Description

NXPI (NXPI Semiconductors NV)

NXPI is a target of a takeover by QCOM for $127.5 per share. It is trading around $115 i.e. ~$12.5 spread implying almost 11% absolute return. The timing is somewhat difficult to pin down because the gatekeeping item here is MOFCOM, the Chinese antitrust authority, notorious for its lax attitude towards its own deadlines, let alone those of the merging companies. Still, between the formal expiration of the MOFCOM review on April 17, and the formal merger termination date April 25, we may be truly in the “any day now” mode, and it’s possible that the deal will close (or break) within a week. We will therefore keep this write-up relatively short, as we try to get it out before it loses relevance.

There are two main reasons for why the spread is so wide.

1.      1. With MOFCOM being the last approval (8 other antitrust approvals have been granted), the prospect of trade war with China, and the escalating war of words between the White House and Beijing, introduced an additional risk, and certainly a lot of anxiety. China may decide to be creative, the logic goes, in its retaliation tactics vs US protectionist policies, and use MOFCOM to block the QCOM/NXPI deal. In this context many analysts also bring up the recent AVGO’s attempt to buy QCOM, which was preemptively blocked by the CFIUS in a rather dramatic and unprecedented way.

We think that blocking the QCOM/NXPI deal does not make much sense as a retaliation tool from China’s perspective. It really does not address any of the tariff issues, nor is it likely to injure any of the industries this administration is trying to protect / prop up. Blocking the deal as a response to the earlier CFIUS action also makes little sense. CFIUS blocked AVGO’s overture based on the US security concerns.  If anything, allowing QCOM/NXPI deal to proceed potentially presents China with access to technologies it otherwise wouldn’t have access to. And moreover, the CFIUS-derailed AVGO’s bid for QCOM was likely viewed as unfavorably by the Chinese as it was by the US. Though in this case it was due to the potentially giant AVGO/QCOMs probable negative effects on Chinese customers, rather than any security risks.

A possible (though highly unlikely in our opinion) risk is that in exchange for its approval, China will demand a divestiture or technology transfer which could create a new issue for the US regulators from the security standpoint, and require an additional review. We think that the Chinese regulators, conscious of their US counterpart’s current protectionist sensitivities, are likely to be thoughtful here, given China’s ultimate interests in preserving access to QCOM.

This, and some of the more recent positive statements coming from the Chinese president, seemingly aiming to deescalate the situation, make us think that the risk of politically motivated MOFCOM block is overblown.

Are there objective unsolvable antitrust issues from China’s perspective? Not really. Just like the other 8 jurisdictions (including US, EU, Japan, S. Korea etc..) Chinese antitrust authorities aren’t likely to find any irreparable anticompetitive problems. Even taking into account the strategic importance of semiconductor industry for China, and the fact that 53% and 41% of QCOM’s and NXP’s revenues are derived from China.

In short, there is little direct overlap between the two companies, but QCOM and NXPI are dominant players in their respective markets (mobile and automotive). That, and the combined entity’s significant IP portfolio will make Mofcom, similarly to their EU and US colleagues, focus on the potential to a) increase royalties to customers and b) exclude competitors in the NFC (Near Field Communications) solutions area. If NXPI can restrict other chipmakers’ access to its proprietary MIFARE technology it would be able to exclude other suppliers from the already concentrated NFC chips market, where it holds 55% share. The likely solution here would be a commitment on the part of the combined entity to friendly licensing practices, particularly around MIFARE. There is nothing prohibitive about structuring such remedies from QCOM’s perspective though working out specific terms of such behavioral remedies will require intensive and time-consuming negotiations. Given the importance of this deal for QCOM and its successful track record of negotiatiing with MOFCOM we think finding a satisfactory solution here is a question of WHEN rather than IF.

The other area of concern is the vehicle/V2X (Vehicle-to-Everything, as in, pedestrians, infrastructure, network, etc.) solutions. The companies do compete in vehicle communications technologies, and again the concern is that the new company will be able to restrict other chip-makers from accessing the V2X technology. However as this market is still emerging, structuring behavioral remedies around V2X would require the regulators to make many assumptions about the future, and is unlikely to be something that could stop the transaction at this stage.

