Silicon Motion And MaxLinear Deal: Hurdles Remain In The Way

It’s been over a month since Silicon Motion Technology Corporation (NASDAQ:SIMO) jumped 17% in one day. The big gain coincided with the release of the Q1 earnings report, but that was not the reason for the move. The quarterly report got overshadowed by news that SIMO and MaxLinear (MXL) agreed to merge the two together. However, it will take some time and effort for the deal to be completed, assuming of course it gets that far as the deal will need to overcome a couple of hurdles. Why will be covered next.

MXL wants SIMO

Bulls got a pleasant surprise when word got out that MXL is looking to acquire SIMO in a cash and stock transaction valued at $3.8B or $114.34 per ADS. Shareholders of SIMO can expect to get 0.388 share of MXL stock for each ADS, plus $93.54 in cash. MXL hopes to close the transaction in the first half of 2023.

The deal would bring together two companies that are focused on different markets, yet similar in size. The table below lists some of the multiples for SIMO and MXL. In general, SIMO trades at lower valuations than MXL. On the other hand, one could argue that is justified with MXL’s greater reliance on the enterprise, unlike SIMO which is more exposed to the more fickle consumer side of things.

	SIMO	MXL
Market cap	$3.14B	$3.02B
Enterprise value	$2.91B	$3.17B
Revenue (“ttm”)	$981.7M	$947.0M
EBITDA	$284.5M	$189.5M
Trailing P/E	14.08	40.22
Forward P/E	11.62	17.73
PEG ratio	0.09	–
P/S	3.14	2.93
P/B	4.86	5.30
EV/sales	2.96	3.25
Trailing EV/EBITDA	10.22	16.74
Forward EV/EBITDA	8.41	7.86

Source: Seeking Alpha

Why SIMO may be under pressure to complete a deal

Some may have been surprised by SIMO’s decision to sell the company. After all, SIMO has done very well recently in terms of sales and profit growth. However, there are signs of a market slowdown, if not an outright downturn, may be on the horizon. SIMO is basically a supplier of NAND flash memory controllers for solid-state storage devices. As such, SIMO is heavily exposed to the smartphone and PC markets, both of which are currently faced with falling demand.

There are some indications this reduction in end-market demand has made its way back to SIMO. Quarterly revenue had increased sequentially for five consecutive quarters, but this came to an end in Q1 FY2022. Q1 revenue increased by 32.7% YoY to $242M, but it also represented a decline of 8.4% QoQ. GAAP EPADS increased by 63.3% YoY to $1.60 and non-GAAP EPADS increased by 55% YoY to $1.72, both less than in the preceding quarter. The table below shows the numbers for Q1 FY2022.

(GAAP)	Q1 FY2022	Q4 FY2021	Q1 FY2021	QoQ	YoY
Revenue	$241.978M	$264.357M	$182.399M	(8.47%)	32.66%
Gross margin	52.1%	49.6%	50.0%	250bps	210bps
Operating margin	27.4%	27.3%	24.3%	10bps	310bps
Operating income	$66.362M	$72.148M	$44.392M	(8.02%)	49.49%
Net income	$54.502M	$60.635M	$34.400M	(10.11%)	58.44%
EPADS	$1.60	$1.73	$0.98	(7.51%)	63.27%
(Non-GAAP)
Revenue	$241.978M	$264.357M	$182.399M	(8.47%)	32.66%
Gross margin	52.2%	49.9%	50.7%	230bps	150bps
Operating margin	29.8%	30.9%	26.6%	(110bps)	320bps
Operating income	$72.032M	$81.620M	$48.538M	(11.75%)	48.40%
Net income	$58.945M	$67.592M	$38.659M	(12.79%)	52.47%
EPADS	$1.72	$1.91	$1.11	(9.95%)	54.95%

Source: SIMO Form 6-K

It may be too early to tell, but it would not be the first time for SIMO to be faced with a downturn after an upturn. The flash memory market tends to go through these cycles, which makes it difficult for SIMO to escape the fallout associated with market turns. SIMO may be wise to close a deal while the going is still good. If the market goes down, quarterly numbers could get a lot worse. SIMO would not receive the same valuation that it does now.

Wall Street may not be totally sold on SIMO and MXL

The chart below shows how SIMO shareholders have gained from the proposed transaction. SIMO has suffered in 2022 along with other semis, but the offer from MXL helped erase most of the YTD losses. SIMO is still down 6% YTD, but that is better than the semiconductor sector as a whole. For instance, the iShares PHLX Semiconductor ETF is down 32% YTD.

