Cavium (CAVM) surfaced on my radar following the announcement that it would acquire QLogic (QLGC). The deal is quite transformative as it allows Cavium to double the revenue base. The transaction will furthermore turn it into becoming a profitable business, as significant synergies are anticipated to result from the deal.
Despite these favorable attributes, the market reaction to the deal has been negative. This might result from the poor revenue growth track record of QLogic, as well as the fact that Cavium will take on some debt to finance the deal. That said, I do not understand the negative market reaction towards this particular deal given the substantial benefits. Of course, the general valuation of the new combination remains up for debate as Cavium itself is an unprofitable business at the moment.
Cavium provides integrated semiconductor processors used in a wide range of applications such as wireless networks, general communication, cloud solutions, security and video solutions, among others. The company creates systems on chips which come with customizable software in order to provide optimum solutions for customers who generally deal with increased traffic. This makes that the business is well positioned to benefit from secular trends such as the internet of things.
As some of Cavium's clients have been consolidating, the company faces some risks from customer concentration. The top 5 customers make up little over half of sales. Cavium's top clients include names such as Cisco (NASDAQ:CSCO), Nokia Networks and Amazon.com (NASDAQ:AMZN), among others. The company is not alone in targeting these customers as well-known names such as NXP (NASDAQ:NXPI), Intel (NASDAQ:INTC), Broadcom (NASDAQ:AVGO) and Marvell (NASDAQ:MRVL) cater to the same customer base as well.
A Growing Business With A Profit Problem
Cavium has delivered an impressive growth over the past decade, in part aided by dealmaking. Revenues came in at $413 million in 2015, versus just $34 million in 2005. The company's gross margins came in around 65% of sales, largely in line with the rest of the industry. Despite the growth and strong gross margins, Cavium is actually not profitable. The company posted an operating loss of $14 million in 2015, in part resulting from the huge R&D investments which totaled $203 million last year.
Note that analysts focus on non-GAAP earnings, and Cavium is profitable on that metric, in part because that accounting methodology excludes stock-based compensation. While these costs do not involve cash outlays, they are very real to investors.
The market has generally regarded the growth trajectory over the past years as shares moved from a low of $10 during the 2009 recession, to nearly $80 in 2015. Ever since, shares have sold off quite aggressively, trading at levels of $48 before the purchase of QLogic was announced. That sell-off was triggered by worsening operational results. Revenue growth slowed down to just 1% in the first quarter of 2016 as net losses increased to $4 million.
With 57 million shares outstanding, equity in Cavium is valued at $2.7 billion at $48 per share. This includes a cash position of $130 million, while the company does not have any outstanding debt. The $2.6 billion enterprise valuation is equivalent to little over 6 times sales.
The Purchase Of QLogic
To increase the scale of the business, and thereby more effectively leverage the R&D investments/expenses, Cavium announced the purchase of QLogic.
Cavium is willing to buy QLogic for $15.50 per share. The deal is comprised out of an $11 per share cash component and $4.50 per share equity component. Investors in QLogic will receive 0.098 shares of Cavium for each share they currently own.
The $1.36 billion enterprise deal is really just a $1.00 billion deal if you take into account the net cash holdings of QLogic. With a $965 million cash component of the deal, Cavium will operate with a net debt load of roughly $835 million going forward. The company did indicate its intention to raise $400 million in fresh equity, reducing the pro-forma net debt load to roughly $435 million. The company will furthermore obtain ownership of QLogic's cash position, indicating that leverage will be very limited going forward, at less than $100 million.
QLogic has strengths in connectivity and storage solutions, adding to Cavium's strength in networking, computing and security offerings. Combined, both firms can provide customers with a broadened range of solutions and products. The deal will furthermore reduce the customer concentration of Cavium, creating improved diversification for the business.
It is important to realize that QLogic is a large business, anticipated to add $400-$410 million in annual revenues. This means that Cavium's sales will double overnight; the issue is that QLogic's growth trends have been dismal. The company posted sales of $600 million in 2011, as revenues have fallen by a third ever since. This decline in sales has weighed on operating margins which traditionally surpassed the 20% mark. Even now, QLogic is able to post operating margins of around 10% of sales.
This reveals that QLogic is actually posting operating profits of $40 million a year. The real kicker are the synergies which are typically high in semiconductor deals as these companies are very R&D intensive. Cavium can avoid duplicated listing costs, eliminate a lot of overlapping R&D and improve both the efficiency and effectiveness of the sales team. The company sees costs savings of at least $45 million per annum, suggesting that the deal could boost operating earnings by $85 million per year. That looks like a pretty decent earnings contribution, given that the enterprise valuation paid for QLogic stands at $1 billion.
The Pro-Forma Business
The combination will post sales of roughly $800 million and operating profits of $25-$30 million. If we include synergies of $45 million, the operating profit number could increase to $70 million, or potentially a bit more if synergies are achieved as well. After subtracting interest costs and taxes, net earnings are likely to come in at $30-$40 million per year on a GAAP pro-forma basis.
Cavium will need to issue roughly 9 million shares in the mid-forties in order to raise $400 million. The company will need to issue another 8-9 million shares which will be forked over to investors in QLogic. As a result, Cavium is expected to have 75 million shares outstanding going forward. At $45 per share, this values Cavium at $3.4 billion. Including the very modest net debt load, Cavium trades at 4.4 times pro-forma sales.
What is somewhat surprising is the negative market reaction to the deal. The actual dollar premium offered for QLogic is just $130 million. Cavium's shares dropped 7-8% in after-hours trading, although this occurred after a good day for the shares. That 7-8% move wiped out roughly $270 million in shareholder value, taking into account the newly issued shares as well.
All in all, the combined value of both businesses drops by roughly $140 million, even as the projected synergies are very high at $45 million. Normally you would expect to see accretion in the combined market value of the firm in response to an announced deal, certainly if synergies are this high. A typical 10 times multiple on synergies should be able to improve the combined market value by $400-$500 million.
Given the modest $130 million premium paid for QLogic, one would expect to see accretion in the range of $4-$5 per share for Cavium's shares. Instead, shares fell quite sharply in response to the news as investors might be nervous about the growth trajectory of QLogic, dilution of the shareholder base or the very modest net debt load as a result of the deal. That being said, synergies look very compelling as QLogic's profitability adds to the current bottom line, making Cavium profitable.
So based on the deal alone, the market reaction of Cavium seems a bit surprising. That said, Cavium was pretty difficult to value ahead of the deal, given that it is not profitable. Based on the negative reaction I might contemplate taking an opportunistic long position, betting on a reversal of the decline in the shares.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in CAVM over the next 72 hours.
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.