Morningstar is initiating credit coverage of STMicroelectronics with an A- rating. A large cash balance helps cover multiple issues we have with the firm, allowing it to score well across each of our four ratings pillars. At the end of 2009, the firm held nearly $2.9 billion in cash against a $2.5 billion debt load. Nearly all of this debt comes due during the next five years, but we still expect the firm to generate enough cash during this period to cover all contractual obligations about twice over. Cash on hand adds another turn of coverage, bringing our forecast Cash Flow Cushion to a healthy 3.0 times. Further adding to STMicro's financial cushion, the firm is set to receive about $500 million of shares in Micron following the sale of its stake in Numonyx, a memory chip joint venture it helped create in 2008. We aren't concerned that STMicro will use cash in a way that is significantly detrimental to debt holders. The firm has carried a large cash balance throughout its history and we expect it to continue to do so as a means of countering the cyclicality inherent in the semiconductor business. In addition, STMicro doesn't have a history of large share repurchases or making major acquisitions.
STMicro's core analog semiconductor business is fairly well-positioned, in our view. Analog chips, which are used to convert real-world signals such as sound and temperature into digital signals, typically have very long product lives and high customer switching costs. As the world's second-largest analog chip maker, STMicro is positioned well, with major industrial customers like Siemens and General Electric. This business isn't nearly as efficient as its rivals, though, and has been in a state of restructuring for several years. As a result, STMicro hasn't turned an operating profit since 2006. STMicro's recent push into the wireless semiconductor business, now in the form of a 50/50 joint venture with Ericsson, also hampers our view of the company. The wireless chip business is very competitive and changes rapidly, requiring heavy R&D investment. The ST-Ericsson venture is also tasked with integrating three disparate businesses into one cohesive unit.
While reported profitability has been poor, STMicro generates solid cash flow. The firm is in the process of shutting down high-cost manufacturing capacity and outsourcing production to third-party foundries, which has sharply reduced needed capital spending. As a result, depreciation expense has run about 60% higher than capital spending during the past three years. We expect that outsourcing some production will actually lower average unit costs and that an economic rebound will push gross margins to the same level the firm reported before the downturn. As restructuring activity wanes, we think the operating margin will steadily improve and free cash flow will average a bit more than $1 billion annually over the next five years.
Because of its struggles in the analog chip business and position in the wireless chip business, we don't believe STMicro has an economic moat, which weighs on our Business Risk score. The firm's size, diverse customer base, and minimal need to access the capital markets--again thanks to its large cash position--offset this weakness. We have not explicitly factored STMicro’s ownership structure into our rating. The French and Italian governments control a holding company that controls 28% of the firm. Given that STMicro is Europe’s largest chipmaker, these governments likely would have an interest in keeping the firm afloat.
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