THE WALL STREET TRANSCRIPT

 

Questioning Market Leaders For Long Term Investors


STEVEN J. BILODEAU - STANDARD MICROSYSTEMS - (SMSC)
CEO Interview - published 11/27/00

DOCUMENT # LAE619

STEVEN J. BILODEAU is currently President, CEO and Chairman of the Board of Standard Microsystems Corporation (SMSC). Prior to SMSC, Mr. Bilodeau spent 13 years with RVSI, where he was, most recently, President of RVSI’s Semiconductor Equipment Group and a member of RVSI’s Board of Directors. In that position, Mr. Bilodeau led the formation and growth of the semiconductor business and built it into the world’s leading supplier of capital equipment for three critical back-end process steps; final package inspection, Ball Grid Array (BGA) ball attach and assembly, and tape-and-reel media packaging. Prior, thereto, Mr. Bilodeau was a Founder, owner and Director of Macrodyne Inc., a start-up company that successfully pioneered remote, high-speed, data acquisition instrumentation. Mr. Bilodeau holds BS and MS Engineering degrees from MIT and an MBA from the Harvard Business School.

Sector: Semiconductors

TWST: Could we start out with a history and a quick overview of Standard Microsystems Corporation?

Mr. Bilodeau: SMSC is a semiconductor integrated circuit provider. We’ve been in business since 1971. Our primary business today is building integrated circuits that serve both the PC industry and the embedded systems marketplace. SMSC is well known for having pioneered the concept of our super I/O devices. I/O stands for input/output devices. Those are solutions that basically integrate multiple communication functions between the PC and its peripherals onto a single chip. SMSC sells to every major PC OEM and to most other branded manufacturers of personal computers. Our sales strategy is to provide innovative designs with some custom content, as opposed to providing commodity-like solutions. We have a commanding market share, about 40%, in our PC I/O business. Our second business, which I mentioned previously, is our embedded systems products, where we sell three basic product families: networking ICs; USB or Universal Serial Bus connectivity devices; and also our input/output devices. Our embedded systems business is quite different from our PC business. It’s characterized by a broad customer base with much longer product lifecycles, and it typically generates higher gross margins. This business is serving high-growth market niches because of the trends toward faster storage and data retention and the innovations going on in machine-to-machine communications. Our embedded products are used in a broad variety of applications such as set-top boxes, factory automation, point-of-sale terminals, ATMs, digital cameras, etc.

TWST: In the PC market, what is it that your product does that they need?

Mr. Bilodeau: We have two families of products. The first, our system controller hubs, are the reincarnation, if you will, of our input/output product line. Input/output devices have historically contained a lot of what’s now called legacy functions — things like serial and parallel ports, floppy disc drive controllers, etc. Those features are becoming less popular, so that portion of the IC is slowly being removed, and we’re replacing it with newer capabilities that are needed in today’s PC architectures, such as USB hubs, hardware monitoring and power management. These functions have become very important because, for example, improving power dissipation in notebook computers results in longer battery life. Our second product family, one we’re very actively developing now, is our chip set business. A chip set consists of two parts. There’s a northbridge or memory controller hub (MCH), which is the performance engine of the chip set. It’s used to optimize the performance between the microprocessor, the graphics and the memory. The second chip is called the southbridge or input/output controller hub (ICH). That’s the feature rich portion of the chip set. It manages, among other things, communication with peripherals, hard drives, USB, ethernet communications, and future applications in wireless. This area is one that we believe has high-growth potential for SMSC.

TWST: Who are you competing with in the PC market?

Mr. Bilodeau: The two product lines really compete with different people. The system controller hub competes with two Taiwanese companies and National Semiconductor. In our chip set business, we compete with three Taiwanese companies, and the major player in the market is actually Intel Corporation. I wouldn’t say we really compete with Intel as much as we’re going to be complementing the Intel architecture by providing chip sets that address the individual needs of the major PC OEMs to differentiate themselves from one another.

TWST: As you look at that marketplace, what is it that you’re bringing to the equation? Why should PC manufacturers come to you for the product?

