Why Hynix ran out on Micron: Asiamoney, May 2002

Asiamoney cover story, May 2002

 The decision of Hynix’s board to reject a deal with Micron, just a day after its creditor committee had approved it, has the international markets doubting that the Korean chip manufacturer can survive. They may be right. But those who believe the decision is a blow to Korean corporate reform miss the intricacies of the deal, and ignore an important point: the right of a board to make an independent decision, even if it turns out to be the wrong one. By Chris Wright.

 There were fireworks, of the literal and the metaphorical variety, all over Seoul on April 30. In several parts of the city, Hynix workers set off firecrackers in celebration. But at the Hilton Hotel, the mood was angrier, as 60 protestors from Daewoo Motor clashed with security officials and occupied a conference hall while two hundred riot police took up positions outside.

Nothing new there, on either count. But in a typically Korean reversal, the more cheerful pyrotechnics were to celebrate the failure of a deal; the angrier scuffles were to protest at the success of another. Hynix’s workers were expressing their delight at their board’s decision to veto a plan by Micron to take over Hynix’s memory businesses. It would have been the largest ever foreign acquisition in Korea, worth over US$3 billion. The protestors at the Hilton, on the other hand, were trying to stop a signing ceremony for what was seen elsewhere in the world as a triumph: General Motors’ US$1.2 billion acquisition of parts of Daewoo Motor. The protestors succeeded, and the high-rolling would-be signatories – GM chairman John F Smith Jr, Daewoo president chairman Lee Jong-dae and Korea Development Bank head Jung Keun-young – had to relocate to the KDB’s head office instead, where the deal was duly signed.

Thus were the topsy-turvey politics of foreign investment into Korea neatly illustrated in a single day. The GM-Daewoo deal, hailed in international circles as a model for Korean corporate reform, took fully four years to conclude and faces many challenges still. The Micron-Hynix deal, which was meant to be the centerpiece of Korea’s restructuring efforts, a landmark remedy to a public and powerful headache, fell apart despite the best efforts of the most senior of Korean financial officials and the willingness of the company’s indebted creditors to lend yet again.

Hynix has put its very survival at stake by rejecting the deal, and the board may soon find itself removed by Hynix’s own creditors. One analyst calls it a “Quixotic gesture,” akin to “the captain of the Titanic refusing to abandon ship”. So why did the board do what it did? And what does it mean for Korea?

 What was on the table?

Micron’s negotiations with Hynix had been underway for five months. The two companies had been acrimonious competitors in the past: when creditor banks set about bailing out Hynix last year, Micron was riled. The Boise, Idaho-based company contacted the state’s senator, Mike Crapo, who lobbied vigorously that support of Hynix contravened South Korea’s obligations under WTO. The dispute even reached the desk of US treasury secretary Paul O’Neill. But on December 3,  Hynix made a formal announcement that the companies were discussing “a possible strategic alliance or other transaction”.

Negotiations were difficult, but well-represented. Goldman Sachs advised Micron, and Salomon Smith Barney continued its long-standing affiliation with Hynix – a link made stronger still by the fact that Citigroup has undisclosed exposure to the company thought to be as much as US$100 million. Those close to negotiations say that Micron sometimes had trouble adapting to the peculiar circumstances, in which creditors were at least as important counterparties as Hynix itself. Untimely resignations didn’t help. First Kim Kyung-Lim, CEO of Hynix’s biggest single creditor, Korea Exchange Bank (KEB), resigned in March. Then the Korean minister of finance and economy, Jin Nyum, stepped down in order to run for election as governor of Kyonggi province. Jin had been an important figurehead pushing for reform in corporate Korea, and his influence had been vital.

