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Company in focus: For SK Hynix, patience pays off in its Toshiba Memory bid

Investment puts South Korean chipmaker in stronger position in NAND memory

An SK Hynix plant in South Korea: The chipmaker will acquire a 15% stake in Toshiba Memory.

SEOUL Almost as soon as group chipmaking company SK Hynix announced in September that it would be contributing nearly $3.5 billion as part of a consortium to acquire Toshiba Memory, SK Holdings Chairman Chey Tae-won was on his way from South Korea to Tokyo aboard his corporate jet.

Once there, Chey met with Toshiba executives and Japanese government officials. During the candid discussion that followed, a Japanese economy ministry official reminded him that SK Hynix, South Korea's second-biggest company by market capitalization, cannot hold more than 15% of voting rights in Toshiba Memory for the next decade. With an easy smile, Chey responded that "management rights are not the goal" of SK's investment, according to a person with knowledge of the meeting.

SK Holdings Chairman Chey Tae-won is investing aggressively in chipmaking. (Courtesy of SK)

The consortium -- led by U.S. private-equity firm Bain Capital and including Apple, Dell, Kingston Technology and Seagate Technology, along with SK Hynix -- was named a preferred bidder for Toshiba's memory chip business in June, but negotiations collapsed in the face of objections from Western Digital of the U.S., Toshiba's flash memory partner.

Western Digital also participated in the bidding for Toshiba Memory, as part of a consortium with U.S. private-equity firm Kohlberg Kravis Roberts & Co. and the public-private Innovation Network Corp. of Japan. Western Digital has filed complaints with the International Court of Arbitration seeking to block the deal. The case is pending.

The Bain-led consortium finally won the 2 trillion yen ($17.5 billion) bid for Toshiba's flash memory unit on Sept. 20 after months of flip-flopping by the company's board. The consortium agreed to acquire 49.9% of the memory business, with Toshiba retaining a 40.2% stake and Japanese technology company Hoya Corp. taking 9.9%. This arrangement allows the pair of Japanese companies to retain control of the unit.

SK Hynix played a key role in securing the deal by agreeing to invest 395 billion yen -- or about 20% -- of the total price even though its stake in Toshiba Memory is limited to 15%. The deal was even questioned by SK Hynix's own outside directors at a board meeting on the morning the deal was announced, according to a source familiar with the consortium.

But Park Jung-ho, the president of SK Telecom and a close associate of Chey, described the deal as crucial for SK Hynix. SK Telecom, a key affiliate of SK Holdings, has a leading 20.1% stake in SK Hynix, and Park is a board director at the chipmaker. "It's in SK's interests to form an easy partnership with Toshiba," Park said in persuading other directors at the meeting, according to a person familiar with the consortium.

"SK Hynix will likely have only limited, if any, access to Toshiba semiconductor's technology and cash flows," said Gloria Tsuen, a senior analyst at Moody's. "However, the acquisition represents a step toward consolidation of the NAND flash memory market, which is a long-term positive."

DRAM makes up 77% of SK Hynix's revenue, but the company wants to focus on NAND.   © Reuters

Other analysts, however, say technology was not Chey's primary aim in investing in the Japanese company. "With SK Hynix participating in the acquisition, the company will benefit by blocking Foxconn or Western Digital from buying Toshiba Memory, which could tighten competition in the NAND industry," according to Nam Dae-jong at KB Securities. Taiwan's Foxconn Technology Group, also known as Hon Hai Precision Industry, was among the bidders for Toshiba Memory.

An industry source said there was "no way" a South Korean company would be able to purchase a businesses so representative of Japan given the latter's wariness over technology outflow. In 2014, SK Hynix paid $278 million to settle a lawsuit brought by Toshiba accusing the South Korean company of wrongfully acquiring its chipmaking technology.

So Chey was patient. He and Park had been considering investing in Toshiba Memory as early as mid-2016, more than six months before Toshiba decided to sell the unit, according to a person familiar with the consortium. From the beginning, they had targeted a 20% stake rather than a majority.

The SK group began as a textile company in 1953 following the Korean War. Known then as Sunkyoung Textile, the company over the decades expanded into oil refining, telecommunications and semiconductors through mergers and acquisitions. Today it is South Korea's third-largest conglomerate by assets, behind Samsung and Hyundai Motor.

FAST MOVER Chey, 57, is the fourth leader of the group, following founder Choi Jong-kun, his uncle; Chey Jong-hyon, his father; and Son Kil-seung, an executive from outside the family. The names Choi and Chey are different romanized spellings of the same Korean name. Chey Tae-won is SK Holdings' largest shareholder, with a 23.2% stake, followed by his younger sister, Chey Ki-won, who owns 7.4%.

Employee walk past the logo of SK Hynix at its headquarters in Seongnam, South Korea.   © Reuters

SK's greatest strength is its ability to quickly determine new growth engines and invest aggressively to acquire the relevant businesses. All of its three key affiliates -- those in oil refining, telecommunications and semiconductors -- joined the group through mergers and acquisitions.

