This is the latest in my "Investing with an Edge" series. For more on the series, please see here.
Company: Hutchinson Technology (NASDAQ:HTCH). Reasons for opportunity: small size, complex deal, regulatory review.
In November, Hutchinson announced a deal to be acquired by TDK (OTCPK:TTDKY). The deal structure is somewhat complex, and the merger received a request for further information from the FTC. The combination of those two factors has led shares to trade at a ~12% discount to the deal's most likely close price. Based on our analysis, we think the market is currently assigning ~20% chance that the deal breaks, but we think the true odds of the deal breaking is ~5% and the merger closes some time during the company's current time frame of late Q1 or early Q2 (so likely ~late April), resulting in an extremely attractive IRR for investors at today's prices.
Let's start with an overview of the deal structure and then discuss the FTC risk. HTCH is getting acquired for $3.62 per share plus $0.0108 per share for every $500k of net cash over $17.5m HTCH has as of the last day of the fiscal month immediately preceding the merger close. This additional consideration is capped at $0.38 (or a net cash balance of ~$35m) for a max value of $4/share. Note that the cash is counted net of the company's revolver draw but ignores other debt.
The obvious first question is: Will investors be paid this additional consideration? We believe the answer is yes, investors will be paid the full $0.38/share. There are several reasons for this:
- The company had $49.9m in net cash as of the end of Q1, up ~$9m from the preceding quarter. That cash balance gives them a huge cushion for cash drawdowns while still receiving the maximum payout.
- The company doesn't have a history of huge cash burn. It was FCF positive in FY2015 and only slightly FCF negative in FY2014 and FY2013. It obviously built up cash in the first quarter, and while that was driven mainly by working capital drawdown, it also would have been profitable without expenses relating to the merger. It would take a huge change in how the company has been operating for several years for them to burn enough cash to even approach the level where their payout would not be at the max.
- Management projections for 2016 (see p. 52) called for them to be FCF positive this year; management would need to be substantially off on their cash generation for the company to miss the max payout. Obviously, projections can be wrong, but given they already have one quarter of cash generation under their belt, it would be surprising to see them switch to an extreme cash burn very quickly.
Putting it all together, we think it's exceedingly likely the company's cash balance is well above $36.5m and shareholders receive the full $0.38 payment. Note that if the cash balance is close it is measured as of the last day of the fiscal month preceding merger close, so even if HTCH started burning cash, it would need to burn it extremely rapidly to fall below the $35m level before the measurement date.
So with the merger consideration discussed, let's turn to the FTC. Under the HSR Act, companies must give the FTC and DoJ notice of any pending mergers. If 30 days pass without hearing back from them, the merger can be completed. However, if either agency thinks the merger might be anticompetitive, they can issue a request for further information (a "Second Request"). Upon receiving a second request, the companies can work with the FTC to help show them why the merger is not anti-competitive. If the FTC agrees with them, the second request period will eventually expire and the merger will go through. If the FTC does not agree (i.e. Staples / Office Depot), the FTC will object to the merger and the companies can either call the merger off or sue the FTC to allow the merger.
HTCH/TDK received a Second Request from the FTC on December 16th. TDK and Hutchinson both compete in the suspension assembly business. The only other significant competitor is Nihon Hatsujo Kabusikigaisha (NHK). Nihon has about 39% of the suspension assembly market. The buyer, TDK, has 33%. The target, Hutchinson, has 23%, and a small competitor, SunCall, has the remaining 5%. When two competitors merge and take the number of substantial participants in an industry from three to two, the FTC will normally take notice.
We do not think the FTC will ultimately take issue with the industry consolidating. Suspension assemblies are critical components of disk drives, and the disk drive industry has been allowed to consolidate to effectively three competitors (Western Digital (NYSE:WDC), Seagate (NASDAQ:STX), and Toshiba (OTCPK:TOSBF)). Western Digital and Seagate are HTCH's two largest customer (TDK is actually HTCH's only other major customer). Our understanding is that the Second Request is not related to any FTC concerns with the merger; instead, they wanted to give HTCH's customers time to comment on the merger if they felt it would be anticompetitive. As part of our due diligence, we talked to several legal experts who agreed that the FTC would not have issue with the transaction and instead wanted to give customers a chance to comment.
Will any customers have an issue with the merger? We don't believe so. The merger proxy reveals that TDK contacted all of HTCH's major customers before the deal closed in "order to perform due diligence on the customers' reaction to a potential acquisition of the Company by MPT". In addition, HTCH had confidential discussion with their customers about the merger, and one of the major customers had the option to buy HTCH outright. None of the customers expressed concerns about the merger or interest in buying HTCH. In all likelihood, the customers are happy that TDK and HTCH are merging, as it lets them cut down on their supplier list and supply chain complexity.
So it seems unlikely that customers will protest the deal, and without a protest the deal should easily go through. Of course, anything is possible: perhaps customers get cold feet on the combination at the last second and protest it out of fear. So what happens if we are wrong and the deal breaks?
Shares were trading for $1.81 the day before the deal was announced. Q1 earnings were better than anticipated, but the market has also sold off pretty hard since deal announcement. If the deal broke, shares would probably settle in around $1.50 per share, so there is some serious downside if the deal breaks. However, at today's price of $3.55, the market is anticipating ~20% chance the deal breaks. We think the deal is ~95% to go through. Below, we have included a table that shows that shows where shares should trade today based on different assumptions on downside levels (i.e. if the deal breaks, the shares will trade at $1.50 versus $2.00) and % chance of the deal breaking. The yellow highlighted area represents a reasonable fair value for shares today.
Disclosure: I am/we are long HTCH.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.