I feel like we have attended a wedding and heard the vows (July 31 announcement of Micron's (MU) Elpida closing) and attended the reception (August 9 analyst day) delicately avoiding the tipsy analysts directing largely useless questions to the groom. Now the hard work begins. What sort of marriage will this be and what sort of fruit will it bear?
There were three previous articles in the series:
- The first began an examination of the only existing pro forma. It is now so old it could almost be carbon dated. Warren Buffett is fond of saying shareholder communications should be like a quick letter to a partner who has been gone for a year. What would he need to know to resume running the business tomorrow. I fault management for giving us no current financials for Elpida. One can bet that their competitors and suppliers know within a few hundred wafers what the results are. It is only us owners who Micron management seeks to keep in the dark.
- The second article began looking at some of the pickup from the "push down" in PP&E and the attendant reduction in depreciation.
- The third article looked at some analysts' timid first attempts to deal with how much accretion Elpida may deliver.
This article plugs the midpoint of the management guidance into a model to show what accretion might be, and then attempts to update the purchase accounting. My finance professor was fond of saying, "Measure with a micrometer. Cut with an ax!" And since the facts that Micron management is willing to dole out are so few, this will necessarily be meat ax crude. On the other hand, it will show some of the mechanisms at work and how they interact. Some of this I learned by purchasing a private company significantly below book value, which caused an elimination of the PP&E for GAAP purposes and a huge reduction in inventory values. All of us, myself at the head of the class, have a lot to learn about bargain purchase accounting.
Management seems to be making heavy weather of the purchase accounting, which should have begun long ago in anticipation of a July 31 closing date. Wall St. Analysts are also wary, as this snippet of an August 8 Morgan Stanley research report indicates:
We talked to the Morgan Stanley accounting team about the treatment of purchases of distressed assets, as we lack a history of distressed transactions ourselves. According to the team, they note that negative goodwill is fairly common in such situations, as the goal of the auditors is to state the assets at their fair value, and the replacement value of the fabs is likely quite a bit higher than $1.3bn. It is unlikely that Micron can provide direct guidance on this metric, given that it can take up to a year to finalize these asset valuations (which could require restatements down the road). We view our $70mn as reasonable. The assets were acquired in a competitive bidding situation, so the purchase price does likely reflect fair value, but there is likely some risk that the numbers get revised higher particularly given 49% gross margins in 2Q.
I was taught that in bargain purchases, where the purchase is less than fair value and less than the GAAP book amounts, the assets are "haircut" or "pushed down" in the inverse order in which they can be converted to cash. In other words, PP&E is the most difficult and time consuming to convert to cash and is discounted first. If PP&E is eliminated in the push down, then inventory, being the next most difficult and time consuming to convert to cash is pushed down, and so on. SA's Retired Securities Attorney has written some good comments on the subject.
Management hasn't given us a lot of data, but did give us some hints at the analyst day on August 9. Notably they said Elpida's cash at closing was $1 billion, they mentioned that the installment payments would have to be discounted since they carry no interest rate, they said that the NOLs would have to be valued. Cranking those numbers into the pro forma released February 5, which in turn used Elpida's September numbers here's what I get:
So we could see an Elpida once consolidated which starts with $0 in PP&E through the miracles of GAAP accounting. In the chart above, the debt is discounted at 5% and the resulting delta from its nominal value is booked in the purchase accounting column. Since sales are about 50% higher than when the pro forma was done, inventory, AR and AP are all increased by 50% to reflect the current run rate. Here, in the purchase accounting column, the inventory is only slightly pushed down to make things balance. In the words of Donald Rumsfeld, "These are the known knowns." There are plenty of "known unknowns" such as the value of the NOLs, and how the $900mm value of Rexchip spread across all the Elpida accounts into which it is consolidated effects the total push down. And of course there are plenty of "unknown unknowns."
My takeaways from this exercise are several. First, there was a general moaning upon hearing that inventory would be marked to market and would go out the door over the next several months at a zero margin. That's not quite correct since there is still a lot of work to do to bring the July 31 inventory into a saleable state. In the last financial statements we've seen for Elpida from September 2012, only 46% of the 71.3 Billion Yen of inventories were finished goods. The rest were raw materials, work in process and the like which will still have a lot of value added at Elpida's extraordinary gross margins, amplified for the moment by this purchase accounting. Also, the inventory may well be pushed down further once Rexchip and the NOLs are valued and cranked into the model. All of that "pushed down" inventory will go out the door at extraordinary margins, even while the marked-to-market inventory may go out at a not so shabby 20-25% margin.
A second takeaway from this crude purchase accounting exercise, is that if PP&E goes away entirely, so will historic depreciation. Management guided on August 9 that depreciation might be as low as $15mm per quarter. How about zero?
Management provided the following slide on guidance at analyst day.
The table below takes the midpoints of that guidance and plugs it into a simple model to estimate the accretion Elpida may deliver to Micron:
Gross margin @50%
Op Ex @ 12%
Tax at 5%
I guess any analyst with less than a $1.28 accretion estimate for Elpida had better sharpen their pencils. I've used 1.2 billion shares to account for the converts and the general increase in the share census.
I was disappointed with analyst day. SanDisk went to a huge amount of effort for theirs and produced over 200 excellent slides. I had a hedge fund friend with over 1mm shares turned away since the room at NASDAQ was too small. And apparently "dozens" were turned away. Those of us who tried to follow on the webcast had lousy audio and slides which weren't remotely in sync with what the speakers were saying. Add to that the insult of not being given even slightly stale Elpida numbers and the whole experience was not exactly as uplifting as I had hoped. But the acquisition is done. Perhaps management will begin to trickle out numbers sufficient to do a more accurate purchase accounting and accretion analysis. And most importantly, the marriage of Micron and Elpida should be very fruitful indeed!