Silicon Motion And MaxLinear: In Limbo, Merger Less Likely

Silicon Motion Technology Corporation (NASDAQ:SIMO), a supplier of NAND controller chips, received some good news and some bad news. SIMO shareholders approved of the proposed merger with MaxLinear (MXL), bringing the proposal one step closer to reality by removing a key hurdle. However, the good news was almost immediately offset by bad news out of China. The gap between the proposed acquisition price and the actual stock price got even bigger as a result. Why will be covered next.

The market is increasingly losing faith in a successful merger

The chart below shows how the stock surged higher on May 5 when SIMO and MXL proposed a merger with the latter acquiring the former in a cash and stock transaction valued at $3.8B or $114.34 per ADS. Every SIMO shareholder will get 0.388 share of MXL stock for each ADS, plus $93.54 in cash.

However, the chart shows something else. The gap between the proposed acquisition price and the actual stock price has steadily gotten wider, which suggests the market is increasingly skeptical the merger will go through as proposed. As a consequence, valuations for SIMO have dropped as shown in the table below and are now way below where they are supposed to be according to the agreement. The stock is at around $70, the lowest price point since the merger was announced, having lost 26% YTD.

	SIMO	MXL
Market cap	$2.43B	$2.74B
Enterprise value	$2.25B	$2.79B
Revenue (“ttm”)	$1,012.9M	$1,021.6M
EBITDA	$290.9M	$224.3M
Trailing P/E	10.81	27.03
Forward P/E	9.89	18.71
P/S	2.37	2.60
P/B	3.60	4.74
EV/sales	2.22	2.73
Trailing EV/EBITDA	7.73	12.44
Forward EV/EBITDA	7.00	6.96

Click to enlarge

Source: SeekingAlpha

There was some good news on August 31 when SIMO shareholders voted to approve of the merger with MXL, but the stock still sold off after both companies announced that China requested they refile their application for regulatory approval using the normal procedure, in effect denying their earlier request to fast track approval using a simplified filing on July 6.

SIMO and MXL hoped to complete their merger in the first half of 2023 and they still expect a final determination from China in the second or third quarter of 2023, but the latest decision from China puts the merger in limbo since regulators in China are under no time limits to come to a verdict on the proposed merger. China could do what it did in the case of the failed acquisition of Kokusai Electric by Applied Materials (AMAT), which is to let time pass by sitting on its hands and stonewalling, not giving approval, but not rejecting anything either.

Why time is against the proposed merger between MXL and SIMO

The merger can technically still go through as China has not officially rejected it, but the latest developments should come as music in the ears of those who are against the merger for whatever reason. At the very least, the transaction will need more time to complete than if China had approved of the use of the faster procedure.

This could turn out to be problematic. The more time it takes to finish the transaction, the more likely it is to encounter a problem. The delay may even turn out to be death knell for the proposed merger for reasons that SIMO and MXL have no control over. For starters, while the semiconductor market is growing, it is also slowing down. Recent industry forecasts predict growth in the semiconductor market will decelerate from 26.2% in 2021 to 13.9% in 2022 and only 4.6% in 2023. Semis should be concerned by the fact that demand is faltering.

Furthermore, weakening demand is even more pronounced in certain market segments, especially as it relates to PC and smartphone demand. Various companies like Intel (INTC), Micron (MU) and Samsung (OTCPK:SSNLF) have made this clear in their latest earnings outlook. This is especially problematic for a company like SIMO since it is heavily exposed to the PC and smartphone market. In fact, MU and INTC are SIMO’s biggest customers according to the most recent Form 20-F.

This slowdown, including at key customers, means the quarterly numbers are likely to get worse for SIMO in the near term as time goes by. It is therefore important for SIMO that the merger is completed as soon as possible as time is not on its side. China taking its time to move forward does not help in this regard.

(GAAP)	Q2 FY2022	Q1 FY2022	Q2 FY2021	QoQ	YoY
Revenue	$252.373M	$241.978M	$221.103M	4.30%	14.14%
Gross margin	52.9%	52.1%	50.3%	80bps	260bps
Operating margin	26.6%	27.4%	27.3%	(80bps)	(70bps)
Operating income	$67.115M	$66.362M	$60.438M	1.13%	11.05%
Net income	$51.583M	$54.502M	$49.545M	(5.36%)	4.11%
EPADS	$1.55	$1.60	$1.42	(3.12%)	9.15%
(Non-GAAP)
Revenue	$252.373M	$241.978M	$221.103M	4.30%	14.14%
Gross margin	53.0%	52.2%	51.0%	80bps	200bps
Operating margin	30.5%	29.8%	29.2%	70bps	130bps
Operating income	$76.957M	$72.032M	$64.481M	6.84%	19.35%
Net income	$62.754M	$58.945M	$52.730M	6.46%	19.01%
EPADS	$1.88	$1.72	$1.50	9.30%	25.33%

Click to enlarge

Source: SIMO Form 6-K

Why MXL could be forced to walk away from SIMO

Keep in mind that MXL made its offer, which valued SIMO at $3.8B, at a time when earnings numbers greatly benefited from the semiconductor boom of the last few years. The quarterly numbers still show healthy growth as shown above, but the pace of growth has come down compared to say last year. The balance sheet has also taken a hit from SIMO spending its cash on dividends and stock buybacks. Furthermore, the numbers are highly likely to get worse for SIMO, which means SIMO would do well to complete the merger while the going is still relatively good.

