The importance of the long-term view

There were short-term pressures in 2005 but ST has succeeded in maintaining its focus on longer-term value creation, argues Chief Financial Officer and Executive Vice President Carlo Ferro.

2005 has been a year of refocusing priorities and reallocating resources in the spirit of Execution Excellence. Within this context there is no doubt considerable pressure across the company to improve financial bottom-line performance. Is this performance being sought at any cost, or are we managing to maintain ST values?

Well, in 2005 we did concentrate intensely on recovering profitability and building shareholder value, these are key objectives and necessary for the existence of a public company, consistent with all ST values, especially our strong focus on people. Employees remain the key asset of a technology company. Indeed our various programs of Execution Excellence are all about empowering people and making them accountable for decisions and results.

What exactly were our expectations regarding performance?

The key performance target at ST is to generate a return on Invested Capital substantially higher than the Weighted Average Cost of Capital, as we believe that by doing so a company creates shareholder value and establishes the right conditions for sustainable growth and prosperity for all stakeholders. We pursue this objective over time, in a sustainable way, as opposed to targeting short-term success. Cost efficiencies are relevant, but expansion of the customer base and product innovation are even more crucial. Continuing to invest capital while pursuing higher return is important as well. ST has aggressively addressed all four of these dimensions in 2005. We have achieved steady progress in each of them and now have good momentum for continuous improvements.

This is not a short-term effort. We have devoted 18.3% of our revenue in 2005 to Research & Development and 16.2% to capital expenditures: overall one third of our revenue has been invested in the future.

Another characteristic of 2005 has been the strong external pressure on companies regarding governance and financial accountability, for example the need to comply with Sarbanes-Oxley. How has the Finance department responded to these changes?

Yes, there has been an increase in the reporting requirements facing us. For example, we have had to comply with new US, Dutch, and international accounting regulations (e.g. US GAAP, IFRS). The bedrock of our approach remains complete transparency and an open response to disclosures required by any regulator. Compliance with Sarbanes-Oxley is important, and is something we have done even beyond pure compliance to regulation. Our CEO and I, for instance, voluntarily submit quarterly certification under rules 302 and 906 of Sarbanes-Oxley that are not required for foreign registrants. Indeed, the fact remains that as normal practice, companies must ensure effective internal controls. In short, for ST, Sarbanes-Oxley is an expansion of our existing business practice rather than a change in our culture.

Can you give some examples of how we are balancing short-term financial objectives with longer-term value creation?

Just look at our reallocation of Research & Development resources. This was not a decision taken for the short term. The management perception was that we had sufficient dedicated resources, but that they needed to be redirected to higher priority programs. So, instead of cutting our total R&D workforce, we redeployed about 10% of it to programs focused on decreasing our time to market, a very clear goal relating to our current performance. In other areas we did take action to reduce costs, such as exiting certain product families, but these decisions were made based upon performance results. This fact-based methodology is extremely important, as resources are being reduced only where the returns expectations are not being met, rather than across the entire company.

Do you think investors today put too much emphasis on short-term objectives? If so, how can companies like ST help shift the balance back to reflect the medium- to longer-term picture?

There are various categories of investors. The Socially Responsible Investment sector is a good example of prioritizing sustainable performance. In the end management doesn't drive investor expectations but must understand them, translate them into a sustainable long-term plan, and focus on execution toward results. I do not personally perceive increased focus on the short term with investors. On the contrary, a deeper, longer view of value creation is increasingly becoming part of mainstream analysis, and this helps a company like ours to think long term.

There is a lot of debate today about the competitiveness of Europe in the global market. One reason why European companies, including ST, are having a hard time is because of the Euro-dollar currency exchange. Among the strategies ST is using to minimize this impact is to focus more of its activity in Asia. What do you see as the risks and opportunities of this approach?

ST is a global company with strong roots in Europe and a marketing and manufacturing presence worldwide. Europe is where we still have almost half of our workforce, with approximately 25,000 employees. Our focus is to be where our customers are and competencies exist. This is still significantly in the USA and Europe, and faster-growing Asia. This means we work in a number of different geographies and leads to a mismatch between the currencies of our sales and our costs. The way we are trying to reduce the mismatch is by balancing our geographic presence, growing in Asia faster than in Europe, as all the semiconductor industry does.

In addition we also deal with financial hedging where we try to smooth the currency impact over time, but cannot completely eliminate it. Our actions have improved the currency balance of our cost structure. Costs in US$, the currency that denominates revenues in the semiconductor industry, are currently approximately 50% of our total costs, or 10 points higher than three years ago, before we started our plan of natural hedging. At the same time we have mitigated our exposure to the Euro, which still remains relevant. The currency exposure is a problem not only for ST or the European semiconductor industry; it is a general issue in Europe that should raise some alarm for the effect of the monetary policy in Europe on the competitiveness of European Industry.

Carlo Ferro
Chief Financial Officer and Executive Vice President