Dialog Semiconductor Gets Rewarded For Walking Away From Synaptics

Summary

• Dialog and Synaptics terminate their merger discussions, and investors breathe a sigh of relief that Dialog didn't overpay.
• Dialog pre-announced a stronger than expected second quarter, but a lot rides on how quickly it can ramp its non-Apple/non-smartphone operations.
• I believe another M&A bid (for a different) company is quite possible; there's value here if the Apple decline is controlled and the non-Apple businesses ramp, but it's high-risk.

Battered power management semiconductor company Dialog Semiconductor (OTCPK:DLGNF) (DLGS.XE) has done a little better since my last update on the company, as the market has reacted positively to a favorable second quarter pre-announcement, and now, the announcement that it has terminated merger discussions with Synaptics (SYNA).

Overpaying for Synaptics wasn’t going to help Dialog, but Dialog does still need a lot of self-help. The company is looking at a steep downward turn in power management integrated circuit (or PMIC) revenue from Apple (AAPL), and the company is a long way from solid traction in markets outside mobile (and/or with customers other than Apple). Although the shares no longer trade at a discount to zero value in the mobile business, there could still be upside if Dialog can grow its rapid charging, connectivity, and auto/industrial businesses and/or find a new M&A dance partner.

So Long Synaptics

Dialog announced late on Tuesday that it had terminated merger discussions with Synaptics. I had my questions about this deal when the two companies first confirmed discussions – although Synaptics offered meaningful cost-reduction synergy potential and some operational synergy potential (as Synaptics’ interface products consume a lot of power), Dialog’s dicey M&A history and Synaptics’ own transitional issues (steadily declining quarterly revenues) made it a curious choice. Synaptics did note in its press release on the termination that it now expected earnings at the high end of its guidance range, though the high end of its revenue range would still imply a roughly 4% year-over-year decline.

Neither company commented on the reason why a deal couldn’t be struck. I doubt I’m making any leap of faith here in assuming price had a lot to do with it, particularly as a deal for Synaptics was going to far exceed Dialog’s net cash on hand, and Synaptics might have rightly assumed that its own shareholders wouldn’t be too excited about a stock-based deal.

And Now?

Prior to this announcement, back in mid-June, Dialog announced that second quarter results were going to come in ahead of expectations. Dialog gave more information than is typical in such “pre-announcements”, indicating that revenue was up 6% on a like-for-like basis and about 2% better than the sell-side expected. Cost cuts and efficiency efforts are paying off, as the company saw 30bp of gross margin improvement (suggesting a nearly one-point beat relative to the Street) and a greater than 25% beat at the operating income line ($42 million versus $33 million).

That’s great … but ultimately doesn’t mean all that much. Whether management could execute on manufacturing efficiency initiatives was certainly an open question, but it doesn’t resolve the potential loss of over $400 million in annual revenue over the next few years from Apple, as the company swaps out Dialog’s main PMICs for its own in new models (and continuing to use Dialog’s sub-PMICs). More efficient operations are a great thing, and margins absolutely do drive semiconductor valuation multiples, but Dialog simply cannot boost margins enough to offset that potential lost revenue.

Which circles me back to “and now?”

For Dialog to have meaningful long-term value, it has to offset the lost Apple revenue. Gaining business from other smartphone OEMs is theoretically possible, and the company has a partnership with Spreadtrum, but historically, Dialog has gotten nowhere with anybody other than Apple. That leaves opportunities like rapid charging (where ON Semiconductor (ON) and Power Integrations (POWI) are serious rivals), connectivity (where it competes with companies like Nordic Semiconductor (OTCPK:NDCVF) and Cypress (CY), and auto where it will be competing with ON and seemingly almost every other chip company.

I believe these non-Apple/non-mobile businesses could grow at a double-digit rate over the next five years, but I still believe Dialog would like to find a dance partner. Among the chip stocks I follow, Lattice (LSCC) could possibly get Dialog’s interest as it is of acquirable size and offers cost-out synergy potential, but the operational synergy angle would be a tough sell. Likewise, maybe Diodes (DIOD) could be in the mix, but that’s based solely on what I see in terms of cost-take out and “acquirability”.

The Opportunity

Dialog shares do continue to price in a bearish view that could, perhaps, be excessive. Apple always keeps its plans close to its vest and Dialog might not lose as much business as quickly as feared. Even so, I think investing on the basis of “maybe it won’t be so bad…” is a questionable approach, and I continue to believe that Dialog must show more momentum and potential in its non-smartphone operations to win back any real benefit of the doubt. And, as before, M&A remains a big potential driver for good or bad – the right deal could give the company much-needed new legs for growth, while the wrong deal (or the right deal executed poorly) would likely kill the company.

A cash flow-based valuation approach that assumes Dialog loses its main PMIC phone business with Apple (in new models) over the next few years but largely retains its sub-PMIC and its iPad and sees low double-digit growth in the non-smartphone businesses can support a fair value in the mid-$20s, while a margin-driven methodology that strips out all of the mobile business entirely supports a fair value in the high teens.

The Bottom Line

Once the “they didn’t overpay for Synpatics, hooray!” enthusiasm abates, I do have some worries about how sentiment is going to go with Dialog. Strong guidance (particularly on margins and non-smartphone revenue growth) could keep the party going, but I do think new M&A rumors will start up again, and I do think the Apple overhang is real and significant. Although there may well still be meaningful value here, this is a tough, high-risk situation to step into right now.

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Analyst’s 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.