Investment banking, asset management and now semiconductors. Merrill Lynch's failed rights issue for Chartered Semiconductor, has seen it add a new business line.
Around 393 million shares in Chartered Semi were unsubscribed in its rights issue, and the company declared this meant the underwriter was left with a 15.7% stake.
Merrill Lynch hard underwrote the offering at S$1 a share and so has paid S$393 million for the stock. It has since traded down to S$0.86 meaning the value of the stock is now S$337.98 million. That is a loss of S$55 million, or $30.7 million รป if marked to market in US dollars.
Additionally the firm's internal accounting will impose a capital charge on holding the position.
Merrill Lynch is not commenting on the deal, which one observer described as "a bit like that movie, The Perfect Storm".
DBS, UOB and OCBC also took an allocation. It is thought they took 30% of the deal and Merrill the remainder. If that is the case, then Merrill's position is slightly better, with the mark to market loss for the US firm closer to $20 million.
The deal was a deeply discounted rights offering and has seen Chartered Semi's price collapse from S$2.10 at the beginning of the offering in September.
Merrill stepped up to the plate to hard underwrite the deal based on an advisory fee of $3.17 million and an underwriting fee of $3.13 million. There are some rival bankers now saying this is a mark of how desperate times now are that Merrill would take on a deal for this.
For Merrill, it has been a bad year in terms of fee income - possibly its worst ever in Asia. In the first half of the year Merrill is thought to have made fees of around $25 million from equity, convertibles, M&A, bond issuance and securitization. Since then it will have earned a fee for the sale of Korea Life, and likewise from Chartered Semi.
A roughly $25 million fee from China Telecom beckons, and could brighten the P&L slightly. But whether Merrill is able to execute the Krung Thai IPO this year (and earn a $10 million fee) is a subject of hot debate.
Obviously, it secondary sales and trading business has benefited from the rising volumes in Asian stock markets, but the above numbers suggest that the pure investment bank has spilled red ink in 2002.
Paradoxically, Chartered Semi may not have ended up being a disaster for Merrill, thanks to the sales and trading business. Other bankers expect that Merrill's derivatives desk was shorting Chartered Semi's stock all the way down, and subscribing to the rights stock. According to the prospectus (page S-69 and 70) this was permitted: "In connection with the rights offering, the underwriter may engage in trading activity for the purposes of hedging... These transactions may include short sales... Short sales and similar hedging activity could place significant downward pressure on the market price of the ordinary shares."
It is also thought that Merrill did a brisk business in shorting TSMC and UMC stock. Both hedging tactics could have proven lucrative and may even have covered Merrill's current mark-to-market losses on the Chartered Semi stock . (Obviously, only Merrill knows this, and others can but speculate).
Even still, what happens to Chartered Semi's stock price in the coming months is going to be a source of great interest for Merrill's managers who are now massively long the stock. Unless there is a swift turnaround in sentiment, it is going to be running a mark to market loss on the position for quite some time.
It will clearly be hoping that the semiconductor cycle has bottomed and it can ride a wave of rising stock prices throughout the industry. While this leaves the bank hostage to the market, there are occasions when such situations can end up being very lucrative. Observers recall that when Goldman did a $765 million exchangeable of the Singapore government's stake in DBS in February 1999 it initially went badly, and the bank had to sit on the position - but it later turned out to be highly profitable for the US bank as DBS's stock price began to outperform the market throughout 1999 and the early part of 2000.
However, Chartered's position looks challenging. The world's third largest semiconductor foundry has been struggling. Having touched a high of S$6.30 in 2001, Chartered's stock price has been on a declining trend for the past year. It has never paid a dividend and has only made a profit in one year, 2000, when it made $244 million and was trading on a P/E of 40.69.
However, Chartered lost $383 million in 2001 and is forecast to make a loss of $389 million this year by UBS Warburg. Indeed, UBS Warburg put a sell on the stock at the end of July, while keeping holds on its main competitors, TSMC and UMC.
UBSW said in a recent report: "We think the near-term outlook remains highly challenging given the ongoing inventory adjustment in the semiconductor industry. With weakening demand, Chartered recently indicated that it would likely miss its earlier revenue target of doubling revenue in Q4 relative to Q1. We expect Chartered to continue operating at a loss over the next four quarters. Longer term, Chartered could face threats from new entrants in the foundry business in China. We expect the new foundries in China to compete in the same market segment as Chartered."
It has a target price for the stock of S$0.91; which if right, is bad news for Merrill.
There are many who believe Chartered simply does not have the scale to survive and that eventually a merger with the likes of UMC is inevitable. Chartered has an excellent client list - including names such as Motorola and Ericsson - but it took a wrong bet on communications chips and this has not helped.
As one analyst put it, Chartered simply needs more customers. Thus while TSMC has 70% capacity utilization, Chartered's is only 40%.
Put side by side with TSMC and UMC, Chartered does not fare well. The Taiwanese are a year ahead of the Singaporean firm in 12 inch fabs, and managed to finance the investments through free cashflow, as opposed to new equity. Chartered expects its capex to be $500 million for 2002 and $300 million next year. It is clear that the rights issue was designed to keep the balance sheet in a reasonably conservative state and allow the firm to take advantage of upswings in demand should we now be at the very bottom of the cycle.
There are some who think that Singapore Inc will, if necessary, buy back more and more of the stock at its current low levels. Of course, this amounts to a nationalization. But if Singapore Inc wants to stay in the strategically important semiconductor sector, and allow Chartered to catch up with its Taiwanese peers, this may be the inevitable alternative to a merger with UMC.