Still, neither resignation derailed negotiations for too long – perhaps the reverse. With Kim’s departure, Hanvit CEO Lee Duk-hoon became point man for the creditors in negotiations, and joined Hynix CEO Park Chong-Sup in the final leg of discussions in the US. Hanvit, like all four of Hynix’s major financial creditors (Korea Development Bank (KDB), KEB, Hanvit and Cho Hung) is majority government-owned, but it may be significant that things seemed to move forward when KEB was no longer so significantly involved in discussions. Although the government is the largest single shareholder in KEB, German bank Commerzbank holds 35% and two seats on the bank’s seven-seat board, and it has been speculated that this led to internal friction about how to proceed. Meanwhile on the political side, Jin’s successor, Jeon Yun Churl, immediately started calling for the same corporate reforms as his predecessor.

On April 22, the two companies announced a non-binding memorandum of understanding for the sale of Hynix’s memory businesses to Micron. The terms, expressed simply, were these: Micron would give 108.6 million shares to Hynix for the memory business, which accounts for 75-80% of the company’s total sales, and would invest US$200 million in what was left of Hynix in exchange for a 15% stake. Hynix’s creditors agreed to extend US$1.5 billion of new, long-term loans to the company. The statements put out by both companies that day set a deadline of April 30 for approvals from Hynix, Micron, and Hynix’s creditor committee.

There was outrage among many groups at the announcement: Hynix employees, who feared for their jobs and felt the company could survive independently (an internal survey, disclosed by Hynix itself, found that 93% of employees were against the deal); the small non-financial creditors whose lending to Hynix was unsecured, and who expected to see what little stake they had in the business disappear; and unions across the country, including the powerful 956,000-member umbrella group, the Federation of Korean Trade Unions, which pledged to strike if the deal went through. But ministers, and senior regulatory figures like FSC chairman Lee Keun Young, involved themselves personally in persuading the relevant people to support the deal. On April 29, after four hours of meetings, 77.73% of Hynix’s creditors voted in favour of the sale, just passing the 75% threshold necessary for it to go through. Hynix’s board meeting was set for the following day, and seemed a formality. Only six members of the 10-man board, of which seven were outside directors, needed to vote in favour for the deal to go through, due diligence and regulatory approvals notwithstanding.

But they didn’t. On April 30 Hynix released a short statement rejecting the deal. Micron has since pulled out of negotiations.

So why did it fail?

 Creditor issues

In one respect, it was remarkable that the deal got as far as it did. Creditors to Hynix were already owed over US$6 billion by the company; wasn’t it a bit rich to expect them to extend a further US$1.5 billion? What’s more, sources who have seen the MoU report that the additional US$1.5 billion the creditors were being asked to put into the company would be unsecured, for seven years, with levels of interest capped at 5% and 6% depending on the tranche.

The overall value of the deal, which Korean observers had expected in advance to be around the US$4 billion mark, turned out to be considerably less, since it was calculated assuming a US$35 per share value of Micron – much higher than the share price ever reached while the bid was in play. The most it was ever truly worth, based on the Micron closing price on April 22, was US$3.4 billion; by the time it was rejected on April 30, it was worth US$3.07 billion. Those proceeds would have been split between the creditors, but only after the deduction of various other expenditures, including all debts incurred by a Hynix plant in Eugene, Oregon. True, if Micron shares increased in value – as well they might have done in what would have been the world’s biggest D-RAM manufacturer – then this could well have proved to be a lucrative return for creditors, but that was by no means certain.

In particular, the small, non-financial creditors with unsecured sums caught up in Hynix stood to lose almost everything, and it was these who were particularly targeted by the government in trying to get the necessary 75% creditor approval on April 29. KEB, KDB, Hanvit and Cho Hung, who between them accounted for 65% of the voting representation at the meeting, were clearly always going to vote along government lines, being government-owned. But the various investment trust corporations, insurers, leasing companies and securities institutions required a lot of convincing, and only a third of them were persuaded to vote for the merger. Quite how is unclear. “It’s possible some concessions will be made to provide some sort of sop to the unsecured creditors,” said an analyst in Seoul, speaking before the creditor’s meeting, and correctly predicting the outcome. “The key problem is them: they are getting nothing from this deal. Their recovery rate is zero. It’s possible the authorities may come up with some saving measure that gives them some prospect of loan recovery.”

