Analog Devices - Linear Deal Looks Solid, Investors Might Be Too Optimistic

| About: Linear Technology (LLTC)

Summary

Analog Devices acquires Linear Technology in another mega-semiconductor deal.

Strategic benefits and shared R&D drive the logic behind the transaction, as investors react very positively.

I believe that investors might be overreacting a bit and believe that the valuation is rather "full," especially given the leveraged balance sheet going forward.

Analog Devices (ADI) announced the acquisition of Linear Technology (LLTC) in order to create a giant high-performance analog leader. The company is joining the deal frenzy in the semiconductor industry in which transactions often makes sense, driven by significant opportunities to slash costs.

While the strategic rationale and financial synergies make the deal look appalling, the market has been fairly aggressive to price in the benefits of the deal. This aggressive market reaction makes that I am not jumping on the momentum bandwagon, in part as the balance sheet becomes highly leveraged overnight as well.

Deal Terms

Analog will acquire Linear for a total sum of $14.8 billion. Note that this amount is based on the equity value and not the enterprise valuation of Linear, which is a bit lower thanks to the net cash balances held by the company.

Investors in Linear will receive roughly $60 for each share they own, comprised of a 46 per share cash component as well as 0.2321 shares in Analog.

Analog's CEO Vincent Roche stresses the combined focus on engineering and complementary product portfolios as the rationale behind the tie-up. Greater capabilities become more important as physical and digital worlds are converging at a rapid pace. The improved innovation power will be important for the customers who operate in industries like automotive, industrial and communications.

While it is clear that the strategic nature is the important driver behind the deal, cost synergies are anticipated as well. 18 months after the expected closure of the deal, anticipated in the first half of 2017, cost synergies are seen at $150 million per annum.

Investors Hit The Jackpot

The $60 offer makes Linear's investors the true winners in this deal. The company ended the quarter with 245 million shares outstanding, which implies a deal tag of $14.7 billion. If I exclude net cash balances of $1.4 billion, the deal values Linear's operating assets at $13.3 billion.

This is equivalent to 9.3 times sales, which is a very rich multiple if you realize that full year sales of Linear were actually down by more than 3%. While Linear operates within growth markets, cumulative revenue gains of 30% over the past decade have been relatively modest. This amounts to average growth of just 2-3% per year.

The reason for the big multiple is the very fat margins with operating profits of $633 million translating into margins of more than 44%. Net earnings came in at $494 million over the past year. This suggests that Analog Devices is paying a 27 times earnings multiple. If we take into account $150 million in synergies and a 25% tax rate, after-tax earnings could improve to roughly $600 million, lowering the effective multiple to 22 times. Of course, this is before we take into account the additional financing costs, which relate to the deal.

While the synergy estimates look aggressive at roughly 10% of Linear's revenues, they might be very realistic. Synergies in the semiconductor industry tend to be very high as these companies spend huge portions of their sales on R&D, while duplicated listing costs can be avoided as well.

Pro-Forma Business

Analog Devices has posted sales of $3.4 billion on a trailing basis, although year-over-year results show modest declines as well. Similar to Linear, sales have been up by roughly 30% over the past decade. While operating margins of 22% are very impressive, they are merely half the margins reported by Linear. Part of this results from a charge taken last year, but even if we adjust for that, margins remain much lower.

Ahead of the deal, Analog operated with a strong balance sheet as well, net holding $1.6 billion in cash. The 312 million outstanding shares traded at $62, for an enterprise valuation of $17.7 billion. This valued the company at 5.2 times sales and 27 times earnings.

The outstanding share base will increase to roughly 370 million shares following the deal. The $11.3 billion cash component of the deal can in part be financed with existing net cash holdings of little over $3 billion at both firms. This indicates that the pro-forma business will operate with roughly $8 billion net in debt. That is quite substantial in my eyes as pro-forma EBITDA comes in just shy of $2 billion, even after generously factoring in the anticipated cost savings.

In the deal presentation, the company reports a 3.6 times leverage ratio going forward. That does include anticipated synergies while it uses adjusted EBITDA. While these are fairly high leverage ratios, both firms operate in growing industries, and have in the past displayed stable margin developments as high amortization charges result in solid cash flow conversion as well.

The 370 million shares trade at $62, for a $23 billion equity valuation and a $31 billion enterprise valuation. That is equivalent to 6.5 times pro-forma sales of $4.8 billion. Pro-forma operating earnings come in at nearly $1.6 billion if I take into account synergies. Note that Analog took special charges of some $200 million over the past year. If we exclude these costs, pro-forma operating profits could come in at $1.8 billion.

If we assume a 4% cost of financing on the $8 billion net debt load, interest costs could come in at $320 million a year. These costs and a 20% tax rate could result in pro-forma net earnings of $1.2 billion. Given the 370 million shares, which are outstanding, earnings could come in at $3.25 per share.

In the deal presentation, management talks about the 2020 target to achieve non-GAAP earnings per share of $5.00. Historically, the gap between non-GAAP and GAAP earnings has been fairly limited, in part resulting from limited stock-based compensation expenses. For that reason, I see GAAP earnings coming in roughly 10% below the guided non-GAAP earnings.

The Market Likes The Deal, A Word Of Caution

Shares of Analog jumped by 4% ahead of the deal announcement although part of these gains were the direct result of deal rumors. Shares rose by an additional 8% in after-hours trading when the deal was officially announced.

This $7 jump in the share price is equivalent to a $2.6 billion jump in the market value on the back of this news. Also, realize that the premium offered for Linear was equivalent to $2.8 billion as well. This makes that the combined market value of both firms jumped by $5.4 billion in response to the deal. That seems like a large amount even if we take into account the strategic benefits as well as the $150 million in projected synergies.

That said, the market seems to like the strategic nature behind the deal, and the fact that the strong balance sheet of both individual companies will finally be put to work. That being said, the market might be getting a bit too optimistic. Based on the $5.00 non-GAAP earnings per share number for 2020, shares are already valued at 15 times earnings if we assume a $4.50 per share GAAP number.

Note that this is an earnings estimate some four years ahead in time. It will take time to achieve this number as the strong balance sheet has overnight turned into a leveraged state as well.

Given that both firms only grew sales at an average of 2-3% over the past decade, this does not make me very enthusiastic. Even as the combination might benefit from super-trends like the Internet of Things, this is a "show me first" story in my book.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.