The Nvidia-Mellanox Deal: 21.99% Expected Annualized Return

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About: Mellanox Technologies, Ltd. (MLNX), NVDA
by: Bram de Haas
Summary

Trade tension between the U.S. and China influences a lot of deal spreads.

The recent blow-up of the Qualcomm/NXP deal is still a fresh memory.

Given the wide deal spread it's worth taking the risk of another blow-up or extensive delays.

This Nvidia (NVDA) - Mellanox (MLNX) spread is attractive today because of U.S - China trade tension and the blow-up of the chipmaker deal between Qualcomm (QCOM) and NXP (NXPI) have pushed out the spread so far that it's an attractive bet with an expected annualized return of 21.99%.

Over the deal lifetime, the raw spread has been as wide as 16%-plus and as tight as 3.4%. It's currently at 12.74% while we are quite a way into the process. If this deal breaks there's quite a bit of downside. I estimate the downside at $72 but there are quite a few analysts that put the downside in the 80s.

China risk for Nvidia - Mellanox deal

The Chinese Ministry of Commerce (or Mofcom) is taking an interest in a huge number of deals. They have a very low bar for the amount of sales in China before they want to be in the loop. As M&A is red hot this puts pressure on manpower, especially in complicated sectors. The chip sector is an industry where both China and the U.S. are focused on and the Qualcomm NXP deal blowing up happened thanks to Chinese approval delays. If China wants to use this deal as leverage I expect a similar playbook. No outright rejection but ongoing delays.

There also has been an update from the Nvidia (NVDA) earnings call:

...Lastly, regarding our pending acquisition of Mellanox, we have received regulatory approval in the U.S. and are engaged with regulators in Europe and China. The approval process is progressing as expected, and we continue to work toward closing the deal by the end of this calendar year...

In my last article I wrote:

Taking into account the expected closing date, estimated break price and my estimated closing probability, I think the expected annualized return is more than 21.06% here. I calculate expected annualized returns for every deal I'm interested in the M&A Dashboard. The expected annualized return isn't just the return in case of success but includes the failures as well. It's a higher bar compared to just the annualized return if the spread is closed.

Some of the important and subjective estimates that go into it are the probability of closing which I put at 92.5%. That's a low closing probability among the universe of deals but it is high compared to real tough cases like Sprint (S) T-Mobile (TMUS) and Oceanwide/Genworth (GNW). The break price is another subjective estimate that I put at $72 but I've heard many arbs use a higher number. As a closing date I'm working with 12/1/2019 but one of the major fears here are endless delays.

Read the full original take here.

Updated projection Nvidia-Mellanox

These deals that are vulnerable to Chinese regulators feel awful to invest in. But perhaps that's a good thing. It's hard to invest here for everyone. Institutional arbitrageurs may fear to look stupid if Chinese regulators wreak havoc on their portfolio. After the fact it will be hard to explain why you didn't see this coming as it is an obvious risk everyone is aware of.

I've slightly revised the odds of closure downward (even though progress has been made like approvals in U.S. and Europe) to 91%. This better reflects trade tension. I've also taken the expected closing date to 3/25/2020. This still gets me to an expected annualized return of about ~22%. This is certainly not the safest deal out there, but given the return profile, I'm retaining a small position.

It's small because I want to be mindful of not letting my exposure to Mofcom decisions run up too much. I have several other important positions that come with this risk as well. For example the very interesting Allergan (AGN) deal.

I like the Abbvie (ABBV) acquisition of Allergan better even though I expect a lower annualized return. Part of the reason is because I like Allergan as a standalone company at 10x free cash flow. Read more about that one here.

Theoretically, these mergers are separate events. The U.S. China tension introduces a significant shared risk factor across these deals.

Disclosure: I am/we are long MLNX. 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.

Additional disclosure: short NVDA