Sources also tell us that the creditors would have been required to observe a two-year lock-up on their Micron shares, and in some cases could only ever dispose of them through what is described as an “underwriting mechanism” rather than straight into the market. “The final proceeds wouldn’t be received until two to three years after the deal was signed,” says someone who has seen the MoU.

Was any of this fair? It depends how you look at it. “This isn’t really about what is right and fair,” says Jonathan Dutton, an analyst at UBS Warburg in Seoul. “Banks have made a decision to lend money to a capital intensive and volatile business. It should have been clear years ago that the debt levels the company was carrying were driving it towards bankruptcy. You can’t really talk about fairness: creditor banks have to live with the consequences.”

And those close to Micron object strongly to suggestions that this was a deal that screwed Korean creditors and employees just because it could. “The point is that what is on the table is, simply, a future,” says one.

 What the board thought

But, in the end, the creditors proved not to be the problem. The board did, and this stunned the market. “They think it’s all over – it isn’t now,” said one analyst research note sent out the following day.

Why isn’t it over now? Well, the official reasons are there for all to see. Hynix spelt them out in a prepared statement. We’ll quote it in some length.

“We have reached the conclusion that there are too many problems with the creditors’ post-merger restructuring plan for the remaining company. The plan overestimates the value of the Micron stock to be paid for the sale of Hynix’s memory business; unrealistically presumes the size and timing of contingent liabilities; and is too optimistic in its estimate of the cash flow of the remaining company.” It goes on to note that the restructuring plan for what would remain of the company is flawed, “based on the restructuring plan placing too much liability onto the remaining company; restricting the sales of the stock of the remaining company as a collateral security; and overestimating the revenue and cash flow of the remaining company.”

And then, the real killer punch: “We are confident that with the upturn in the semiconductor industry and new developments in our technology… it is possible for Hynix to successfully exist as an independent entity.”

Several points there, but first it’s worth taking a look at the people who made the vote. Hynix championed its own corporate governance when it set up a board containing three of its own people and seven outside directors. The media championed it too: this was a sign of a new Korea, free of the vested interests that had dogged the chaebol. But it seems to have scuppered the deal. The board members were:

•           Chong-sup Park, chairman and CEO of Hynix;

•           Sang-ho Park, COO and president of Hynix;

•           In-baik Jeon, executive vice president and CRO of Hynix

•           James Guzy, president and CEO of Arber Investment Company, and a founder and board member of Intel;

•           Chul-hee Kang, in the engineering department of Korea University;

•           Yong-wook Jun, Professor of business administration at Chungang University;

•           Chang-rok Woo, managing director of Yulchon law firm;

•           Yong-kwon Sohn, president and CEO of Oak Technology, and a senior executive of Intel;

•           Yong-sung Lee, chairman of the Banking Supervision Authority at the Ministry of Finance and the Economy;

•           Eui-Je Woo, former acting president, Korea Exchange Bank.

So who, in that crowd, would have been expected to vote for it? Surely CS Park, among the most proactive of corporate reformers in the country? Certainly Woo from KEB must have been in favour too, given that KEB approved the deal as a creditor the previous day? Lee had seen and approved consolidation in another sector, banking, so would have been expected to rally for this; and Guzy and Sohn, both linked to Intel, might have been expected to support consolidation in technology if they believed it was good for the industry. That’s half the board right there. But the decision was unanimously against it – despite the fact that it was followed by CS Park’s resignation, and despite the presence of a former senior member of the company’s biggest creditor bank on the board.

Oh to have been a fly on the wall of that meeting. The exact discussions will doubtless never be made public, but at least one analyst pondered: “Perhaps the interests of the board members did not ally with those of the creditors.”

