and services with over 2,000 patents. They have developed an excellent production process allowing them to quickly introduce new products. However, they have not developed a clear way on how to reduce their debt. And they are molding the company to customers that are losing market share. This company has a lot of problems and is not worth the risk.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in MX over the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This analysis is only to inform investors or potential investors the risk they are taking when investing in MagnaChip.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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