National Semiconductor [NSM] is in the type of cyclical business you wouldn’t really expect an activist to pursue. How do you think through the risk of being right about everything else but then getting the timing of the cycle wrong?
RW: National has been through three industry cycles since we’ve been in it. What we want to see – and what we have seen here – is increasingly better operating metrics at the cycle bottoms and increasingly higher trough stock prices. We take a long-term view and are willing to absorb cyclical volatility if the underlying business is continuing to improve.
National’s expertise is in chips that help manage power in cellphones, solar panels, automobiles and a variety of other uses. Given where the world is going, this leadership position in power management is something that should help them better weather industry ups and downs.
Your National stake also seems like quite a long-term holding for an activist investment. Explain that.
RW: After the initial analog-vs.-digital discussion, the second phase of the conversation centered on margins. National had something like 45% gross profit margins, while its competitors were closer to 60%. The response from the company was, “Well, we have plant capacity we have to fill, so we fill it with lower-margin business to cover our overhead.” Our response was, “Or you could rationalize your capacity.”
We made the point that the market would more highly value a company with higher gross margins because it would be considered safer in the down cycles of a cyclical industry.
That led to our helping them review their product mix, even to sell off some analog product lines and invest in those with more profit potential to fill freed-up production capacity. As they rationalized the mix over the next two or three years, they brought gross margins up to the industry average and beyond.
Are you now on to another phase?
RW: Yes. Because the long-term growth prospects of their industry have declined and we believe the company is ceding market share to tougher competition, we think the highest-return strategy for National would be to pursue consolidation, most likely as a seller.
The company seems to understand the rationale for a merger, which makes both strategic sense and provides a long list of potential cost savings through improved plant utilization, taking out redundant general and administrative costs and streamlining R&D.
Despite this, management has dragged its feet. We believe one big impediment is the incentive structure and the change-of-control provisions in top-manager contracts, which essentially create incentives to delay any sale or merger. We want those compensation plans changed and have made a specific proposal to the company to do so.
The stock currently trades around $14.30. How much value could be extracted in some sort of combination?
RW: The level of cost and operating synergies would obviously depend on the partner’s product mix and operational and manufacturing footprint. But the upside is real: the way we look at it, we’d expect something like $5 to $6 per existing National share in additional value to come out in a combination.