Why Microchip Is Spending More Than $10 Billion to Buy Microsemi

Microchip Technology's (MCHP) heavily-rumored deal to buy Microsemi (MSCC)  is now official, and it likely won't be the last big chip deal we see this year. 

By striking a $10.15 billion deal to buy Microsemi, Microchip is betting that it can reap the kind of giant cost and pricing synergies that it obtained from its $3.4 billion purchase of Atmel in 2016 with an even larger target. The company is also betting that it's worth paying up to increase the number of design wins it can land with major chip buyers across several verticals.

Following multiple media reports suggesting a deal was close, Microchip, the world's No. 3 micro controller (MCU) supplier and also a sizable analog chipmaker, announced on Thursday that it's buying Microsemi, a supplier of high-performance analog and mixed-signal chips for a number of end-markets, for $68.78 per share in cash. The price represents a 17% premium to where Microsemi traded before Reuters reported on January 23rd the company had received a buyout offer from a then-unnamed suitor.

In November, I mentioned Microsemi could be targeted as the chip industry's M&A wave continued, given both its moderate valuation and differentiated product line.

The deal, which Microchip aims to close in the June quarter, has an equity value of $8.35 billion and (after factoring Microsemi's net debt) an enterprise value (EV) of $10.15 billion. The EV is equal to nearly 20 times Microsemi's consensus fiscal 2019 (ends in Sep. 2019) free cash flow estimate of $516 million.

Microchip plans to take on $8 billion in debt and a $600 million bridge loan to help pay for the deal. It predicts Microsemi will boost its annualized EPS run rate by $0.75 within a year of closing, and -- with the help of an expected $300 million in synergies -- boost fiscal 2021 (ends in March 2021) EPS by $1.75.

That, in turn, is forecast to help Microchip grow EPS by more than 14% annually from fiscal 2018 to fiscal 2021. At its Thursday analyst day, the company said it's aiming for fiscal 2021 EPS of about $8, or roughly twice its reported fiscal 2017 EPS.

But if its acquisition of microcontroller rival Atmel is any precedent, Microchip might be guiding conservatively. Microchip originally forecast the Atmel deal, which closed in April 2016, would boost its fiscal 2017 EPS by $0.33, and predicted a roughly $0.90 boost for fiscal 2019. Yet when the books had closed on fiscal 2017, Atmel had, per Microchip CEO Steve Sanghi, provided $0.69 of accretion.

Also: At the time the Atmel deal was inked, Microchip was aiming for fiscal 2019 EPS of $4.25. Today, thanks to both Atmel and organic growth, the company's fiscal 2018 EPS consensus stands at $5.43.

Aggressive cost-cutting, driven in part by shuttering Atmel manufacturing facilities and migrating their activities to Microchip plants, helped the Atmel deal outperform. So did cross-selling Microchip's analog products to Atmel's microcontroller clients, and revamping Atmel chip-testing operations that were relying on outdated equipment.

It's worth noting, however, that Microchip also benefited from price hikes it carried out for many Atmel products. "I think Atmel was the most undisciplined company that we ever saw in the pricing area," Sanghi said during a Morgan Stanley conference talk.

Microchip might see similar opportunities to hike Microsemi's prices. The company's product lines contain many specialty analog and mixed-signal chips that meet demanding performance and reliability requirements, see limited competition and enjoy long shelf lives. Microsemi already enjoys high gross margins on a lot of these product lines, but Microchip could see room to boost margins further.

There should also be plenty of cross-selling opportunities. Whereas Microsemi respectively gets 29% and 31% of its sales from the aerospace/defense and communications (telecom infrastructure) verticals, Microchip only gets a combined 7% of its sales from them. Microsemi also now has healthy enterprise/cloud data center exposure, thanks to a booming storage controller and switching chip business.

On the flip side, Microchip gets 35%, 25% and 24%, respectively, of its sales from the industrial, automotive and consumer electronics verticals. Those markets collectively account for less than 20% of Microsemi's sales.

Cost, pricing and cross-selling synergies have also of course led many of Microchip's peers to make big acquisitions, and -- particularly in the wake of tax reform -- it wouldn't be shocking to see those peers strike fresh deals of their own this year.

Texas Instruments (TXN) and Analog Devices (ADI) , the world's two biggest analog chipmakers, could see value in buying an MCU supplier such as Cypress Semiconductor (CY)  or a mixed-signal player such as Integrated Device Technology (IDTI) . And top-tier MCU suppliers such as Renesas, Infineon and STMicroelectronics (STM) could find value in buying an analog player such as Maxim Integrated (MXIM) , ON Semiconductor (ON) or Semtech (SMTC) .

In January, Renesas quickly denied a CNBC report that it was in buyout talks with Maxim. But notably, the company's shares rose by over 3% before the report was shot down, and Maxim's shares didn't fully give back the big gains they saw on account of CNBC's report following Renesas' denial.

Markets are wagering more chip industry consolidation will happen, and are generally rewarding companies when they take part in it. This fact likely isn't lost on either Microchip or its biggest rivals.

Editor's note: This article was originally published by The Deal, a sister publication of TheStreet that offers sophisticated insight and analysis on all types of deals, from inception to integration. Click here for a free trial.

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