Tax Inversion may lead to more M&A in semi
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5:26 PM ET
Qualcomm for ARM? Intel for MediaTek? Pondering Chip M&A
By Tiernan Ray
A couple of folks on the Street today were banging the drum for mergers and acquisitions in semiconductors, arguing that both tax reasons and the search for earnings growth should propel further deals.
FBR & Co.‘s Christopher Rolland today opines that semiconductors are primed for a phenomenon known as “tax inversion” that has already prompted a lot of deal making in the pharmaceuticals industry, in which a U.S. company basically moves almost all its equity to a foreign property in order to shelter overseas cash.
“An inversion occurs when a U.S. corporation reverse merges into foreign acquisition and re-domiciles in a more favorable tax jurisdiction. Besides a favorable ongoing tax rate, the new entity is often able to repatriate its U.S. cash without penalty,” explains Rolland.
Going into a bit more detail:
The U.S. tax code allows corporations to benefit from a foreign inversion if, after an M&A transaction, less than 80% of the equity in the new company is owned by legacy shareholders in the U.S. corporation and the company has significant foreign operations. Companies are unable to benefit if they have more than 80% legacy U.S. equity holders, the foreign company acquires “substantially all” of the U.S. assets, and the new company “does not have substantial business activities in the foreign country.” “Substantial operations” is defined as more than 25% of the new corporation’s employees (in either head count or compensation), assets, or gross income. Companies who meet these criteria are deemed “inverted corporations treated as domestic corporations” and are not respected as a foreign corporation—continuing to be taxed as U.S. firms. This prevents any of the benefits of an inversion.
Rolland notes there’s been a lot of dealmaking thus far, and there might be more:
While the semiconductor industry has witnessed 11 medium to large acquisitions in 2014, and three in just the past few weeks, a wave of tax inversions may serve to accelerate the consolidation process. Given the highly technical 20%, 25%, and 40% rules (discussed later in this analysis), there are surprisingly few combinations that fit the tax requirements to be considered a “bona fide” inversion by the U.S. Treasury.
Rolland posits some theoretical takeover deals that are rather eye-opening: “Qualcomm (QCOM) for ARM Holdings (ARMH), Texas Instruments (TXN) for NXP Semiconductor (NXPI), Intel (INTC) for MediaTek (2454TW) , and Cavium (CAVM) for Mellanox (MLNX),” all of which, potentially meet the IRS requirements for inversion, he notes.
However, his favorite chip picks in this context are Altera (ALTR), Advanced Micro Devices (AMD), ARM, NXP, ON Semiconductor (ONNN), Qualcomm, And Xilinx (XLNX).
Similarly, Romit Shah of Nomura Equity Research notes that “Mergers and acquisitions happen in waves.”
“Our understanding is that today we are in the middle stage of a powerful swell,” he writes.
“We’ve seen announcements in the last week from Analog Devices (ADI) and Hittite Microwave (HITT), Synaptics (SYNA) and Renasas, ON Semi and Aptina and SanDisk (SNDK) and Fusion-io (FIO).”
“These transactions come on the heels of RF Micro Devices (RFMD) and Triquint Semiconductor (TQNT) and Microchip (MCHP) and Supertex in Q1.”
Aside from SanDisk’s buy of Fusion-io, “none add revenue growth. It is all about EPS accretion,” leading him to conclude “We believe that potential acquirers are looking at companies with prospects for improved operating expense leverage, strategic fit and valuation.”
As such, Shah offers 15 candidates for a take-out within those three broad categories:
“Sub-scale companies“: Many companies offer unique products with strong IP protection that generate strong gross margin (60%+). However, they may be sub-scale and are spending significant amount of operating expense (as percentage of sales) especially for selling and administrative functions [...] Five companies in this category include Integrated Device Technology (IDTI), Intersil (ISIL), M/A -Com Technology Solutions (MTSI), Micrel (MCRL), Semtech (SMTC), and Silicon Labs (SLAB).
“Strategic companies“: Strategic acquisition is the most common reason for M&A [...] For example, Avago’s acquisition of LSI allows Avago to have a more balanced profile of growth and profitability, while ADI’s acquisition of Hittite offers a more complete set of production in the full electromagnetic frequency spectrum [...] Six companies that fall into this category include ALTR, Applied Micro Circuits (AMCC), Atmel (ATML), Broadcom (BRCM), CAVM and Monolithic Power (MPWR).
“Undervalued companies“: We see semiconductor company valuations highly correlated to the profit margin. Highly profitable companies like Linear Technology has a high valuation multiple, while companies with low profits such as Fairchild has low valuation multiple. Three companies in this category include Diodes (DIOD), International Rectifier (IRF), and Microsemi (MSCC).