Mr. Bilodeau: Let’s take our input/output and system controller hub devices first. Clearly there we have a very strong position, and it’s been built upon providing a unique service and capability to the major PC OEMs — the Compaqs and Dells and Toshibas of the world. We work with their architecture teams looking out a year or two, and we develop products that they need to provide differentiation and unique capabilities. So we provide a service to them, an engineering capability to provide unique functionality in their end products. Our competitors, such as the Taiwanese manufacturers, provide more of a commodity solution. Our being a US-based company also provides some advantage because the largest OEMs are US-based. There are also very important PC manufacturers in Japan. We have our own company in Japan. So we’re very well positioned geographically to provide the excellent service and capabilities that our customers need.

TWST: Is that a key differentiator for you?

Mr. Bilodeau: Yes, it is.

TWST: Is that enough in this marketplace to set you apart?

Mr. Bilodeau: We see no evidence of anyone else addressing the manufacturers’ needs in quite the way that we do. I believe the real answer to your question is in market share, and our market share has been growing.

TWST: What is your market share today?

Mr. Bilodeau: If you divide the I/O market into three pieces, the first would be the major OEMs — the top five PC manufacturers. We estimate our share over the past four quarters to be approximately 54% of the unit volume. As a percentage of total revenues, our share would be even higher because we sell a higher value added part. The second segment is the other branded personal computer manufacturers. These are manufacturers like Toshiba, Fujitsu, NEC, Sony, etc. We have about 40% of the unit volume sold to this group. The third market segment we would call the channel PCs, or white box market. They’re typically the unbranded PCs that are sold for very low prices. We do not focus on that market. We get some spillover because of our market share at the major manufacturers, and we have about 11% of that market. So the composite for all PCs shipped around the world is about a 40% market share.

TWST: Where is the opportunity beyond just normal industry growth here for you?

Mr. Bilodeau: Let’s again first look at the I/O area where there are several focus areas for growth. First of all, we’re increasing our focus on some markets, such as Taiwan and Korea, where our presence has been less than in other areas, and we are looking at opportunities to grow our channel market position. In addition, we have added customers that we didn’t serve previously, such as Toshiba. So, we’re basically growing by gaining market share through both an individual customer and a geographical focus. Second, a key element of our thrust is to add more value into the chips that we sell. In other words, we are incorporating other capability that’s on the motherboard into the system controller hub chips that we sell, thereby realizing a higher proportion of the dollar value in each PC sold. Last, our focus is on the higher growth segments of the markets we serve. For example, the notebook market is growing considerably faster than the desktop market. Depending on whose numbers you look at, desktop PCs might display 16% unit growth, while notebooks might show 22% growth. We’re strong in both, but in the notebook area, we’re running at about a 60% market share. We’ve gained a lot of market share in that area. So these are the initiatives that are directly linked to the current I/O business. Probably the biggest way we hope to grow our business is in chip sets, which is the second product line that I mentioned. Chip sets are a much higher dollar value portion of the personal computer. An I/O device might sell for say $3, while a chip set might sell for $30. You need one of each per PC, so the total dollar value of the available market is 10 times as large. Even if we achieve a much smaller share of the chip set market than we currently enjoy in our historical products, the potential for growth is very large. For example, if we can get only one-third of our current I/O market share, we would triple our existing PC business. This is a big opportunity for us to grow our business at rates exceeding the industry growth if we can find the right niches and execute well. Two other related emerging areas are the server market and the Internet appliance area. Our advanced I/O is very relevant to these areas, and we are looking at them as opportunities for additional growth.

TWST: As you look at that marketplace, what’s the risk that somebody can come in and knock you out of the box in terms of the strength of your market position?

Mr. Bilodeau: We are very aggressive in the marketplace, so we don’t take anything for granted, but I think we’re doing the right things to protect our position. Basically we think we can maintain our position by being very aggressive and bringing value to our customers.

TWST: Are there still customers out there that you’re not serving, or have you pretty well done that part of the equation?

Mr. Bilodeau: The server market, the Internet appliance market and the channel market are all ripe areas for us to grow our customer position.

TWST: Do you feel you’re finding the right niches?

Mr. Bilodeau: Yes, with the chip set initiative being a good example. The start of our activities in this area is fairly recent. We put out an announcement last fall regarding an arrangement that we signed with Intel Corporation. That is, essentially, a partnering agreement to develop value-added southbridges that are based on the Intel hub architecture. We’re working diligently on bringing leading-edge products to market in that area. We just announced on October 16 our first chip set, which we call our Victory 66 chip set. The importance of that is primarily to demonstrate that SMSC has now developed the capability to build these kinds of devices. A southbridge is considerably more complex than an I/O device.

TWST: What’s been the initial response to your announcement?