On the other hand, MXL has not fared as well. MXL continues to fall, which means the MXL shares SIMO shareholders are supposed to get are losing value. MXL has lost 52% of its value YTD. The price action suggests the proposed transaction is getting the thumbs down from the market. Note also how SIMO is trading below the proposed acquisition price, a sign there are doubts about the deal as proposed.

Why there is reason to doubt the deal will go through as proposed

There is reason to be skeptical. There are a number of hurdles to overcome before the deal can be finalized. For instance, shareholders need to give approval. Some may be reluctant because the offer may not be enticing enough in their eyes. The cash component, for instance, only brought the stock price back to where it was in late 2021 before the deal. There’s also the MXL share component, but that one continues to lose value as the stock goes down. One could argue the offer is merely okay, but nothing that blows people away. Shareholder approval is not a given.

More importantly, the deal needs to pass regulatory approval. While SIMO is the market leader in NAND controllers, there are lots of competing suppliers. Most regulators will therefore be less inclined to oppose the deal. Nevertheless, regulatory approval could be difficult to come by in the case of China. Keep in mind that China and the U.S. are in a struggle in the semiconductor market with both trying to increase their share of the market.

The U.S. government has used its position to deny the supply of certain semiconductors to a number of Chinese companies. China has in turn tried to develop its own semiconductor companies, but it still needs access to outside suppliers. Acquisitions are one way to boost domestic suppliers, but many acquisitions in the semiconductor space have come under increased scrutiny.

For instance, the U.S. government has blocked a number of acquisition attempts by China-based entities. Examples include Micron (MU), Lattice Semiconductor (LSCC) and, more recently, Magnachip (MX). From China’s perspective, this could be seen as a policy to restrain the development of its own semiconductor industry. Geopolitical considerations have come into play.

In response, China could adopt a policy of limiting U.S. influence by blocking certain acquisitions by U.S. companies, if it hasn’t already. While each case differs, China seems to be more willing to approve acquisitions that only involve U.S. semiconductor companies than acquisitions involving a U.S. company and a non-U.S. one. AMD’s (AMD) acquisition of Xilinx is an example of the former and Nvidia’s (NVDA) aborted attempt to acquire ARM is an example of the latter. China approved of the first, but not the second because the latter would increase U.S. standing.

There is an incentive on the part of China to make sure that non-U.S. companies do not come under the control of the U.S. as that would effectively cut them off from China, if the U.S. government chooses to do so. If this is correct, then MXL’s intention to acquire SIMO may be dead on arrival as it involves a U.S. company trying to acquire a Taiwanese company, the latter having fairly extensive dealings with China.

Investor takeaways

The proposal to combine MXL and SIMO has gotten a mixed reaction. On the one hand, a merger makes sense as the two would complement each other. There are several arguments as why a deal could be a good thing. Shareholders would get a significant premium and it would remove the risk of the stock losing value if the market goes south.

On the other hand, the odds of the deal going through as proposed is probably 50/50 and one could argue it is worse than that. There is reason to doubt the deal is a sure thing. There are substantial hurdles to overcome if the deal is to pass muster. While it is by no means the only obstacle in the way, regulatory approval from China may be the hardest to come by.

The reality is that China has encountered great difficulties due to the sway the U.S. government has over much of the semiconductor industry. It’s hard to see how letting one more semiconductor company come under the control of the U.S. is in China’s best interest. China not giving approval is more likely than not with this in mind.

A previous article from March ended with the conclusion that SIMO was a buy at $70 or so, even though the stock was trending lower. That turned out to be a good move with the stock having gone on a rally, in part due to the offer from MXL valuing SIMO at over $114 per ADS. However, while I remain bullish on SIMO, I would refrain from being a buyer at the moment.

In fact, some may want to lock in profits by taking some chips off the table as there is a high probability the stock loses ground if or when the proposed transaction by MXL encounters pushback, whether from China or some other corner. The fall could be amplified by current market conditions with the stock market struggling and if the quarterly numbers from SIMO get worse due to declining end-use demand.

At the same time, it is worth holding onto SIMO. There is still an outside chance of another offer from another party. Not only would there be a higher price, which may please those who feel the current offer is not good enough, but China is more likely to approve a deal if it is done by a non-U.S. company, removing a key reason to raise objections.

In addition, SIMO still has good prospects in the long run. The NAND market is growing and it is expected to keep growing in the coming years. For instance, the market for SSD controllers is predicted to expand from $14B to $53B in 2020-2030, which represents a CAGR of 14.4%. SIMO is a good way to ride this market higher as it holds technological leadership in the market.

Bottom line, longs should be prepared for a bumpy road ahead. Lots of things can still happen. The proposed acquisition is not a done deal and it could very well fail, which would almost certainly cause the stock to drop, especially under current conditions. Still, SIMO is worth holding whether the deal with MXL goes through or, more likely, does not.