Responding to Asiamoney questions, Hynix’s spokesman Chan Jong Park says: “It is true that Mr CS Park initiated these talks with Micron. But at some point, the negotiation proceeded in favour of Micron and our suggestions were not reflected.” Park returns to the issue of whether the leftovers of Hynix could survive, and adds: “I think all of the BOD members couldn’t vote for a deal that would not secure the viability of the remaining Hynix.”

Were they also swayed by the emotions of staff resentment and union pressure? Doubtless it played a part, but if one looks to history, the very vocal nature of Korean employee movements rarely has a long-term effect if the government’s will is strong, as it appears to be with corporate reform. When Kookmin announced its proposed merger with Housing & Commercial Bank, senior executives were barricaded into their offices for days while disgruntled employees vetted their mail and on one occasion threatened to set themselves on fire. The deal still went through. An economist in Seoul once told Asiamoney that a useful economic barometer was the consumption and use of tear gas in any given period: protests in Seoul are very physical and very emotional. But do they derail deals? Probably not.

And so to the reasons the board actually gave. Their concerns about the restructuring plan for what would remain of Hynix are difficult to assess, given that the restructuring plan has never been made public, but enough has made its way out to the media for us to make some educated guesses about what it proposed. With the memory business gone, 75-80% of the company’s sales would have gone with it, leaving a foundry business. As we understand it, the restructuring plan called for creditors to write off W1.78 trillion in debts, followed by a capital write-down in a ratio of 13.5 to one, reducing the capital from W19.8 trillion (dizzyingly high given its assets) to W1.7 trillion. Under an agreement forged last October, W3 trillion of debts held by creditor banks will be swapped into equity in May, and at the end of it all, with the debts from the Eugene, Oregon plant paid off, the remaining Hynix would have had about W3 trillion in remaining debt. Korean creditors would own 69.3% of the company.

Was the board correct to question this? Perhaps so, although it was hardly arguing from a position of strength. “We have our doubts,” says Dutton, asked if he thought the proposed new Hynix could survive (and speaking before the board rejected the deal). “It doesn’t have leading edge process technology, it doesn’t appear to have any track record of strong customer relationships, and its cash flow per wafer – one of the key metrics to look for – is one of the lowest among major players. It would be a new company starting off in life with W3 trillion of debt, paying interest on it, with a 120% debt equity ratio. The theory is that the bulk of its assets would be Micron shares, and that when the time comes the creditor banks can sell them down and retire the debt. But the key question then is what the value of Micron shares is at the time.” Another commentator puts the matter more bluntly. “The bit of Hynix that would be left over is the bit Micron didn’t want. Draw your own conclusions.”

Hynix clearly agreed: CJ Park says the board wanted the remaining company to be left with less than W1 trillion of debt but was overruled by the creditors. “It was obvious that the remaining Hynix cannot survive with interests that were three times of its profit,” he says. And even at one of the creditors that approved the deal, there is a dissenting voice. Manfred Drost is deputy president at KEB. He says: “This is a point that has been neglected in the public discussion: the viability of the remaining company. It’s questionable, even on legal terms, whether you can strike a deal where you buy 80% of the core business and structure it as an asset deal – it is essential to prove the viability of what’s left.”

As for the assertion that Hynix can survive anyway, analysts have their doubts about that too. Many quickly put out sell recommendations, either formally or in private notes to clients. The company will surely lack the internal cashflow to finance upgrades in its manufacturing facilities. Yes, there has been something of a turnaround in the market – the DRAM spot price was US$1.50 when the companies opened negotiations in December, but reached US$4.50 in March before dropping back towards US$3 more recently – but this is a notoriously volatile sector with an oversupply problem. Hynix’s share price jumped on the news of the board’s rejection of the deal, but as Merrill Lynch analyst Sun Chung notes: “We believe that the trend [in the share price] could continue for little longer if, and only if, the creditors are willing to provide the same financing, debt forgiveness and other concessions that they were offering to Micron.”