We are happy to address any further antitrust questions in the comments section, but as we discuss below, we think the wide spread is due more to the peculiarities of the US risk arb world, than to those of the Chinese antitrust process.

The most recent drop in the stock was driven by a story that with the MOFCOM deadline coming up on April 17, QCOM has been unable to schedule a meeting with the regulator. This, after a recent report of MOFCOM being dissatisfied with the remedies offered by QCOM so far. (These are likely to deal with licensing terms to local companies, commitments to refrain from patent legal action, and interoperability commitments with NXP products - all reasonably addressable concerns, as demonstrated by the recently satisfied EU regulators.) Understandably, local companies are lobbying MOFCOM to make life difficult for QCOM.

 Again, given the importance of the deal for QCOM’s stand-alone strategy (note the raised bid from $110) after it fought off AVGO bid, and its history of successfully navigating Chinese regulatory concerns (e.g. it took QCOM’s 10 months of MOFCOM review to close the CSR deal a couple of years ago), we feel QCOM can and will structure satisfactory concessions.

As for the tough time QCOM is having arranging MOFCOM meetings, it is likely due to China’s concurrently ongoing annual parliament meeting. (In the meantime, for what it’s worth, QCOM’s CEO did manage to meet the head of China’s top internet regulator, the Cyberspace Administration, Xu Lin, in the last couple of weeks. Xu Lin is also in charge of the Central Leading Group for Cyberspace Affairs – a separate agency reporting directly to the Chinese President http://www.cac.gov.cn/2018-03/30/c_1122617187.htm )

So why is the spread really so wide?

  2. The stock is primarily held by arb funds who are living through one of the toughest, most frustrating years in recent memory. Half a dozen high-confidence, widely held deals broke recently or got derailed. Traumatized by these shocks and unable to assess risks in many high profile deals the arbs are in defensive mode. This lack of confidence was evidenced recently by the gyrations of the MON spread. After trading too tightly in the face of the remaining unresolved regulatory uncertainty and headline risks, the market hugely overshot in its reaction to the unexpected but manageable regulatory concerns, and drove the spread unreasonably wide. This, only to collapse it again just a few days later, as these concerns were alleviated. Before the good news the market was implying less than 50% chance of the MON/Bayer deal completion, seemingly oblivious to the pretty obvious solutions to the regulator’s concerns, and ignoring strong fundamentals of MON. Many other deals in the arb world have been trading at the widest levels seen in years, showing the minimal risk tolerance on the part of the arbs.

Those arb shops that may retain some healthy risk appetite, and that are still able to assess the risk-reward objectively,  are likely to be full on this positon, as the NXPI deal has been out since September of 2016 and is one of the more liquid and interesting deals.  Therefore finding a marginal arb player able to drive the spread tighter with fresh capital is not easy.

What about the downside if he deal is indeed blocked?

Since the deal was announced, NXPI’s peer group (high end analog/MCU) is up about 50% whereas NXP is up just over 40%. Though trading at a premium to its historical 14x NTM PE, it is also cheaper than the peer group (~16x vs 18x), This is probably fair, given NXPI’s lower gross margins (54% vs 66%). Assuming consensus 2018 EPS of $7.37, 16x gets us to $117 while 15x and 14x PEs imply $110 and $103.

In addition, NXPI will be getting $2bn break-up fee from QCOM which, together with its $3.5bn cash, is likely to be used for buybacks, raising the figures above by another couple of bucks.

It seems that even at the most conservative downside scenario, the market, much like in the MON case above, implies a higher than 50% chance of failure. Assuming a more reasonable downside number, like $110, current spread seems even more irrational, and risk-reward of the long position all that more compelling.

We are aware of CITI’s note earlier today estimating the break-up downside to be $90. This is based on their uber-conservative 2019 EPS estimate, 7% below consensus. While the initial arbs’ unwinding can certainly drive the price below our estimate, we feel it’s fairer to apply a conservative multiple 14x to the consensus EPS as we try to assess where the market will settle in the break-up scenario. Assuming this $90 value, the market implies 33% of a break, which we feel is still very conservative considering all the things we discussed above

Catalyst

MOFCOM approval