Which Way Forward for Infineon?

Infineon Technologies AG (NYSE/Frankfurt: IFX) is profitable but only barely so, and current trends in the general economy and within several of its end markets point to major turbulence ahead for the German semiconductor company. After a series of turnaround programs executed over several years, Infineon is still in recovery mode, and it probably will be for at least the next several quarters.

On Tuesday, Infineon's share price and valuation fell more than 6 percent after it said it would report lower-than-expected results for its fiscal fourth quarter, which will end Sept. 30, including a slight decline in sales from the fiscal third quarter. For the first quarter of fiscal 2013, the company expects "a revenue decline of up to ten percent relative to the fourth quarter of the 2012 fiscal year."

Infineon clearly remains in jeopardy, but this situation could be worsened by management missteps that, in my opinion, were inspired by an overexaggeration of the challenges it faces. First, the bad news: Though sales grew sequentially in the last two quarters, they are expected to decline for the next two. A decline of as much as 10 percent from a year earlier would be huge for a company that has been steadily ramping up its growth and initially appeared to be on an upward trend. Margin pressure is also expected to intensify, with operating margins dropping from a high of 13.6 percent in the fiscal first quarter of 2012 to as low as 5 percent a year later.

What does the company plan to do, and what actions must it avoid? Infineon says the management board "will define and implement measures to improve profitability beyond the first quarter of the 2013 fiscal year." It did not specify further, but I expect it to squeeze savings out of selling, general, and administrative expenses, which have hovered at around 12 percent of sales for the last three quarters. It may also tamp down R&D costs and try to reduce the cost of goods sold to improve the gross profit margin, currently at around 36 percent. All these actions will invariably involve job cuts.

Investors and executives shouldn't underemphasize the company's strength, though. Yes, sales are weakening, and margin pressure is building, but the two are closely related. The company's cost structure isn't too high, and the drop it expects in the operating margin is only because sales will not be as robust as anticipated. Furthermore, Infineon is in the relatively strong position of having adequate cash to fund ongoing operations. With €2.1 billion (about $2.8 billion) in cash and short-term investments as of the end of the June quarter and only €192 million in long-term debt, Infineon isn't in danger of defaulting on anything or even running out of cash.

Therefore, Infineon shouldn't cut expenses so deeply it gets hobbled when the market turns around, as I expect it will in the second quarter of 2013. I believe the electronics industry will experience weak sales in the next two quarters but should see a reversal by the second half of 2013. Companies that aren't prepared for growth by that time or that have retrenched key employees will not benefit from the rebound.

It's important to note that Infineon has already done a lot of the reorganization it needs to improve. On an annual basis, its sales have grown strongly in the last couple of years and may only be slightly lower in fiscal 2012 from the prior year. For the restructuring actions it has already taken to yield the desired results, Infineon's management must take the longer-term view and use the sales lull to invigorate operations, fortify alliances with customers, and crank out new products.

Yes, margins are under pressure today, but others are feeling the pressure, too, and it's as important to plan for future growth as it is to safeguard profitability. Cutting R&D may help improve operating margins, but it will also decimate the product pipeline, and that's really what drives growth and long-term profitability.