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By Justin Dove

If you can’t beat ‘em, just buy ‘em…

Broadcom’s (Nasdaq: BRCM) acquisition last week of NetLogic (Nasdaq: NETL) is likely to set off a chain reaction as larger, older semiconductor companies try not to get left in the dust. Valued at 3.7 billion, it’s the largest semiconductor industry acquisition in seven years. The willingness of Broadcom to pay such a high premium represents the degree of paradigm shift in the industry.

Semiconductor stocks across the board rose due to an overall market rally last week. But according to The Street, “The chip rally is notable because several stocks in the sector climbed on heavier volume – a sign that institutions are piling into the stocks.”

This institutional pickup could signal anticipation of a wave of consolidation within the industry.

The Nitty Gritty on the Semiconductor Industry

While Broadcom supplies chips that are used in many end products, such as wireless devices and iPods, NetLogic chips are key players in network processors. NetLogic’s innovation in networking processors fills a hole in Broadcom’s product line. Considering the deluge of network-connected devices entering the market, network processing will be a very important sector of the industry going forward.

“Broadcom is now better positioned to meet growing customer demand for integrated, end-to-end communications and processing platforms for network infrastructure,” said Broadcom CEO Scott McGregor.

In return, NetLogic shareholders stand to make a quick 57-percent gain over the stock’s previous Friday closing price if the deal holds up.

However, the premium Broadcom is paying is actually just 15.5 percent greater than NetLogic stock’s 52-week high closing price of $43.28 on May 2. Broadcom’s timing represents two current opportunities for buyers in the semiconductor industry.

  • The troubles in the broad market represent good values for stocks across the board.
  • The very cyclical nature of the semiconductor industry is currently in a downturn due to oversupply and lack of demand. This creates opportunities for bigger companies to take advantage of smaller, weaker companies and consolidate the industry.

NetLogic vs. Cavium

Many analysts and pundits have labeled Cavium Networks (Nasdaq: CAVM) as the most obvious choice for the next takeover target. That makes sense, considering Cavium and NetLogic are similar. Both companies play to roughly the same markets and before the deal was announced, were trading within $1 of each other.

Netlogic Microsystems vs Cavium Networks

So why did Broadcom select NetLogic?

Despite similarity in stock price, NetLogic has almost 20 million more shares outstanding. NetLogic also reported $100 million in net cash in Q2, compared to $70 million for Cavium. Since Broadcom now has access to that cash, it acts as a rebate. Broadcom selected a more valuable company. It’s also important to note that NetLogic recently entered the market of physical layer chips – one of Broadcom’s core strengths. So this move was defensive, as well.

Additionally, Piper Jaffray analyst Gus Richard calls Cavium’s chips “long in the tooth.”

“BRCM is not buying CAVM and this confirms our view on the relative positioning of the two companies,” writes Richard. “While CAVM will likely get a bounce due to the acquisition of NETL, we do not believe [Broadcom's competitors] would be interested in buying the company and do not believe there is a natural buyer.”

Ouch. Obviously, Broadcom was able to get the pick of the litter, but the move could still force the hand of a Broadcom competitor trying to keep up.

Using a $50-per-share premium and considering the cash on the books, Cavium would likely cost under $3 billion. Considering QUALCOMM (Nasdaq: QCOM) reported $5.7 billion in net cash last quarter, it doesn’t seem out of the realm of possibility, but only time will tell.

If Not Cavium, Who?

Another possible takeover target is EZchip Semiconductors (Nasdaq: EZCH). While EZchip also specializes in networking processors, it has a less-diversified product offering than NetLogic and Cavium. It’s also relatively expensive, with a P/E of 65 and just about $30 million in cash on the books.

PMC-Sierra (Nasdaq: PMCS) may be another attractive target. PMC-Sierra’s stock price is similar to Ezchip’s, but with 234 million shares, its market cap is closer to Cavium. The P/E is also in line with Cavium, but the kicker is the whopping $170 million cash on the books last quarter.

A sleeper, and possibly an attractive investment regardless of takeover, is Mindspeed Technologies, Inc. (Nasdaq: MSPD). Mindspeed also deals in networking processors, but has a relatively tiny market cap of approximately $200 million. Mindspeed also has a tiny P/E, 13.18, relative to other technology and semiconductor companies. Its low P/E and $40 million in cash in the books make Mindspeed look like a real bargain for potential buyers and investors alike.

Watch Insider Options Activity

While guessing who will be acquired next is all speculation at this point, most signs are pointing to further consolidation.

Although stocks such as Cavium and EZchip have experienced slight run-ups following the NetLogic move, it’s not too late to capitalize. Broadcom set the market premium around 50 percent, which may be too much to expect from an inferior company. But somewhere in the realm of 30 or 40 percent may be within reason.

Investors should keep an ear out for rumors and keep an eye on options activity for some of the proposed targets. While it’s not always foolproof, it can be a short-term indicator that a deal will soon go down. As insiders and speculators gain confidence in a deal, they’ll purchase call options to take advantage of the deal without needing the large up-front investment of buying shares of the stock.

Disclosure: Investment U expressly forbids its writers from having a financial interest in any security they recommend to our subscribers. All employees and agents of Investment U (and affiliated companies) must wait 24 hours after an initial trade recommendation is published on online - or 72 hours after a direct mail publication is sent - before acting on that recommendation.

Source: Who's Next In Semiconductor M&A?