Despite a Disappointing Acquisition Price, M-Systems Investors Should Stay the Course

by: Shlomi Cohen

Israel’s contribution to Monday merger mania was the acquisition of M-Systems Flash Disk Pioneers Ltd. (Nasdaq: FLSH) by SanDisk Corporation (Nasdaq:SNDK) for $1.55 billion in a share-swap deal.

Many investors believe that this merger was initiated two months ago when the options scandal erupted at M-Systems. The affair may have brought the merger forward - I believe that the merger was planned for the end of this year or early 2007 when M-Systems would have had a higher price - but I don’t think it was behind it.

SanDisk CEO Eli Harari apparently placed his first offer on the desk of M-Systems chairman, president and CEO Dov Moran when the two companies signed their cooperation agreement to found U3 in September 2004. M-Systems’ share was then traded at a low point of $11.80, a third of its current price, and it reached that price thanks to a notorious “Sell” recommendation by Citigroup Smith Barney analyst Craig Ellis. Citigroup led M-Systems’ latest offerings, and was probably the company’s advisor in the merger.

In September 2004. SanDisk was traded at half its current price, and at a press conference in Tel Aviv, Harari didn’t really deny that he wanted to buy M-Systems. In the end, he had to be satisfied with a cooperation agreement on M-Systems’ flagship product, DiskOnKey [DOK]. Moran already knew then that he had a lot of work ahead of him on his secret winning card - x4. He knew that only x4 could bring his company past the $1.5 billion or even $2 billion market cap threshold, the level at which a merger could be carried out. I think that he also knew that it was impossible to survive in the flash world without fabs, which cost billions of dollars to build.

One of the things that bothered me over the past year as an investor in M-Systems was the unexpected departure of director Eliyahu Ayalon, the chairman and CEO of DSP Group Inc. (Nasdaq: DSPG). He is considered a great CEO and straight as a die, and I was concerned that he left M-Systems’ board after a brief tenure of two years. When I tried to find out among his associates the reason for his departure, I received an answer that I understand only now: “Too many investment bankers are always wandering around there.”

Ayalon is known as a bitter critic of the sale of successful Israeli companies to foreign corporations. It could be that back in late 2005, he read Moran’s road map would lead to a sale which he opposed, which is why he left the board at the cost of foregoing handsome remuneration in the form of options for directors.

During the “Globes” business conference in December 2005, Moran was due to sit on a panel with Ayalon and explain why thriving Israeli companies should not be sold to global giants. Moran cancelled his participation, and Ayalon was alone on stage with his position facing Mercury Interactive Corp. chairman Dr. Giora Yaron, who argued that a company should be sold when it hits the glass ceiling in its development. Last week, Yaron sold Mercury to Hewlett Packard Co. (NYSE:HPW) for an astonishing $4.5 billion in cash.

Instead of Moran, I’d have appointed Yaron as chairman of M-Systems, and let him handle the negotiations with Harari. I’m sure the results would have been completely different. It’s impossible to compare apples and oranges, even though both Mercury and M-Systems are high-tech companies and even software companies, but Mercury was sold at a multiple of least 5 on its expected sales for 2006, whereas M-Systems was sold at a multiple of only 1.5. It’s clear to me that this was because of M-Systems’ low gross profit margin, but the difference is huge. I also had great hopes that the company’s margins would improve with the x4 platform.

Little is known about Mercury’s p/e ratio because of its options and the absence of financial reports, but I don’t think that it is significantly higher the M-Systems’ p/e ratio in the deal - 25 on 2006 profits. Nevertheless, Yaron sold Mercury for three times the price Moran was able to get. Yaron also got a high price of $52 per share, a level Mercury has not reached in the past two years, whereas Moran was unable to get M-Systems’ peak price for this year of $37.60 per share.

Despite this, I think that M-Systems’ investors who stay the course and hold onto SanDisk shares both before and after the merger have a good chance of getting a better return than the current price, provided that the stock market stabilizes and begins to climb in autumn and winter, which are normally the better seasons.

It should also be remembered that nearly all investment houses published warm “Buy” recommendations for SanDisk after it published its results and guidance last week. Presumably, they will be even happier today, now that SanDisk has acquired M-Systems for a fairly low price in a share-swap deal, since SanDisk’s cash is intended for a huge joint investment with Toshiba in Japan. It recently raised $1.15 billion in bonds convertible to SanDisk shares at $95 per share.

Harari’s broad hint

In conclusion, the huge argument surrounding x4 technology ought to be mentioned. Investors dream that Toshiba’s fabs will be the first to try to apply this revolutionary new platform. Rumors claim that M-Systems has conducted the trials to date with South Korea’s Hynix Semiconductor Co. Ltd., which supplies it with processors after it invested $100 million in equipment there.

Without anyone saying so, it is clear that the SanDisk-M-Systems merger also means that Toshiba will try to apply x4 technology in its joint lines with SanDisk. Harari made a broad hint to this effect last week. I don’t think there has been any dramatic change for Saifun Semiconductors Ltd. (Nasdaq:SFUN), since no one seriously believes that x4 is a tall tale.

Samsung Corporation will continue to be the main target for applying Saifun’s NROM technology, and the SanDisk-M-Systems merger changes little, except that maybe Saifun’s managers will have to speed up and press Samsung to sign. x4 is now backed by two giants, SanDisk and Toshiba, and the day x4 is commercialized Samsung will want to apply it as a follow on to MLC for which it already pays royalties to SanDisk.

As I’ve written before, a small and marginal beneficiary of the SanDisk-M-Systems merger is Tower Semiconductor Ltd. (Nasdaq: TSEM), which in future will able to produce controllers for x4, as well as receiving large orders for the regular NAND chips it already produces in large quantities for SanDisk. M-Systems will now become a potential customer for Tower.

Published originally by Globes [online], Israel business news -
© Copyright of Globes Publisher Itonut (1983) Ltd. 2006. Republished on Seeking Alpha with full permission.