Mr. Bilodeau: It has been good. I would note that this particular chip set is one that’s targeted for the embedded marketplace over the long term, not the PC space. The reason for this is principally that it’s a superset of Intel’s BX chip set. More of those chip sets have been sold than any other chip set in history, so it was a very popular chip set. But it’s near the end of its market life in the personal computer industry. We’ve enhanced its performance and we’ll get some extension of its life in the PC space, but our principal application is going to be in the embedded space. One of the reasons we did this particular chip set was that we knew we could get to market quickly with it, and we were anxious to demonstrate capability in this area. A bigger effort, which is ongoing now, is developing more advanced chip sets that will come out in the future and will be in a market leadership position.

TWST: What might the timing be on those?

Mr. Bilodeau: We haven’t made any public announcements yet as to specific timing in that area.

TWST: If we put all of this together on this side of your business, what kind of growth should investors expect from you over the next two or three years?

Mr. Caggia (SVP & CFO): In terms of revenue growth, you really have to break it into pieces. Certainly there’s guidance out there in terms of how much the PC market in general is expected to grow. Dataquest’s projections of 16% compound unit growth in desktop PCs and 22% in notebooks are relevant here. Industry forecasts for embedded applications range anywhere from 19% to 45% unit growth, depending on the particular application. Beyond that, a big driver of our growth potential is the chip set opportunity. As Steve explained earlier, we have a 40% market share in I/O, and the chip set market is 10 times as large as the I/O market. To forecast specific growth expectations, we would need to make some assumptions of what percentage market share we will achieve. That will be a function of the timing of our product introductions, as well as the product introductions of our customers. It’s a little bit early to be quoting specific numbers on that.

TWST: Are you waiting for general trends that should be positive?

Mr. Caggia: Definitely. Chip sets should cause us to grow faster than the PC market overall because it’s a new area that we’re entering while continuing to supply our historical products. In the area of embedded products, there’s embedded networking, USB connectivity, and I/O devices and chip sets, which are growing at various rates. In the area of embedded networking, our estimates call for that market to grow in the range of 30% per year. Then with regard to USB connectivity applications, Dataquest has estimated that the market applications for those products will grow at the rate of about 45% per year. The applications that embedded chip sets, as well as I/O devices, will go into should grow at that rate of about 19% per year, also according to Dataquest estimates.

TWST: In those markets, do you feel you can equal or exceed the overall growth rates as you gain share?

Mr. Caggia: We are pursuing those markets because we believe the growth opportunity to be large, but we are not providing specific estimates at this time.

TWST: Do you have everything that you need in-house to do this? Will you be looking for acquisitions to fill out the product line, or are you comfortable with what you’re doing?

Mr. Bilodeau: We are clearly pleased with the progress we have made to date, but are continuously looking to enhance our capabilities. In the system controller hub business, we have the basic capabilities in-house, and we’re strengthening them incrementally. In the embedded space, we are looking at some acquisition opportunities and product line expansions. In the chip set space, we have grown our team and our capabilities quite significantly over the last year and a half, and we will continue to invest heavily here because the market opportunity is very large.

TWST: As you look out over the next two years, where’s the risk in this story as far as you can see?

Mr. Bilodeau: There are things in our control, and there are things out of our control. All markets are subject to their overall underlying growth rates. We’ve tried to mitigate market risk by serving particular niches where we can command a strong position. We have some diversity in the markets that we serve. Our biggest business is PC related, so we’re subject to the PC trends. With our market share, our business should grow at least on par with the unit growth of PCs and be enhanced as we add value to our products. In the embedded space, we’re serving three different niches of a very broad product offering. These are all high-growth areas that should continue to provide growth as long as the general state of the economy remains reasonably healthy. Internally our risks are working closely with our customers, identifying the right products and executing on them.

TWST: Do you have the management team in place that you need today?

Mr. Bilodeau: I think we do. I just joined the company in March 1999, and frankly because of all the significant opportunities that were apparent to me in the company. Having said that, we have worked to upgrade the management team quite significantly. Andy Caggia has joined us as CFO. Andy is a really high-caliber individual. I think he brings a lot of talents to the company. We’ve also hired a new Senior Vice President of Engineering. He is a top-notch chip set industry expert and he brings a lot of capability. We’ve also rounded out several other very important positions within the company.

TWST: Since you’ve been there, have you changed the corporate culture at all, or are you satisfied with the direction?

