Buy NXP Semiconductors For An Upside Of 9% In 1 Month Or 15/20% In 3 Months, With Very Limited Downside Risk

Summary

• NXP Semiconductors is currently under offer by Qualcomm and the deal will likely close in 1 month.
• An even better outcome would materialize if the deal will not close, as NXP will likely trade around USD135 in 3 months.
• Deal failure would let management free to reset guidance, do stock buy-backs, and tell the market how NXP changed and grew in the last 18 months (long time!).
• NXP would likely re-rate once the cash cap of the deal is removed.

NXP Semiconductors' (NASDAQ:NXPI) operating performance is on a roll because most of its business is exposed to growing trends such as new connected cars filled with wireless and entertainment, driverless cars, and other applications in notebooks and mobile which require chips for traditional and secure connections. NXP, in particular, has the no. 1 market share in automotive, with 48% of its revenues in this industry.

The global car industry keeps growing and there is no sign of slowdown. See below the historical trends related to the number of car units delivered in the US each year. The US is now just back to the higher part of the cycle, which typically lasts around 5 years before decreasing again.

Source: FRED Economic Data

The remaining chunk of revenues (52%) are related to various industrial markets, mobile phones and other forms of communication, with average CAGRs of 8%.

NXP Semiconductors recently reported Q4 results which beat consensus expectations. For the quarter NXP delivered $2.5bn in sales with a record gross margin of 54%, driven by as 12% growth in the automotive segment and 31% in its connected-devices business.

The company is very cash generative, with $1.9bn of cash generated in 2017, $2.5bn expected by analysts for 2018 and $2.8bn for 2019, touching almost a 6% FCF/EV yield, which is very significant for a company expected to grow its EBITDA 25% between the actual 2017 result and 2019 consensus expectation.

The company has delevered very quickly since its most recent acquisition, Freescale, executed in 2015:

Source: Company

There is abundant space for the company to re-leverage its balance sheet and increase its ROE, or do buy-backs, or find another company like Freescale to buy. The semiconductors sector is consolidating quickly, with lots of M&A activity around the world.

The deal with Qualcomm (QCOM) is at USD127.5 per share. Note that Qualcomm recently had to increase its offer from USD110 per share to USD127.5 per share to secure enough tenders from NXP shareholders. The main reasons for this increase were, as per Qualcomm statement:

• NXP in 2017 grew its operating income by 20%, exceeding Qualcomm expectations
• Strong market dynamics and positive outlook for the key segments in which NXP is involved

The only outstanding condition is the Chinese antitrust. All the other jurisdictions, included Europe and US, have approved the deal. The stock price is currently distressed because a couple of reports mentioned that the Chinese are holding off on completing the approvals because of the trade war that Trump started. The Chinese are likely trying to extract the best possible conditions for the Chinese clients and the local semiconductor companies from the deal. These include making sure that Qualcomm and NXP commercial policies on bundling their products and on giving access to their patents are fair and open. Qualcomm has a long history of doing business in China and its role and products in the region are very relevant. Also, other reports mention that Qualcomm has submitted new remedies and Mofcom is currently reviewing them.

I believe the Chinese will agree to this deal as the required licences and behavioural commitments that are typically required in these cases will help the local semiconductor industry.

Should for any reason such approval not arrive, even better.

A deal failure would draw mutual funds and traditional long-only funds back in the stock, as the upside would not be capped by the current deal, the investment time-horizon would expand, and the stock would not be a plain M&A arbitrage play anymore as it is now.

NXP has traded historically at 15x NTM P/E, which corresponds to $110. In case of deal break Qualcomm will pay NXP a $2bn break fee, which is $4.33 per NXP share after taxes. Add the two numbers and you are around $115 already. This should cover well your downside in any worst case. Also, any semiconductor company is trading today at a premium versus historical multiples.

Since the deal was announced, the semiconductor sector has materially re-rated, and NXP peers like Texas Instruments, Maxim Integrated products, Microchip Technology and Analog Devices trade 45% higher on average. Apply this to NXP and you are at $120. Add the break fee and you are close to $125.

Should you do the same math using the SOX index, you get to $135 per NXP shares. Add the break-fee and you get $140.

NXP peers are trading on average at 18x '18 PE, and while they have some better margins, they also have less projected growth and higher debt because they are not involved in the same industrial niches of NXP. NXP has always made it part of its strategy to have high market shares in niches that grow higher than markets, instead of dispersing its focus. As a consequence, NXP Industrial and Automotive end markets have a 2016-2021 CAGR of 9.3% and 9.2%, respectively, as per recent Elliott Presentation on NXP created using data from Gartner.

At 18x '18 earnings, NXP is worth $135, + $4 of break-fee, close to $140 again.

Also, NXP will likely have some M&A speculation in it once it breaks because of the following reasons:

Elliott Management is a major shareholder with 7.2% of NXP shares (biggest position for Elliott Management, worth $3bn+ at current offer price) and will likely make sure that NXP uses its cash to create immediate value. Elliott is also particularly active in selling the companies where it is involved.

Texas Instruments could be a buyer of NXP. TI is 2.5x NXP and there is a strong strategic fit with limited antitrust risk as TI market share in the automotive industry is only 5.5% while NXP is around 14%.

Hence, add some % of M&A speculation to the valuations described above and you are well into the $135/$140 territory for NXP in the coming months.

You could add some hedge to your position by shorting the SOX index, maybe for 1/3 of your NXP total position.

Conclusion

This is a situation with very high chances to bring home a good return, with almost any scenario playing in your favour. NXP price has been distressed recently by the huge amount of arbitrageurs that sold the stock because disappointed that the deal has not closed immediately after the price increase offered by Qualcomm. This creates a strong opportunity for those who can hold the stock couple of months should the deal break.

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Analyst’s Disclosure: I am/we are long NXPI. 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.