Seeking Alpha
Long/short equity, special situations, value
Profile| Send Message|
( followers)  

Investors in Avago Technologies (NASDAQ:AVGO) are applauding the company's acquisition of LSI corporation. The deal of the somewhat struggling company will double the company's footprint in terms of revenues.

On the back of the stiff premium and jump in Avago's shares as well, investors are a bit too enthusiastic in my opinion, especially as interest expenses will largely outdo expected synergies.

The Deal

Avago Technologies announced that it has entered into a definitive agreement under which it will acquire LSI Corporation (NASDAQ:LSI).

Shareholders in LSI stand to receive $11.15 per share in an all-cash deal valuing the company at $6.6 billion.

Through the deal, Avago will become a highly diversified semiconductor market leader adding enterprise storage to Avago's wired infrastructure, wireless and industrial business. Combined, the companies are well positioned to capitalize on growth opportunities in data center and mobile data traffic.

According to the presentation related to the deal, LSI has key customers like Cisco Systems (NASDAQ:CSCO) and Intel (NASDAQ:INTC) in the storage connectivity area, Western Digital (NASDAQ:WDC) for hard disk drives and Micron (NASDAQ:MU) in flash storage.

The deal is expected to be immediately accretive in a significant way to Avago's non-GAAP earnings per share. Annual cost savings of $200 million per annum are seen at the end of the fiscal year ending in November 2015, the first year after expected closing of the deal.

Back in September, LSI released its third quarter results. Revenues for the first nine months of the year came in $1.77 billion, down over 7% compared to last year. Based on the guidance, full year revenues of $2.37 billion are expected. Earnings more than halved to $79.6 million, as full year earnings are seen around a $100 million.

The deal is expected to close during the first half of 2014, as it has already been approved to the board of directors of both companies. The transaction remains subject to regulatory review as well as approval by shareholders of LSI.

Valuation

At the start of December, Avago released its fourth quarter results. The company ended the year with $985 million in cash and equivalents. The company holds virtually no debt, for a solid net cash position which is approaching a billion.

The $6.6 billion deal will be financed with a billion cash at hand, a $4.6 billion term loan from a banking consortium and an investment in the form of convertible notes from Silver Lake Partners.

Avago reported full year revenues of $2.52 billion for its fiscal year of 2013, up 6.6% on the year before. Net earnings actually fell by two percent to $552 million.

Before the deal has been announced, Avago traded around $45.50 per share, valuing the business at $11.3 billion, or operating assets around $10.3 billion when backing out the net cash position. This values Avago's operations at 4.1 times annual revenues and 18-19 times annual earnings.

Before the deal has been announced, Avago's quarterly dividend of $0.25 per share yielded investors a 2.2% annual return.

Some Historical Perspective

Avago's shares were sold to the general public at $15 per share back in the summer of 2009. Ever since, shares have steadily risen to current highs of $50 per share on the back of this deal. The initiation of a dividend and growing operations boosted the stock in the meantime.

With shares approaching $50 per share, Avago's shares have already returned some 55% year to date.

Between 2009 and 2013, Avago has increased its annual revenues by a cumulative 70% to levels just above $2.5 billion. The company improved its earnings notably, with earnings coming in at $563 million.

Investment Thesis

The deal was applauded by shareholders in both firms. The 42% premium which Avago is willing to pay represents a premium of about $2.0 billion for LSI. Avago's shares rose by nearly 10% at $50 per share, boosting the value of the firm itself by another $1 billion.

The $6.6 billion deal values operating assets around $6 billion when backing out the net cash balance of LSI. This values operations at 2.5 times annual revenues and around 60 times earnings on a GAAP basis.

Given the strong balance sheet of both firms little equity will be issued to finance the deals. Nearly $5 billion of the deal tag will be issued in debt, while the net cash balances of the firm will largely vanish. The to be issued convertible notes could dilute equity by another billion.

Trading around $50 per share, Avago is valued around $12.4 billion. Adding a billion in convertible notes and the firm is valued around $13.5 billion, while holding nearly $5 billion in debt. The combined company will generate annual revenues of around $5 billion and earnings of around $600 million at first. Note that expected synergies of $200 million will be made undone to a large extent by interest expenses, estimated $175 million per annum. This is on the back of effective interest rates of 3.5% of nearly $5 billion in debt.

Therefore the $13.5 billion valuation implies a valuation of 2.7 times annual revenues and 22-23 times GAAP earnings. Most of the accretion in terms of synergies will be used to pay interest on debt following the deal. Furthermore note that LSI has a difficult year in 2013 with earnings being cut in half versus 2012's earnings of about $200 million.

Investors and analysts are applauding the acquisition. Besides the tangible financial results in terms of synergies, a greater diversification of operations should make the business less volatile. The added scale significantly adds to the company's operations, extending the footprint in data. It is quite possible that synergies could come in higher, and the strategic improved rationale might boost earnings to about $800 million to $1 billion by let's say 2015. This would value the business around 15 times earnings.

Back in April of this year, when Avago announced the acquisition of CyOptics, I last took a look at the company's prospects. Shares traded at just $35 per share at the time, given the subdued demand for Apple's (NASDAQ:AAPL) iPhone, with Avago being a key supplier. The deal with CyOptics added growth at a relative cheap multiple, while share repurchases provided a boost to the shares as well.

I noted that those deals would support shares in the weeks and months to come, and shares have risen by more than 40% ever since. Despite the great deal, the combined value accretion of $3 billion in Avago and LSI seems a bit overdone despite $200 million in estimated synergies.

I remain on the sidelines.

Source: Avago Technologies: Nice Buy Of LSI, But The Market Is Too Enthusiastic