The SEC requires publicly traded businesses to spell out their worst fears in annual filings. These are the items that keep management up at night and could damage the business if they come to pass. Ignoring early warning signs of these potential disasters could be hazardous to your portfolio's health.
At the very top of NXP's risk overview, you'll find the recently closed merger with Freescale Semiconductor. And for good reason, too.
The $11.8 billion buyout combined two mid-range semiconductor stocks with related but not often overlapping interests in the mobile, embedded, and automotive end markets. Taken together, the new NXP is one of the largest chip companies in the world, with serious economies of scale and a chokehold on the exciting automotive sector.
The deal is a game-changer. But with great power comes great responsibility.
The integration of Freescale into the larger NXP structure is of critical importance to the company's future. Flub this merger, and it's not just a wasted $12 billion -- NXP would end up damaging its original business as well.
So NXP lists a number of sub-risks under the Freescale heading. Key talent must be put in the right places, and motivated to stay on board during this large-scale transformation. Clients and partners must be convinced that the new company is at least as good and trustworthy as the old one, and then management expects to build future synergies and cross-sales on that base. Integration costs could run out of control at any point.
All of these risks are very real, and any of them could undermine NXP's future plans. Every investor needs to keep a close eye on the Freescale integration.
So far, NXP CEO Rick Clemner says that the combination is proceeding as planned. The integration milestones that were set up for the first 90 days were passed "smoothly," and the cost synergies are on track as originally laid out.
The sales teams have been merged, internal development processes are being aligned with new operating targets, and management is sorting out the flow of the two supply chain structures. Clemner says that customer response has been "outstanding," and that clients are getting excited about the solutions this new chip giant can produce.
In other words, no red flags to worry about yet. Just keep the Freescale combination in mind for the next several quarters, as the company continues to navigate this important process.
Need to innovate
This one is a no-brainer.
If NXP fails to introduce new technologies and products in response to changing market conditions and demands, the company will fail. The competition would eat NXP's lunch in a heartbeat. The best way to stay ahead of this risk is by leading the market with fresh insights and new ideas, and that comes from a healthy investment in research and development.
In the first quarter of calendar year 2015, NXP's R&D budget stood at $199 million. Freescale's R&D expenses added up to $222 million, for a grand total of $421 million between the two merging businesses. The recent first-quarter report did not show growth on top of that base, but shrunk 3.8% to $403 million instead.
Yes, NXP is unlocking cost savings as redundant efforts are deep-sixed. The company also had to sell of the part of its business that developed radio frequency power controllers to Chinese investors, as part of the Freescale deal's closing conditions. So it's a little early to panic about this data point. But I do expect the R&D line item to grow again over the coming quarters, or it would be a sign of NXP moving in the wrong direction. You can't cost-cut your way to business growth, after all.
Having the right clients and contracts
This is a two-part risk.
- First, NXP must win contracts and selection processes in the right places. Send in the best sales teams to the most important deal negotiations, deliver on all the right promises. Here, NXP has at least some control over the final outcome -- but must still execute where it matters the most.
- Then, there must be strong demand for the products that NXP won those contracts for. If self-driving cars never take off, it won't matter whether NXP defended its market share in that segment. The global consumer is a fickle beast, and not always predictable. There's market research involved here, but also a bit of luck.
The Freescale deal, for example, was a huge bet on the automotive market. NXP saw that sector heading toward massive growth in the near future, and made a $12 billion move to secure its place at the table. That was probably a smart move, but you just never know for sure. There are no surefire crystal balls, and even the best laid plans of mice and men way go wrong.
So this risk ties back to the Freescale integration issue in a big way, and also connects to the demand for strong innovation. Everything is connected.
These three risks are a good starting point, but NXP also pointed out many other important risk factors. These include potential manufacturing problems, having factories and research centers in areas prone to natural disasters, and the heavy yoke of $7.5 billion in net debt. You should read through that list and make sure that NXP isn't falling short on some crucial detail not discussed here.