Should ON Semiconductor raise the offer for FCS?
ON Semiconductor (NASDAQ:ON) is currently in a bidding war with a Chinese suitor to acquire Fairchild Semiconductor (NASDAQ:FCS). I recently analyzed ON Semiconductor and came to the conclusion that the company is relatively attractively priced. Given that ON Semiconductor is so reasonably priced, it is prudent to check whether the planned acquisition of FCS would deliver a similar return on investment.
When I first analyzed Fairchild in 2013, I valued it at roughly $13.50 per share as a standalone company. Two years later, I valued it at $15 and I would currently put a $16 sticker on it as a standalone business. Anything more is a takeover premium and future synergies from a significantly larger business size. So my opinion about the FCS takeover price is that it is reasonable due to the acquisition premium but it awards more of the acquisition synergies to FCS shareholders than to ON Semiconductor.
The Chinese suitor is clearly not buying for a purely economic reason but also to acquire some technology related to the defense sector. Though it may not be a high-margin, cutting-edge technology, it may still give China some valuable know-how they currently don't have. On the other hand, ON Semiconductor should buy FCS purely for economic reasons and to get scale. Or should it? There is an economic aspect and then there is a strategic level.
The strategic level: China entering the market though Fairchild is a major long-term risk to my long thesis due to margin pressure
One factor that may influence ON's decision to raise the bid price is that China entering the market via Fairchild would increase competition and margin pressure in the long run. My gut feeling is that this factor will be the final straw that will break the decision-making inside ON to pay up and increase the bid. In the long run, it may be the correct strategic decision.
Although Keith Jackson, ON's President and CEO, sounded tough on the conference call saying about the FCS bid that "Well, at this point, we don't see any reason to raise it and as I said, we'll act prudently and appropriately is about all I can share with you." However, this may all be a part of the tough business negotiation going on.
The economic dimension of the Fairchild merger
Judged purely by the economic aspect, I'm of the opinion that ON Semiconductor should not raise its bid and just take the termination fee instead. Pass up on FCS deal, walk away and attempt to acquire another company. Try to win some of Fairchild's customers with the new cash bonus. Especially the sensitive defense-sector customers that might be reluctant to contract with a China-owned company. And last but not least, boost the share buybacks at the current lower share price.
The company said on the latest conference call that it is adopting a "wait-and-see mode" on further buybacks until it is clear whether the acquisition of FCS is successful. Although buybacks don't solve the long-term need to grow in size, in terms of ROI, they offer a better short-term ROI than buying a low-margin business at 2x sales, even with the synergies.
That being said, I'm afraid ON will go ahead anyway and raise the offer price for the strategic reasons mentioned. Nevertheless, if the merger goes through, ON Semiconductor's stock price should definitely benefit from the synergies. From this perspective, the current stock price is very attractive as well and the merger is still overall positive for ON.
The $70 million break-up fee that FCS would pay ON represents just 2.4% of ON's market cap but it doesn't hurt either and it is risk-free money. The question would arise what to do with the shares ON already tendered in a quasi-hostile tender at $20 per share which has so far received a very lukewarm reaction from FCS investors who tendered only ~6.6% of the shares floating. ON prolonged the tender period until February 18. With the stock price trading above the tender price, investors have clearly "voted" with their actions that they demand a higher price for FCS.
Risks of the floating rate loan
Call me crazy but buying a low-margin, very cyclical business at almost 2x sales with a floating-rate loan of at least LIBOR + 3.50 interest rate with a 0.75 floor for LIBOR for a total minimum interest rate of 4.25 floating is a bit risky for my taste given that the lending conditions have already tightened since the deal was announced in November, and that the size of the loan would be roughly 0.5x combined sales in a low-margin business, in addition to the existing ~$850M net debt of ON.
Interestingly, ON Semiconductor is a cheap acquisition target itself
If FCS is worth $21.30 per share, it would be sold at 1.8x sales. The two companies operate in a similarly low-margin, volatile environment and have had similar historical margins (though FCS's margins have fluctuated more, making it hard to pinpoint the average value with much certainty as the dispersion of the margins is very high).
Using the same logic and the same valuation methodology as the market currently applies to FCS, ON Semiconductor is worth almost twice its current price.
ON Semiconductor currently trades at just 0.90x forward sales (which are pricing in a ~6% y/y fall). I'm sure ON's CEO likes to acquire companies and grow its business instead of being acquired. But at the right price and remuneration package, or an attractive position in the combined company, ON could easily be acquired at double its current price. An EV/sales comparison, which is more fair due to different levels of net cash (~5% net cash for FCS, ~25% net debt for ON), comes in a bit better for FCS but the valuation discrepancy in the EV/sales ratio is still large, roughly 70%.
To wrap up my merger opinion, the takeover price is fair thanks to the synergies and the controlling stake premium, but more benefits go toward FCS shareholders. I understand that ON Semiconductor needs to grow in order to stay competitive. So yes, I think ON should definitely pursue an acquisition, either FCS or another one. But not at any price.
The winner in a bidding war almost always ends up overpaying. I believe the current jittery market will offer solid acquisition opportunities very soon and ON should be patient. But the China competition factor described above may change the entire equation and ON Semiconductor has a tough strategic choice ahead. To raise or not to raise? That is the question.
Disclosure: I am/we are long ON.
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.