SK Hynix has its roots in Hyundai Electronics Industries, which was established in 1983 by Hyundai founder Chung Ju-yung. Hyundai Electronics Industries merged with LG Semiconductor in 1999 as part of then-South Korean President Kim Dae-jung's Big Deal policy that forced chaebol, or family-run conglomerates, to focus on their core businesses and take over noncore assets from each other.

Two years later, however, the company was hit by low chip prices and creditors took control, changing its name to Hynix Semiconductor. SK Telecom acquired the company in 2012 and renamed it SK Hynix.

Chey Tae-won was sentenced to four years in prison in 2013 for embezzling money from SK group companies. He was pardoned in 2015 and has since pushed for aggressive investment in the semiconductor affiliate.

A source at SK group said Chey has a special affection for SK Hynix because it was acquired in a deal he initiated, while the group's two other pillars -- telecommunications and oil refining -- came from deals overseen by his predecessors.

"Chairman Chey often visited Hynix's production lines, having lunch with employees," a manager at the group said, requesting anonymity. "He made it clear that the group would take care of the acquired company."

Riding the boom in the global chip market, SK Hynix reported strong third-quarter results on Oct. 26. The company's net profit rose more than fivefold to 3 trillion won ($2.65 billion) in July-September from 598 billion won in the same period a year earlier, while operating profit soared to 3.7 trillion won from 726 billion won. Sales jumped 91% to 8.10 trillion won.

Thanks to robust demand from data center servers, mobile gadgets and consumer electronics, the average price of dynamic random-access memory, or DRAM, chips has surged, up more than 40% this year, according to Daiwa Capital Markets. The price of NAND flash memory chips has also soared. NAND flash memory is considered more reliable and durable than traditional hard-disk drives, making it the preferred choice for long-term data storage.

DRAM chips accounted for 77% of the company's revenue in the third quarter, followed by NAND at 21%. Thanks to high prices for both types of chips, SK Hynix's gross margin stood at 58% in the quarter, up 24 percentage points from a year earlier. Its operating margin showed an even more dramatic increase, to 46% in the third quarter from 17% a year earlier.

Analysts say SK Hynix was keen to seal the Toshiba Memory deal because it needs an alliance in order to survive. In DRAM chips, SK Hynix is No. 2 by sales behind Samsung Electronics. But in the NAND sector, which SK Hynix is concentrating on, it is fifth behind Samsung, Toshiba, Western Digital and Micron Technology.

One industry source said Samsung is roughly one year ahead of Toshiba Memory in terms of NAND technology, with Micron and SK Hynix roughly another year behind Toshiba. SK Hynix may well have struggled to survive on its own had Toshiba Memory been acquired by Western Digital.

The market appears to have welcomed the investment, with SK Hynix's stock price rallying since the announcement. It closed at 78,700 won on Oct. 26, up 72% this year. As of Oct. 24, its market cap stood at $52.8 billion on the South Korean stock market, second to Samsung Electronics's $346.5 billion and exceeding Hyundai Motor's $35.2 billion and LG Chem's $26.0 billion.

NAND chips are a high-demand commodity thanks to the proliferation of smartphones, artificial intelligence and the internet of things, and supplies are tight. "As for NAND, we expect the low yield rate and capacity loss from 3D-NAND conversion to limit supply growth until the first half of 2018," S.K. Kim, an analyst at Daiwa Capital Markets, said in a report.

Because of the upbeat outlook for the industry, analysts do not expect SK Hynix's investment in Toshiba Memory to affect its credit rating. "We expect SK Hynix will generate over 15 trillion won in operating cash flow this year, which will be enough to fund capex of around 10 trillion won and the planned investment in Toshiba's semiconductor business," Tsuen of Moody's said in a statement.

Still, SK Hynix faces challenges. Samsung Electronics is expanding its DRAM chip production lines at its plant in Pyeongtaek, about 65km south of Seoul, to meet increasing demand. And while SK Hynix plans to increase its DRAM production in China, Yangtze River Storage Technology, a Chinese company, began building a NAND factory in Wuhan last December.

Hwang Min-seong, an analyst at Samsung Securities, said that in 2018 semiconductors companies' profit cycle will "downgrade" because of a supply increase. "We recommend to cut risks, even though the market will see robust growth next year."

Hwang added that the Toshiba Memory deal will also pressure companies to cut prices of their memory chips because several customers, including Apple, have a stake in the company. "Signs are emerging that supply and demand will slacken," said a source affiliated with a Japanese manufacturer of chipmaking equipment.

The Bain-led consortium expects to complete its acquisition of Toshiba Memory by March 2018, but the legal battle between Toshiba and Western Digital -- which share a NAND joint venture -- could complicate matters. The dispute "may weigh on the deal," said Noh Geun-chang, an analyst at HMC Investment Securities. "The consortium may face considerable difficulties to complete the deal [due to] the litigation."

Nikkei staff writer Kenichi Yamada in Seoul contributed to this story.

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