Description
In his seminal work on special situations investing – You Can Be a Stock Market Genius – Joel Greenblatt explained how distilling a complicated situation into simple terms can lead to outsized returns for the everyday investor. The edge in a special situation doesn’t necessarily lie in possessing extensive company-specific knowledge or industry expertise, but rather in properly thinking about what the potential outcomes can be once the situation is resolved.
In that vein, I’d like to present what I’ll frame as a unique merger arbitrage – the rare long/long.
Idea: Purchase shares of both MaxLinear (MXL) and Silicon Motion (SIMO).
Background: On 5/5/2022 MaxLinear announced it had entered into an agreement to acquire Silicon Motion for total consideration of $114.34 per share, based on a mix of cash and stock. Silicon Motion shareholders will receive $93.54 per share in cash, and will also receive 0.388 shares of MXL stock.
- At the time of the deal announcement MXL shares were trading at $53.61 which valued the stock component at $20.80;
- on the day of the deal announcement MXL shares traded down to $44.68, valuing the stock component at $17.34;
- and today MXL shares trade at $31.50, valuing the stock component at $12.25.
Even at today’s MXL share price, SIMO shareholders still stand to receive $105.80 of total consideration IF THE DEAL WAS TO CLOSE TODAY.
Now, I am no semiconductor industry expert (to the point I made at the beginning of this writeup), but there are two observations I can make about this situation which I think are common sense:
- Silicon Motion shares are not priced as if the deal will close – trading at $65 (60%+ upside if the deal closes), there is little-to-no chance of deal approval being priced in.
- MaxLinear shareholders hate this deal! MXL stock declined by over 20% in the week following the deal announcement, and as of today are down by over 40% vs. the pre-deal price.
Why might MXL shareholders hate this deal? Well, a quick glance at MXL as a standalone entity shows a business with ~$1 billion in revenues, 60%+ gross margins, 30%+ EBITDA margins, and a debt-free balance sheet. In the proposed transaction, MXL is acquiring a business that will nearly double its top-line but with inferior margins, and is taking on over $3 billion of debt to fund the cash component of the deal – net leverage on the combined entity pre-synergies is probably 5x if not greater!
(Note: at the time of the deal announcement MXL management quantified leverage as 4.5x, which included $100m of pro-forma synergies; however, street estimates for 2023 show both businesses declining vs. the figures used at the time of deal announcement in mid-2022, and I suspect synergies take time to achieve as well).
As a standalone entity, MaxLinear earned $4.23 EPS in 2022. Estimated EPS on FactSet for 2023/2024 is $2.81 / $3.40. At $31.50, MXL trades less than 10x 2024 earnings estimates, and that’s with net cash on the balance sheet as well. I am not an expert, and I might be wrong here, but I don’t think semiconductor suppliers with both the margin and leverage profile of MXL trade at 10x PE – a more appropriate multiple might be in the mid-to-high teens.
So to summarize the situation, SIMO shares are priced as if the deal will NOT close, and MXL shares are priced as if the deal WILL close, which makes some sense – as a MXL shareholder it would be tough to just assume you own the standalone business with no debt when behind Door B is a scenario with an over-leveraged entity at a time where the cost of financing has probably gone up by 500 basis as well.
The opportunity therefore is pretty unique: go long both!
In a scenario where the deal does not close, MXL shares should re-rate to a more appropriate multiple – at 15x 2024 EPS you would have a share price north of $50, close to 70% upside. Even at 13x you would have a share price of $44, almost 50% upside. Your SIMO shares might trade down, but I’m not sure there’s much downside – there is little deal premium priced in as it is, and if you combine existing cash + the break fee to be received from MXL, SIMO would have $13+ of net cash on the balance sheet. With FactSet showing $5.16 of 2024 EPS SIMO shares are fairly inexpensive already at just 12.5x earnings – and ex-cash would be trading closer to 10x.
In the scenario where the deal does close, you will get a 60%+ premium on your SIMO shares. Pro-Forma leverage will be high, so your MXL shares might decline even from today’s price, but with shares already down 40% from deal announcement I suspect the downside in MXL is far less than the upside in SIMO.
Conclusion: I have not talked about why the deal has not closed yet (Chinese regulatory approval still required), I have not said a word about what these businesses do either – but I still think taking a common sense approach to this special situation can yield a satisfactory result even to the most casual of investors.
You can STILL be a stock market genius.
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.
Catalyst