Much depends on that question: whether Korean creditor banks would be prepared to lend anything else to Hynix. Well, in the circumstances, would you? “I’m not in a position to make a judgement on this deal, but I do know that most of the banks have provisioned about 70% of their existing loans to Hynix,” says David Coe, formerly the senior resident representative for the IMF in Korea, and now responsible for the country in Washington DC. “If I was a banker and I was already provisioned to take a 70% hit on those loans, I wouldn’t be lending more.”

The creditors themselves were non-committal when Asiamoney asked them if they would lend again. “It’s a very complicated problem and very early to say about Hynix,” said an investor relations spokesperson at Hanvit on May 2. “We have a special task force team set up for Hynix but we cannot talk about details because they are very secret.” Asked if the bank would lend to Hynix again, a Cho Hung Bank spokesperson would only say: “At this moment, in this situation, no.” Drost at KEB declined to comment, as did KDB’s investor relations team, and Hynix declined to comment on conversations with its creditors.

 What next?

Although Micron has officially pulled out of negotiations, the deal may not be dead in the water, because Hynix’s board is not as all-powerful as one might think. This is where the debt-equity swap for W3 trillion of debt owed to Hynix’s creditor banks, hammered out last October and due at the end of May, becomes all-important. Why? Because if that debt converts, it will give the creditors majority control of Hynix, potentially even over 75% – which means they could sack the board and appoint a new one with the task of reconsidering the Micron offer, if the Idaho company was prepared to return to the table. A representative of one of the creditor banks, asking not to be named, goes so far as to tell Asiamoney that he “presumes this will happen”.

“We think that the board’s decision may be more of a Quixotic gesture than a substantive act which will scupper the Hynix/Micron merger,” says Dutton. “Compare it to the captain of the Titanic refusing to abandon ship. The creditor banks ultimately control the fate of Hynix.” Even if the creditors did not behave so drastically, they could refuse Hynix fresh loans and push it into receivership, or indeed just threaten to do either of these things in order to get the board to think again.

Court receivership, under which the creditor banks would get whatever a firesale of Hynix assets would provide them with, would have its own political problems in Korea. But the government appears to have worried quite enough about that. Asked for a comment, a Ministry of Finance and Economy spokesperson referred us to Minister Jeon’s remark on May 1 that “the government is taken aback and finds it [the veto] regrettable”. He added: “It is up to the creditors to determine the fate of Hynix. The government will urge creditors to reach a decision at an earliest possible date so as to clear the uncertainties over the Korean market.”

Not everyone is convinced this is the right idea, though. “Great, we’ll push out the board, replace the lot of them,” says someone close to the situation. “Replace them with whom, exactly? We need experts, not retired bank directors and civil servants. It’s not that easy.”

And for Korea? There were plenty of people around the world offering glib “that’s Korea” responses to the news of Hynix’s refusal. But they miss the point. Because the fact is, a board has a right to refuse a deal that it doesn’t think represents its best interests; it has a right, frankly, to be wrong, if that’s how it turns out. “If nothing else,” says one observer, tongue in cheek, “you have to say Hynix’s board certainly demonstrated its independence. To everybody’s surprise.” Whatever else the Hynix situation may represent – and stubbornness may well be a part of it – it is not a government bailout, nor really a step backward in Korean reform.

Although the December election brings with it uncertainty, there is a will at the highest level to see through corporate reform in Korea, and the Daewoo sale to General Motors will doubtless and rightly be promoted by the government as a symbol of Korea’s willingness to move forward. “In terms of the overall progress of corporate restructuring, you have to say this is a bit of a setback, but on the same day it happened the GM deal was signed, and an MoU was signed between Lehman and Woori [Financial Holdings, for a US$1 billion investment],” says Coe. “I think the trend is clearly in the right direction; progress is being made.”