LSI Logic’spending merger with Agere Systems presents a compelling opportunity to invest in the leading storage semiconductor player at a very cheap valuation and with significant embedded optionality. 

 

·       Announced synergies are conservative and should be at least $175mm.  Each $50mm of synergies adds 6c to pro forma earnings and ~$1.10 / share of value

·       No-one is considering revenue synergies but there is a significant opportunity in hard drives given the combined technology platform and lack of penetration in 60% of the addressable customer base.  There is also an opportunity to apply AGR’s success in monetizing its portfolio of 6,000 patents to LSI’s 4,000.  These opportunities could be worth another $1-4 / share of value

·       The base business should grow.  The key storage end-market is growing in the high single-digits and the combined company has several new potential products.  Declining revenues at AGR have been driven by legacy businesses but I think this will turn around later this year

The pro forma estimates account for $125mm of announced synergies from the merger, the pro forma capital structure and a previously announced $500mm share repurchase.  It does not incorporate the upside opportunities mentioned above.

 

On December 4, 2006, LSI announced that it would acquire Agere Systems in a ~$3.8bn all-stock transaction, exchanging 1 share of AGR for 2.16 shares of LSI.  The stock traded down 14% on the deal announcement with the analyst community confused about synergies, growth and execution risk.  

 

LSI designs, develops and markets semiconductors and storage systems for enterprise applications.  Their semiconductors segment includes three subsegments: storage, consumer and communications.    

 

 

AGR designs, develops and markets semiconductors for a variety of computing and communications applications.  The company operates in three segments: consumer storage, consumer mobility and networking.  The consumer storage business sells semiconductor devices for hard disk drives (primarily system-on-a-chip and pre-amps).  The primary customer for these products is STX, within which AGR has a 50% market share on non-enterprise hard drives.  The mobility business develops baseband chips and DSPs for handsets and AGR has roughly two-thirds market share at Samsung.  Finally, AGR also has a strong intellectual property portfolio that they have been monetizing at 90% gross margins.

 

 

Most of these businesses have high switching costs within a product cycle and lower but still material switching costs across product cycles because both customer and supplier collaborate on product design spending significant time and money on the process. 

 

 

LSI announced $125mm in cost savings associated with the merger, allocating 50% to COGS and 50% to operating expenses.  However, this represents less than 3% of combined COGS and less than 5% of combined operating expenses.  Realistically, based on conversations with management, the cost synergy number should be at least $175mm.  At this level, synergies would represent just 9% of combined operating expense.  Each $50mm in synergies would add 6c to pro forma EPS or $1.10 / share in value.

 

The combined company has historically had limited traction with other hard drive manufacturers outside of STX.  MRVL has virtually 100% share at Fujitsu, WDC, Samsung and Toshiba and 50% at Hitachi.  These vendors comprise over 60% of the hard drive market.  I expect certain hard disk drive manufacturers are looking to diversify their supplier base to emulate STX’s multi-sourcing strategy and there are specific opportunities at Samsung and Fujitsu.  These are large opportunities—if the combined company were to get 25% of system-on-a-chip business at drive manufacturers where it has no share currently, this could generate 13c of EPS and be worth ~$2.40 / share

 

Another revenue synergy opportunity is the ability to leverage AGR’s expertise in intellectual property portfolio management.  AGR manages a portfolio of 6,000 patents that generate roughly $130mm in revenues at 90+% gross margins, and is growing by $5-$10mm annually.  LSI has another 4,000 patents with limited focus on monetization to date.  If the new company is able to get 50% of AGR’s IP revenues from the addition of LSI’s IP portfolio, this would translate to 7c of EPS and be worth ~$1.20 / share.

 

The valuation seems to be pricing in no growth even though the core end-markets are growing and there are several new products the company is pursuing.

The analyst community has been critical of LSI’s consumer and AGR’s mobility businesses even when they were stand-alone companies, because of the business losses in LSI’s consumer business discussed above and perceived structural challenges with AGR’s business relating to the transition to 3G.  If LSI were to divest these divisions, I believe that it would be accretive to the overall valuation and also drive multiple expansion.  Such divestitures seem likely considering a key strategic rationale for the deal was to create a storage powerhouse rather than a consumer company. 

 

In terms of AGR’s mobility business, a similar baseband business (SLAB’s) was recently sold for 2.0x revenues including an earn-out.  Valuing AGR’s mobility business at the same multiple would yield after-tax proceeds of $650mm (assuming the tax base is ~$100mm).  Based on estimated profitability, the net effect of divesting this business would be a reduction in the current P/E multiple by 0.3x.  More notably, such a transaction would be accretive to the valuation anywhere above 1.25x EV/revenues (SLAB’s baseband business was sold at 1.6x excluding the earn-out).

In terms of LSI’s consumer business, the segment would be just 3% of the pro forma revenues so it is largely immaterial and the business is likely break-even or even slightly unprofitable.  I think this business could be shut down or sold with minimal impact on the remaining business.  

Pro forma for these potential divestitures, the remaining business would be almost 75% storage, which as mentioned before should make the business more comparable to MRVL. 

LSI/AGR trades at a significant discount despite the similar end-market exposures and/or perceived future growth rates. 

 

 

Each company’s move to a fabless model in the recent past reduced the ongoing need for capex.  This presents a favorable dynamic in conjunction with the earnings power of the combined company and my estimate of the disconnect going forward is 5-7c / share.  The company has already announced a $500m share repurchase post merger but should generate significantly more than this in free cash flow in the latter part of 2007.

 

It is a strong signal that the departing AGR CEO and CFO bought stock despite having no involvement in the new company after the merger.  The purchases are significant relative to their pay packages (~20%). 

 

Abhi Talwalkar joined LSI in May 2005 from Intel and promptly decided to exit the ASICs business and cease manufacturing operations.  I expect this management team understands the multiple expansion that would ensue following the rationalization of the non-core assets and that they will make decisive shareholder friendly decisions in this regard post-merger.