Mr. Bilodeau: Definitely it’s gone through an enormous change. We’re not finished, but we’ve made enormous strides. We’re basically trying to instill a culture that has not only a high sense of empowerment, but also accountability bringing a much more entrepreneurial flavor to the way the company is run. We’ve made a lot of fundamental changes throughout the company, including things as simple as incentive plans. For example, every single employee in the company now has stock options. So we’ve gone a long way to try to unite the interests of the employee with those of the shareholders, and we’ve changed the culture to be much more growth oriented.

TWST: As CEO of the company, where are you focusing your attentions right now?

Mr. Bilodeau: On growing the company. Last year was a year of restructuring, reorganization, some cost savings, and redeployment of assets. We did a lot of blocking and tackling operationally. At the tail end of last year, we repositioned the company in areas where we thought we could grow, and this year we’re really trying to execute our initiatives in that area.

TWST: Do you have the financial wherewithal to support what you want to do?

Mr. Caggia: Because of our operational improvements, we have been able to fund our new product initiatives with internally generated cash. In addition, we have a very strong balance sheet. Because of the asset redeployment that Steve talked about earlier, a lot of non-productive assets have been converted into cash. Our last publicly reported balance sheet was as of August 31. That balance sheet shows that we had $124 million of cash and short-term investments and no debt. In addition to that, we still hold an investment in Chartered Semiconductor Manufacturing. As of that date, we still held about $38 million and that’s a publicly traded security. All of that gives us some wherewithal to pursue initiatives beyond those currently in process. In addition to that, our stock price has been rising to some degree, and we believe that there is considerable additional value in the company. As we continue to perform and it’s recognized in the market value of our stock, that should provide us additional financial wherewithal to grow.

TWST: What are the capital spending plans at this juncture?

Mr. Caggia: We are a fabless company, and we also sub contract our assembly. Our primary value add is in the design and the service to the customer and the final test. So our capital demands are not as great as many other semiconductor companies. At our current revenue levels, capital spending in the range of $20 million per year would not be unusual for us. Our big areas of investment really are in research and development and strategic marketing.

TWST: Where is the operating margin today, and where would you like it to be two years from now?

Mr. Caggia: I’ll talk about the operating margins at two levels, gross margin and operating income margin. With the improvements that Steve has spearheaded since he joined the company in March 1999, our gross margin percent has grown from the low 30s as a percentage of sales to just above 40%. Our operating income margin is currently below 5% because of the significant investment we are making in research and development and marketing to support our new product initiatives, most notably chip sets. Without the investment to support that product line that is not currently generating revenue, our operating income margin would be well above 10%. Looking ahead, as we grow the top line, which we are well positioned to do, we should see considerable leverage to our operating income margin as our gross margin improvements are realized on a higher revenue base and the relative growth in operating expenses begins to slow down.

TWST: When should investors expect that to begin to show up?

Mr. Caggia: That’s really contingent upon the timing of our success in the chip set market. As we said earlier, it is a bit difficult to pinpoint an exact time because timing will be affected not only by our development schedules, but also the design schedules of the PC makers. So it will move into that realm into the next couple of years, but to pinpoint an exact time would probably not be appropriate.

TWST: How do you feel about the value the market is currently putting on your company?

Mr. Caggia: We are certainly happy that it is now in the neighborhood of three times what it was just a year ago. But we also believe that there is significant additional value beyond what’s being recognized today. We also recognize the fact that we have a lot more to prove, and our focus is on working very hard to continue to deliver that value and have it recognized.

TWST: Do you think the market has an understanding of the strength of your position?

Mr. Caggia: I think they’re beginning to. I also think that, as we continue to move in the direction in which we’ve been moving and continue to increase our successes, the market will come to a greater understanding of our value.

TWST: If you were sitting down with some potential investors, what two or three reasons would you give them to go out and buy your stock today?

Mr. Caggia: The first reason would be the size of the opportunity. The second would be the change in direction and culture that the company has experienced in the last year and a half. The third is the beginning of a track record of meeting expectations.

TWST: Thank you.

STEVEN J. BILODEAU
 Chairman, President & CEO
ANDREW M. CAGGIA
 Senior Vice President & CFO
 Standard Microsystems Corporation 
 80 Arkay Drive
 Hauppauge, NY 11788
 (631) 434-2885
 (631) 434-1348 – FAX
 www.smsc.com
 e-mail: investor@smsc.com
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