Remember that while SIMO has done well recently, it was not always like this. There have been plenty of times when SIMO struggled. The numbers from the last couple of years are more like an anomaly than business as usual. A trip back in history shows that recent quarterly numbers are atypical. For instance, revenue has grown at a CAGR of 30.5% in the last three years, but this goes down to 14.5% in the last ten years. Similarly, EBITDA has grown at a CAGR of 17.2% in the last ten years, but much faster at 49.9% in the last three years. SIMO is still benefiting from being on an upswing, but for how much longer remains to be seen.

This is why SIMO needs to close the deal as quickly as possible. If the numbers get worse for SIMO, SIMO becomes less attractive to MXL, especially at the proposed acquisition price. MXL may even feel that it is overpaying for an asset that is losing value with the semiconductor market heading for a slump and earnings likely to drop as a result.

Note that the market for NAND controller chips is fairly crowded with many players, which suggests very stiff competition in a downturn with everyone fighting for market share, making it extra hard for everyone to stay out of the red. SIMO should not expect to receive the same valuations it got during the boom years if earnings are much less in a downturn.

In addition, MXL will use mostly debt to finance the SIMO acquisition, but this could become problematic as time goes by. Interest rates, for example, are going up due to Fed policies, which are designed to make debt and leveraging yourself more costly. The longer MXL has to wait to issue debt, the higher the interest rate is likely to be. MXL may have to decide whether leveraging yourself shortly before a possible recession is such a wise move or if it could backfire on the company.

MXL has stated that it took a potential downturn into account when it decided to acquire SIMO, but it’s worth asking if MXL will still feel that way if or when the semiconductor market and the overall business environment deteriorates, certainly in comparison to earlier in the year when the deal was contemplated. If the semiconductor market goes into a deep slump, there may even come a point at which time it makes more business sense for MXL to walk away rather than complete the transaction as proposed.

Investor takeaways

A previous article concluded that the proposed merger between SIMO and MXL would face its greatest challenge in China. This has turned out to be the correct assessment with the proposed merger gaining U.S. antitrust approval and the subsequent approval by SIMO shareholders. It now comes down to regulatory approval from China if the merger is to go ahead.

However, while China has yet to make a final determination, its refusal to fast track approval and the timing of the decision suggest a fair amount of reservations on the part of China. It should be noted that the proposed merger comes at a time when the U.S. and China are effectively in a struggle as to who controls what in the semiconductor market.

The U.S. government has, for instance, recently decided to deny Chinese companies access to certain high-end GPUs from Nvidia (NVDA), the latest in a long list of moves targeted at China. Moves like this are likely to make the Chinese government cognizant of the fact that giving approval to the merger may not be in the best interest of its companies. China is also likely to remember how the U.S. government has blocked numerous potential acquisitions by Chinese entities, including fairly insignificant ones like the one for Magnachip Semiconductor (MX). It may be better for China if SIMO remains an independent company when viewed from this perspective.

On the other hand, a merger is still possible. SIMO is arguably in the lead for NAND controllers technology-wise, but there are alternative suppliers in the market, including from within China. So China is not obliged to block the merger. China could give regulatory approval under the right conditions if China can leverage it into something else. This suggests that while the likelihood of a merger has become smaller, it is not zero either.

Still, while I will hold on to SIMO, I would not be a buyer either. It’s worth holding on to SIMO since a merger is still possible, provided exposure is not too great, but to be a buyer means potentially risking a significant loss if the merger fails in the end. True, the stock trades at a hefty discount to the proposed acquisition price, but that’s because the likelihood of an aborted merger is fairly high.

Anyone who gets in at this point stands to profit if the merger does end up going through as proposed. On the other hand, the proposed merger has helped keep SIMO’s stock afloat in what has been a tough year for stocks, semis in particular. SIMO has not sold off as much as most semis, but if the merger fails for whatever reason, the stock will lose the support it got from the proposal and it is likely to sell off as a result.

Bottom line, the odds the merger goes through has gotten smaller. The proposal is still alive, but China’s decision, increased U.S.-China disputes regarding semiconductors and other recent developments suggesting the semiconductor industry is heading for a downturn have stacked the odds against the merger.

If the odds were 50/50 for a successful merger when the proposal was first made, then it may now be more like 1 in 3 with recent developments. The odds are likely to keep dropping the longer it takes to complete the merger the way things stand, which make it increasingly harder to justify a continued pursuit of a merger between SIMO and MXL as proposed. The proposed merger is still out there, just don’t bet it all on it happening.